Shortages (demand exceeding supply) and surpluses (supply exceeding demand)

Allocation of Resources – Price Determination

Key Concepts

• Demand: Quantity of a good that consumers are willing and able to buy at each possible price.
• Supply: Quantity of a good that producers are willing and able to sell at each possible price.
• Equilibrium price (P_e): The price at which quantity demanded equals quantity supplied.
• Shortage: Situation where quantity demanded exceeds quantity supplied at a given price.
• Surplus: Situation where quantity supplied exceeds quantity demanded at a given price.

How Shortages and Surpluses Arise

When the market price is not at the equilibrium level, either a shortage or a surplus will develop.

1. Price set above equilibrium (P > P_e)

   • Quantity supplied > Quantity demanded → Surplus.
   • Producers have excess stock; they will tend to lower the price to clear the surplus.

2. Price set below equilibrium (P < P_e)

   • Quantity demanded > Quantity supplied → Shortage.
   • Consumers cannot obtain enough of the good; they will bid up the price.

Graphical Illustration (Suggested Diagram)

Mathematical Representation

The basic demand and supply functions can be written as:

\$Q_d = a - bP\$

\$Q_s = c + dP\$

where a, b, c, d are positive constants. At equilibrium:

\$Qd = Qs \;\Rightarrow\; a - bPe = c + dPe\$

Solving for the equilibrium price:

\$P_e = \frac{a - c}{b + d}\$

Consequences of Shortages

• Rationing may occur (first‑come, first‑served, price‑capped, or non‑price mechanisms).
• Black‑market activity can develop.
• Consumers may switch to substitutes.
• Producers receive higher marginal revenue, encouraging them to increase output.

Consequences of Surpluses

• Unsold inventory builds up, increasing storage costs.
• Producers may cut production or lay off workers.
• Prices tend to fall, restoring balance.
• Government may intervene (e.g., purchase excess stock, impose price floors).

Supply‑and‑Demand Schedule Example

How Markets Self‑Correct

When a shortage exists, the upward pressure on price reduces the quantity demanded and encourages producers to increase output, moving the market toward equilibrium. Conversely, a surplus creates downward pressure on price, increasing quantity demanded and reducing output, also moving toward equilibrium.

Key Points to Remember

1. Only at the equilibrium price do quantity demanded and quantity supplied match.
2. A price above equilibrium creates a surplus; a price below creates a shortage.
3. Market forces (price adjustments) tend to eliminate both shortages and surpluses.
4. Government intervention can alter the natural adjustment process.