# Competitive market equilibrium

> IB Economics Higher Level · Microeconomics Unit 2
> Source: https://www.owlsprep.com/study/ib-economics-hl-u2-competitive-market-equilibrium/

This sub-topic explains how supply and demand interact to set price and quantity in perfectly competitive markets. You will learn how markets adjust to disequilibrium and analyze the impact of shifts in market conditions on outcomes.

**Prerequisites:** [Supply and demand curves and their determinants](https://www.owlsprep.com/study/ib-economics-hl-u2-supply-and-demand/)

## Learning objectives

- Define competitive market equilibrium and disequilibrium
- Distinguish between excess supply and excess demand
- Explain how the price mechanism adjusts markets to equilibrium
- Calculate equilibrium price and quantity from linear functions
- Analyze the effects of supply/demand shifts on equilibrium outcomes

## Defining Competitive Market Equilibrium

**Competitive Market Equilibrium** — A state in a perfectly competitive market where quantity demanded by consumers equals quantity supplied by producers. There is no inherent tendency for price or quantity to change from this point.

*Notation:* Equilibrium price = $P_e$, Equilibrium quantity = $Q_e$

*Example:* At $5 per coffee, 1000 coffees are demanded and 1000 are supplied, so the market clears at equilibrium.

At equilibrium, the market clears: there is no unsold stock and no unmet consumer demand. For linear supply and demand functions, we can solve for equilibrium algebraically.

**Worked example:** Given the demand function $Q_d = 100 - 2P$ and supply function $Q_s = 20 + 2P$, calculate equilibrium price and quantity.

1. Step 1: At equilibrium, quantity demanded equals quantity supplied, so set the functions equal:
2. $$100 - 2P = 20 + 2P$$
3. Step 2: Rearrange to solve for equilibrium price $P_e$:
4. $$100 - 20 = 2P + 2P \implies 80 = 4P \implies P_e = 20$$
5. Step 3: Substitute $P_e$ back into either function to get equilibrium quantity $Q_e$:
6. $$Q_e = 100 - 2(20) = 60 \quad \text{Check: } Q_s = 20 + 2(20) = 60$$
7. Conclusion: Equilibrium price is 20, equilibrium quantity is 60.

## Disequilibrium: Excess Demand and Excess Supply

**Disequilibrium** — Any state where quantity demanded does not equal quantity supplied, leading to pressure on price to adjust towards equilibrium.

Disequilibrium occurs when the market price is not equal to $P_e$. There are two types of disequilibrium:

- **Excess demand (shortage):** Price is below $P_e$, so $Q_d > Q_s$
- **Excess supply (surplus):** Price is above $P_e$, so $Q_s > Q_d$

**Worked example:** Using the previous functions ($Q_d = 100 - 2P$, $Q_s = 20 + 2P$, $P_e = 20$), identify what type of disequilibrium exists at $P = 15$.

1. Step 1: Calculate $Q_d$ and $Q_s$ at $P = 15$:
2. $$Q_d = 100 - 2(15) = 70, \quad Q_s = 20 + 2(15) = 50$$
3. Step 2: Compare the values:
4. Since $Q_d (70) > Q_s (50)$, this is excess demand (a shortage) of $70 - 50 = 20$ units.
5. Step 3: Explain the adjustment: Competition between consumers who cannot buy the good will push price up towards $P_e$. As price rises, quantity demanded falls and quantity supplied rises until equilibrium is restored.

> **tip**
>
> On a supply-demand diagram, excess demand is the horizontal gap between the demand and supply curves below $P_e$. Excess supply is the gap above $P_e$.

## Adjustment to Equilibrium: The Price Mechanism

The price mechanism (often called the 'invisible hand') is the automatic process by which prices adjust to eliminate disequilibrium in competitive markets. When supply or demand shifts due to changes in non-price determinants, the market moves from an old equilibrium to a new equilibrium.

**Worked example:** The apple market is initially at equilibrium. A drought destroys one third of the apple crop. Explain how the market adjusts to a new equilibrium.

1. Step 1: Identify the shift: The drought reduces supply at every price, shifting the entire supply curve to the left. Demand remains unchanged.
2. Step 2: Disequilibrium at original price: At the original equilibrium price $P_e$, quantity supplied after the shift is now less than quantity demanded, creating excess demand.
3. Step 3: Price adjustment: Competition between consumers who cannot get apples pushes the market price up.
4. Step 4: New equilibrium: As price rises, quantity demanded contracts along the fixed demand curve until a new equilibrium is reached. The new equilibrium has a higher price and lower quantity than the original equilibrium.

