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Understanding Markets
Equilibrium
Determining a Competitive Equilibrium
Page 1 of 2
In this lecture we put together our previous analysis about supply and demand to come up with a model of the market.
And the payoff is we have a way of predicting how factors in the environment will influence the price of a good and the
quantity of that good traded. We’re going to be developing a tool that economists use called the competitive
equilibrium.
The competitive equilibrium is what happens when you get together a bunch of buyers and sellers, all of whom believe
that they have no influence over the price. That is, all of the agents in our market are price takers. They accept the
market price as given and do the best they can subject to that price as a constraint. So the buyers take the price as
given and choose their quantity demanded. The sellers take the price as given and choose their quantity supplied.
When the price is such that the quantity supplied is equal to the quantity demanded we say that we have a
competitive equilibrium.
Now first we should define the concept of equilibrium in Economics. An equilibrium is a situation from which there is
no tendency to change. And as we will see in our model of supply and demand, there is only one price at which there
is no pressure for something to change. Let’s go back to the analysis that we developed earlier. The red dots in this
diagram represent quantities demanded at different prices. This information comes from the table that’s over on the
board. At a price of $5.00 the quantity demanded is one loaf of bread per week. At a price of $4.00 per loaf the
quantity demanded is two loaves per week, and so forth, giving us this collection of red dots.
We can collect these red dots and form the demand curve. But we’re going to wait to do that for just a moment,
because I think that leaving this in the form of dots will help me make my argument more clearly. The blue dots
represent the supply curve. That is, at a price of 40 cents per loaf we get one loaf of bread supplied per week, two
loaves at 60 cents, three loaves at $1.00, and so forth. The blue dots represent the supply curve.
Now, we’ve got these price taking buyers and price taking sellers. All of them are doing the best they can subject to
the price that they are given by the market. Let’s find now the price at which an equilibrium obtains. Suppose, first of
all, that we consider a price of $1.00 a loaf for bread. What would happen in that case? Well, with a price of $1.00
per loaf for bread there are three loaves the bakers are willing and able to supply each week. The quantity supplied is
three at a price of $1.00. At a price of $1.00 the quantity demanded, however, is eight loaves per week. That is,
buyers are willing and able to purchase eight loaves of bread at a price of $1.00.
The fact that there are more buyers than sellers, or the quantity demanded is greater than the quantity supplied at a
price of $1.00, means that we have excess demand. We have excess demand, which is the difference between the
quantity demanded and the quantity supplied at the price of $1.00. I’ll label this with a little sign that says “excess
demand.” Now when there is excess demand the bidding mechanism takes over. The bidding mechanism is the
process by which unsatisfied buyers try to bid up the price of bread to guarantee that they get some. After all, we’ve
got eight loaves of bread demanded here and only three loaves of bread supplied. We’ve got five loaves of bread
excess demand. That could be five people who aren’t able to buy their loaf of bread at a price of $1.00 per loaf.
Those five people are now going to offer sellers a higher price. They’re going to bid the price of bread up to $1.10 or
$1.20 or $1.50 or $2.00 a loaf. They’ll continue bidding until either it’s no longer worth it to bid higher prices or until
enough bread becomes available that the shortage of bread is eliminated. Look, if the price of bread goes up to a
$1.50 per loaf the quantity supplied increases to four loaves. Some baker has a reservation price of $1.50. That is,
he offers his loaf of bread for sale as soon as the price goes up to $1.50. At the same time, when the price goes up to
$1.50 we have one of the buyers drop out. That is, there was one buyer who was willing to pay $1.00 but not $1.50.
So the excess demand shrinks as the price rises, because additional sellers enter the market and some of the buyers
drop out of the market. Finally, when the price of bread rises all the way up to $2.10 a loaf, the quantity supplied is
equal to the quantity demanded. Enough buyers have left the market and enough sellers have entered the market to
give us an equality of quantity demanded and quantity supplied. At a price of $2.10 per loaf the quantity demanded
equals five loaves of bread per week. And the quantity supplied equals five loaves of bread per week. This means
that we have a competitive equilibrium. Taking prices as given the quantity demanded by buyers and the quantity
supplied by sellers are equal at a price of $2.10 per loaf. And we get there by the bidding mechanism.
