Syllabus points
- Explain how equilibrium price and quantity are determined.
- Explain how markets clear shortages and surpluses through the price mechanism.
- Analyse the effects of demand and supply shifts on equilibrium.
- Explain allocative efficiency and the role of the price mechanism (signalling, incentive, rationing).
Market equilibrium
Equilibrium occurs where the demand and supply curves intersect: the price at which planned quantity demanded equals planned quantity supplied. At this market-clearing price there is no tendency to change.
- Above equilibrium: quantity supplied exceeds quantity demanded — a surplus. Firms cut price to sell stock, so price falls back to equilibrium.
- Below equilibrium: quantity demanded exceeds quantity supplied — a shortage. Consumers bid the price up, so price rises back to equilibrium.
Key definitions
| Term | Exam-ready definition |
|---|---|
| Equilibrium | The price and quantity where quantity demanded equals quantity supplied. |
| Surplus | Excess supply at prices above equilibrium. |
| Shortage | Excess demand at prices below equilibrium. |
| Price mechanism | The way prices signal, ration and incentivise to allocate resources. |
The functions of the price mechanism
Prices allocate resources in a market economy through three roles:
- Signalling — prices convey information about relative scarcity and demand.
- Incentive — a higher price rewards producers for supplying more.
- Rationing — a higher price discourages some consumption when a good is scarce.
Rising demand → higher price → signals scarcity → incentivises more supply → rations demand → resources reallocated to that market.
Shifts and the new equilibrium
To analyse any event, decide whether it shifts demand, supply, or both, then read off the new equilibrium:
- Demand rises (curve right) → higher price, higher quantity.
- Supply rises (curve right) → lower price, higher quantity.
- Both shift → the price or quantity effect can be ambiguous depending on relative sizes.
Worked example
A poor harvest reduces the supply of coffee (supply shifts left). At the old price a shortage appears; the price rises, rationing the smaller quantity to consumers most willing and able to pay while signalling growers to supply more next season. Equilibrium settles at a higher price and lower quantity.
Common exam mistakes
- Confusing a surplus/shortage (a disequilibrium at a *given* price) with a shift.
- Forgetting to relabel the new equilibrium price and quantity on the diagram.
- Ignoring the price mechanism's role when explaining reallocation.
Exam technique
For "analyse the effect of…" questions: identify the curve that shifts and why, draw and label the shift, then state the direction of change in price *and* quantity. For evaluation, comment on the size of the shift and elasticity.
Quick revision
- Equilibrium = where D meets S; surpluses and shortages self-correct via price.
- Price mechanism: signal, incentive, ration.
- D right → P↑ Q↑; S right → P↓ Q↑.