Price tends towards the level which equates supply with demand'. Explain this statement.

Answer Details

This statement describes how a free market reaches equilibrium. The equilibrium price is the price at which the quantity that buyers wish to buy exactly equals the quantity that sellers wish to sell. Price tends to settle at this level because, whenever it is above or below equilibrium, market forces automatically push it back.

When price is above the equilibrium level: quantity supplied exceeds quantity demanded, so there is a surplus (excess supply). Sellers are left with unsold goods, so they compete by lowering their prices to clear stock. As the price falls, quantity supplied falls and quantity demanded rises, and the surplus shrinks. The price keeps falling until supply again equals demand.

When price is below the equilibrium level: quantity demanded exceeds quantity supplied, so there is a shortage (excess demand). Buyers compete for the limited goods and bid the price up. As the price rises, quantity demanded falls and quantity supplied rises, and the shortage shrinks. The price keeps rising until supply again equals demand.

Only at the equilibrium price is there neither surplus nor shortage, so there is no pressure for the price to change; the market is said to clear. This self-correcting behaviour of demand and supply is why economists say price tends towards the level which equates supply with demand. We can summarise it as:

• Price above equilibrium \(\Rightarrow\) surplus \(\Rightarrow\) price falls.
• Price below equilibrium \(\Rightarrow\) shortage \(\Rightarrow\) price rises.
• Price at equilibrium \(\Rightarrow\) quantity demanded \(=\) quantity supplied \(\Rightarrow\) price stable.

Graphically, equilibrium is the point where the demand curve and the supply curve cross; away from that point the gap between the curves creates the surplus or shortage that drives the price back towards it.