Buyers who can’t get bread at the lower price will bid up the price and as buyers and sellers respond to the rise in
price, an equilibrium is established. The excess demand is eliminated as the quantity demanded falls and the quantity
Understanding Markets
Equilibrium
Determining a Competitive Equilibrium
Page 2 of 2
supplied increases with the rise in price. Now, you can see the same analysis working from the other direction.
Suppose we start with a high price for bread. Suppose $4.00 a loaf. What would happen in that case?
At a price of $4.00 per loaf the quantity demanded is going to be smaller, that is, two loaves of bread per week.
Because the price of bread is high the quantity demand would be much smaller. However bakers are very excited
about this high price and the quantity supplied is quite high because a lot of bakers can cover their opportunity cost at
that higher price and there’s a larger quantity supplied at $4.00 per loaf. That quantity in our example is eight loaves
of bread per week. Well, there you’ve got a problem, because we’ve got an excess supply. That is, the quantity
supplied is eight loaves at $4.00 per loaf and the quantity demanded is two loaves at $4.00 per loaf.
We have an excess supply of six loaves of bread every week. Bread piles up un-purchased on the shelves. What’s
going to happen in that case? The bidding mechanism will operate from the other direction. In this case sellers who
are unable to move bread from their shelves will begin to put the bread on sale. They will lower their price. Some
sellers will offer their bread for $3.50 a loaf or $3.00 or $2.75, and the price will begin to fall. As competition from the
bidding mechanism pushes down the price of bread two things happen.
First, additional buyers will enter the market. Notice when the price drops to $3.00 a loaf you can then sell three
loaves of bread because three people are willing and able to purchase bread at that price. As the price drops down to
$2.50 a loaf the quantity demanded increases to four loaves of bread and so forth. So additional buyers enter the
market as the price falls. As the price falls from the supplier’s perspective things are getting less attractive. So at a
price of $3.00 per loaf you find that a seller or two may have left the market and your quantity supplied is down to
seven loaves of bread. And at a price of $2.50 per loaf the quantity supplied drops even further to six loaves of bread.
Finally, when the price is $2.10 per loaf, the quantity demanded is equal to the quantity supplied and the excess
supply has been eliminated. Partly by bringing additional buyers into the market and partly by reducing some of the
over-supply by pushing some of the sellers out of the market, sellers who can’t cover their opportunity costs as the
price of bread falls. Well, what’s the outcome?
The outcome is we wind up with a stable situation. The price of bread is set at $2.10 per loaf. We call that the
equilibrium price. Since the quantity supplied and the quantity demanded are equal and they are both equal to five
loaves at that price of $2.10, the bidding mechanism is going to just sit there and do nothing. There is no tendency for
prices to change. There’s no excess demand, so prices don’t rise. There’s no excess supply, so price won’t fall.
When quantity supplied and quantity demanded are equal we’re in a stable situation, a competitive equilibrium.
So when the price is $2.10 the quantity of bread traded will be equal to five loaves of bread per week. We can label
this P*, $2.10, that’s the price at which supply and demand are equal and we can label this Q*, the quantity of bread
that’s traded at a price of $2.10. So there you have it, the stable outcome, the competitive equilibrium. The bidding
mechanism takes us to the point where the quantity supplied and the quantity demanded are equal. And once we
reach that point, there is no further tendency to change.
In the next lecture we’ll look at factors that can shift the supply and demand curve, upset this equilibrium and lead to a
new equilibrium. But first let’s connect the dots and make this picture look like something that we might be more
familiar with. Connect these dots and they become the demand curve. Connect the blue dots, that is, allowing prices
and quantity to vary continuously and we get a supply curve. The competitive equilibrium is found at the place where
the supply curve and the demand curve intercept. As in most economic graphs, the most interesting point is where
the curves cross and it’s where the curves cross that we find the price and quantity where supply and demand are
equal. And when quantity supplied and quantity demanded are equal at a particular price there is no further tendency
to change. This is what a competitive equilibrium looks like. And usually we will mark the price and quantity with lines
down to the axis to show us the price and quantity at which the market has a stable outcome.