Equilibrium, Excess Demand, Excess Supply

Equilibrium in a Perfectly Competitive Market

A perfectly competitive market brings together buyers and sellers, each pursuing their own self-interest. Consumers aim to maximise their satisfaction (or utility), while firms aim to maximise their profits. These two sets of objectives become compatible only when the market reaches a state of equilibrium.

Equilibrium is defined as a situation where the plans of all consumers and all firms in the market match exactly, and the market "clears." In other words, at equilibrium, the total quantity that all firms wish to sell equals the total quantity that all consumers wish to buy. This means market supply equals market demand.

The price at which this balance occurs is called the equilibrium price (denoted as $p^*$). The quantity that is bought and sold at this price is called the equilibrium quantity (denoted as $q^*$).

Excess Demand and Excess Supply

The market is not always in equilibrium. When the price is different from $p^*$, a mismatch occurs between what buyers want and what sellers offer.

• Excess Demand: If at a given price, the quantity demanded by consumers exceeds the quantity supplied by firms, we say there is excess demand in the market. In this situation, buyers cannot buy as much as they want at the prevailing price.
• Excess Supply: If at a given price, the quantity supplied by firms exceeds the quantity demanded by consumers, we say there is excess supply in the market. Here, sellers cannot sell all they have produced at the prevailing price.

Therefore, equilibrium can be defined alternatively as a situation of zero excess demand and zero excess supply.

The "Invisible Hand" and Out-of-Equilibrium Behaviour

Whenever the market is not in equilibrium — meaning there is either excess demand or excess supply — there is a natural tendency for the price to change. The classic account of why is the idea of an "Invisible Hand," set out in the box below.