Competitive Market Equilibrium

Market equilibrium occurs where the quantity demanded equals the quantity supplied (Qd = Qs). The price at this point is the equilibrium price (P)* and the quantity is the *equilibrium quantity (Q)**.

At P > P* (above equilibrium):

• Qs > Qd → surplus (excess supply).
• Producers cut prices to clear stock → price falls toward P*.

At P < P* (below equilibrium):

• Qd > Qs → shortage (excess demand).
• Consumers bid up prices to secure scarce goods → price rises toward P*.

The price mechanism performs three functions:

• Signalling — prices tell producers what to make more of (rising prices) or less of.
• Incentive — high prices reward producers; low prices encourage consumers.
• Rationing — those willing and able to pay get the good.

This is Smith's "invisible hand" — coordination without central direction.

Consumer surplus (CS) = the difference between the maximum price consumers are willing to pay and the actual price they pay. Graphically, the triangle ABOVE the equilibrium price and BELOW the demand curve, up to Q*.

Producer surplus (PS) = the difference between the actual price producers receive and the minimum price they would accept. Graphically, the triangle BELOW the equilibrium price and ABOVE the supply curve, up to Q*.

Total welfare = CS + PS (also called social surplus or economic surplus).

Calculating surplus. If D and S are linear:

• CS = ½ × Q* × (P_max − P*) where P_max is where D hits the price axis.
• PS = ½ × Q* × (P* − P_min) where P_min is where S hits the price axis.

Allocative efficiency is achieved when:

• Resources are allocated to produce the goods consumers want most.
• At the equilibrium quantity, Marginal Benefit (MB) = Marginal Cost (MC).
• Total welfare (CS + PS) is MAXIMISED.

Any other quantity (lower or higher) reduces total welfare.

Why this matters. Competitive markets, in theory, achieve allocative efficiency automatically — no central planner needed. This is the standard against which market failures (next subtopic) are measured.

Caveat (key concepts: equity). Allocative efficiency doesn't say anything about FAIRNESS. A market can be efficient AND highly unequal — the rich consume more because they can afford to bid more. This is the tension between efficiency and equity.