You undoubtedly know the importance of supply and demand in understanding business principles. This is the crux of any economic system. Consumers' demand for goods and services must be supplied sufficiently, and this demand drives producers' actions regarding how much of their product to make and how to tailor it to the markets they serve. Equilibrium price is the price at which a product or service's demand is adequately met. At this price point, there is enough of the product or service to supply all those who want to buy it without there being any left over.
Understanding a product or service's equilibrium price is important because this is the point at which its price stays stable. When demand outpaces supply, there is a shortage of the product. This drives its price up. When there is not enough demand to meet the available supply, prices drop. This is known as a surplus. In either scenario, the producer can lose money and cease to be competitive.
Equilibrium Price Formula
Using Chewy Bits dog treats as an example, we can start the process of finding the equilibrium price by solving:
- Quantity supplied = 100 + 150 x Price
- Quantity demanded = 500 - 50 x Price
Then, set the equations as equal to each other and solve for P. This is the price per box.
- 100 + 150 x Price = 500 - 50 x Price
- 200(Price) = 400
P = $2.00 per box
You now have the price per box, but you need to determine the equilibrium price for this product. Here is how to find that:
Qs = 100 + 150 x Price = 100 + 150 x $2.00 = 400 boxes
Qd = 500 - 50 x Price = 500 - 50 x $2.00 = 400 boxes
For Chewy Bits dog treats, the supply and demand reach equilibrium when supply equals demand of 400 boxes at the equilibrium price of $2.00 per box. Sales revenue equals 400 boxes times $2.00 per box, or $800.
Effect of a Change in Demand
Consumers' demand for a product rarely stays the same over time. This changes the product's equilibrium price. It does not, however, change the supply equation. When demand for a product decreases, the first step in determining its new equilibrium price is solving:
Qs = 100 + 150 x Price
Then, a different formula is applied to find its new demand figure. This formula is:
Qd = 350 - 50 x Price
To find the equilibrium price, set these equations as equal and solve for P:
100 + 150 X Price = 350 - 50 X Price
200 Price = 250
Price = $1.25 per box
At this new price, the equilibrium demand is 288 boxes: Qd = 350 - 50 x $1.25 = 288 boxes. Now, equilibrium sales revenue is $1.25 times 288 boxes, or $360.
Effect of a Change in Supply
When a product experiences a change in supply rather than a change in demand level, the supply formula is the formula that needs to be switched to determine the product's new equilibrium price. This formula is:
Qs = 200 + 150 x Price
Just like before, solve:
200 + 150 x Price = 500 - 50 x Price
200 Price = 300
Price = $1.50
Qd = 500 - 50 x $1.50 = 425 boxes
Qs = 200 + 150 x $1.50 = 425 boxes
Increasing the supply resulted in a reduced revenue in this case because at the new equilibrium price of $1.50 per box and an equilibrium quantity of 425 boxes, the sales revenue is $531.
Understanding all the economic forces at play in this market and beyond is a crucial part of making the executive decisions that lead to profitability and growth. Some forces are within a manufacturer's control, like how many unique products it introduces to the market and how its products compare to its competitors' products in quality. Others, like changing consumer tastes and recessions, are beyond their control. All factors, those within and those beyond a manufacturer's control, must be considered carefully before increasing or decreasing a product's supply or price.
- Boston University Department of Economics: Lecture 6: Market Equilibrium, Demand and Supply Shifts
- Lewis University Faculty Forum: Gasoline Price Economics
- University of Southern California, Ergin Bayrak: Using Supply and Demand to Analyze Markets
- University of Hawaii UH Pressbooks: Changes in Equilibrium Price and Quantity: The Four-Step Process
- Huw David Dixon. "Surfing Economics," Page 3. Red Globe Press, 2001.
- Paul A. Samuelson. "Foundations of Economic Analysis." Harvard University Press, 1983.
Lindsay Kramer has been a full-time writer since 2014. In that time, she's experienced the ups, downs and crazy twists life tends to take when you're launching, building and leading a small business. As a small business owner, her favorite aspect about writing in this field is helping other small business owners and aspiring entrepreneurs become more fluent in the terminology and concepts they face in this role. Previously, she's written on entrepreneurship for 99designs and covered business law topics for law firms.