**Check your understanding**

Test your understanding of shift effects:

1. If consumer income increases and the good is normal, what happens to equilibrium price and quantity?

   - A. Price falls, quantity falls
   - B. Price rises, quantity falls
   - C. Price rises, quantity rises
   - D. Price falls, quantity rises

   *Why:* An increase in income for a normal good shifts the demand curve right. At the original price, excess demand pushes price up, leading to a higher equilibrium quantity.

## Comparative Statics for Shifts

Comparative statics is the process of comparing the original equilibrium to the new equilibrium after a shift in supply or demand. This is a common exam skill, both for diagram analysis and algebraic calculation.

**Worked example:** Original functions: $Q_d = 200 - 4P$, $Q_s = 50 + P$. Demand increases by 30 units at every price. Calculate the new equilibrium price and quantity.

1. Step 1: Write the new demand function: A 30 unit increase in demand at every price means add 30 to $Q_d$:
2. $$Q_d' = (200 - 4P) + 30 = 230 - 4P$$
3. Step 2: Set new demand equal to supply to find new $P_e$:
4. $$230 - 4P = 50 + P \implies 180 = 5P \implies P_e^{new} = 36$$
5. Step 3: Calculate new equilibrium quantity:
6. $$Q_e^{new} = 50 + 36 = 86$$
7. Step 4: Compare to original equilibrium: Original equilibrium was $P_e = 30$, $Q_e = 80$. A rightward demand shift increases both equilibrium price and quantity, matching theoretical predictions.

## Common pitfalls

- **Wrong:** Confusing shifts of the curve with movements along the curve during disequilibrium adjustment
  - Why it fails: When price changes to eliminate disequilibrium, this is a movement along the existing curve, not a shift of the whole curve
  - Correct: Only changes in non-price determinants of supply or demand shift the entire curve
- **Wrong:** Assuming excess demand is always caused by a rightward shift of demand
  - Why it fails: Excess demand can occur even if demand is unchanged, for example if price is fixed below equilibrium
  - Correct: Always check the source of disequilibrium before concluding a curve has shifted
- **Wrong:** When calculating new equilibrium after a quantity shift, adjusting the price term instead of the quantity term in the function
  - Why it fails: Shifts are almost always given as a change in quantity at every price, so the quantity term must be adjusted
  - Correct: If supply increases by 20 units at every price, add 20 to $Q_s$, not to P, in the supply function
- **Wrong:** Predicting lower price after a leftward shift of supply
  - Why it fails: A leftward supply shift creates excess demand at the original price, which pushes price up, not down
  - Correct: Left shift of supply: higher P, lower Q; Right shift of supply: lower P, higher Q
- **Wrong:** Describing equilibrium as a permanent fixed point that never changes
  - Why it fails: Equilibrium is just the current resting point of the market; it changes whenever supply or demand determinants change
  - Correct: Equilibrium is a dynamic state that adjusts to changing market conditions

## Cheatsheet

| Change in Market Conditions | Effect on Equilibrium Price | Effect on Equilibrium Quantity |
| --- | --- | --- |
| Demand shifts right | Increase | Increase |
| Demand shifts left | Decrease | Decrease |
| Supply shifts right | Decrease | Increase |
| Supply shifts left | Increase | Decrease |
| Price < $P_e$ | Rises towards $P_e$ | Excess demand (shortage) |
| Price > $P_e$ | Falls towards $P_e$ | Excess supply (surplus) |

## What's next

Understanding competitive market equilibrium is the foundation for almost all microeconomic analysis in IB Economics. This framework is used to analyze the effects of government intervention like price controls, taxes, and subsidies, which are common exam topics. It also forms the baseline for comparing outcomes in less competitive market structures like monopoly and oligopoly, and for analyzing market failures such as externalities. Building on this topic, you will develop the skills to evaluate the welfare effects of different market outcomes and policy changes, which is core to both Paper 1 and Paper 3 exam questions.

- [Consumer and producer surplus](https://www.owlsprep.com/study/ib-economics-hl-u2-consumer-and-producer-surplus/)
- [Government intervention in markets](https://www.owlsprep.com/study/ib-economics-hl-u2-government-intervention-in-markets/)
- [Overview of market failure](https://www.owlsprep.com/study/ib-economics-hl-u2-overview-of-market-failure/)

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