In a perfectly competitive market, market equilibrium is reached when the plans of all consumers and firms match, clearing the market. At this point, the aggregate quantity demanded equals the aggregate quantity supplied.
When the market is not in equilibrium, price adjustments occur to clear the market. This self-correcting mechanism is historically referred to as the Invisible Hand. If there is excess demand, competition among buyers pushes prices up. If there is excess supply, competition among sellers pushes prices down.
Under the assumption of a fixed number of firms, equilibrium is determined at the intersection of the market demand and market supply curves.
Consider a market where demand and supply curves are given by:
$$q^D = 200 - p$$
$$q^S = 120 + p$$
Equating demand and supply to find the equilibrium price ($p^*$):
$$200 - p^* = 120 + p^* \implies 2p^* = 80 \implies p^* = 40$$
Substituting $p^* = 40$ back into either equation yields the equilibrium quantity ($q^*$):
$$q^* = 200 - 40 = 160$$
The theory of wage determination applies demand-supply analysis to the labour market, where households supply labour and firms demand it.
Changes in consumer preferences, incomes, technology, or input prices shift the demand or supply curves, altering the equilibrium price and quantity.
When both curves shift simultaneously, the net effect on equilibrium price and quantity depends on the direction and magnitude of the shifts:
| Shift in Demand | Shift in Supply | Quantity Impact | Price Impact |
|---|---|---|---|
| Leftward | Leftward | Decreases | May increase, decrease, or remain unchanged |
| Rightward | Rightward | Increases | May increase, decrease, or remain unchanged |
| Leftward | Rightward | May increase, decrease, or remain unchanged | Decreases |
| Rightward | Leftward | May increase, decrease, or remain unchanged | Increases |
When firms can freely enter and exit the market, the long-run equilibrium price is determined solely by the minimum average cost of production.
With free entry and exit, a shift in demand has no impact on the equilibrium price, which remains anchored at $p = \text{min } AC$. Instead, it only changes the equilibrium quantity and the number of active firms in the market.
A Price Ceiling is a government-imposed maximum limit on the price of a good or service, typically set below the market-determined equilibrium price to protect consumers of essential goods (e.g., wheat, sugar).
A Price Floor is a government-imposed minimum limit on the price of a good or service, typically set above the equilibrium price (e.g., agricultural price support, minimum wage legislation).