Figure

Surplus, Shortage, and Market Equilibrium

At an industry average price of \$27,000, excess supply creates a surplus of 5 million units exerting downward pressure on both price and output levels. Similarly, excess demand at a price of \$23,000 creates a shortage of 5 million units and upward pressure on both prices and output. Market equilibrium is achieved when demand equals supply at a price of \$25,000 and quantity of 8 million units.

Average price per auto (\$ thousands)

Average price per auto (\$ thousands)

Quantity of new automobiles (millions)

market equilibrium price

Market clearing price

The quantity supplied at an industry average price of \$27,000 is derived from the market supply curve, Equation 4.9, which indicates that QS = -42,000,000 + 2,000(\$27,000) = 12 million cars. At an average automobile price of \$27,000, the quantity supplied greatly exceeds the quantity demanded. This difference of 5 million cars per year (= 12 - 7) constitutes a surplus.

An automobile surplus results in a near-term buildup in inventories and downward pressure on market prices and production. This is typical for a market with a surplus of product. Prices tend to decline as firms recognize that consumers are unwilling to purchase the quantity of product available at prevailing prices. Similarly, producers cut back on production as inventories build up and prices soften, reducing the quantity of product supplied in future periods. The automobile industry uses rebate programs and dealer-subsidized low-interest-rate financing on new cars to effectively combat the problem of periodic surplus automobile production.

A different type of market imbalance is also illustrated in Figure 4.5. At an average price for new domestic cars of \$23,000, the quantity demanded rises to 9 million cars, QD = 20,500,000 - 500(\$23,000) = 9 million. At the same time, the quantity supplied falls to 4 million units, QS = -42,000,000 + 2,000(\$23,000) = 4 million. This difference of 5 million cars per year (= 9 - 4) constitutes a shortage. Shortage, or excess demand, reflects the fact that, given the current productive capability of the industry (including technology, input prices, and so on), producers cannot profitably supply more than 4 million units of output per year at an average price of \$23,000, despite buyer demand for more output.

Shortages exert a powerful upward force on both market prices and output levels. In this example, the demand curve indicates that with only 4 million automobiles supplied, buyers would be willing to pay an industry average price of \$33,000 [= \$41,000 - \$0.002(4,000,000)]. Consumers would bid against one another for the limited supply of automobiles and cause prices to rise. The resulting increase in price would motivate manufacturers to increase production while reducing the number of buyers willing and able to purchase cars. The resulting increase in the quantity supplied and reduction in quantity demanded work together to eventually eliminate the shortage.

The market situation at a price of \$25,000 and a quantity of 8 million automobiles per year is displayed graphically as a balance between the quantity demanded and the quantity supplied. This is a condition of market equilibrium. There is no tendency for change in either price or quantity at a price of \$25,000 and a quantity of 8 million units. The graph shows that any price above \$25,000 results in surplus production. Prices in this range create excess supply, a buildup in inventories, and pressure for an eventual decline in prices to the \$25,000 equilibrium level. At prices below \$25,000, shortage occurs, which creates pressure for price increases. With prices moving up, producers are willing to supply more product and the quantity demanded declines, thus reducing the shortage.

Only a market price of \$25,000 brings the quantity demanded and the quantity supplied into perfect balance. This price is referred to as the market equilibrium price, or the market clearing price, because it just clears the market of all supplied product. Table 4.3 shows the surplus of quantity supplied at prices above the market equilibrium price and the shortage that results at prices below the market equilibrium price.

In short, surplus describes an excess in the quantity supplied over the quantity demanded at a given market price. A surplus results in downward pressure on both market prices and industry output. Shortage describes an excess in the quantity demanded over the quantity supplied at a given market price. A shortage results in upward pressure on both market prices and industry output. Market equilibrium describes a condition of perfect balance in the quantity demanded and the quantity supplied at a given price. In equilibrium, there is no tendency for change in either price or quantity.