How does the Intersection of Supply and Demand Determine Equilibrium Price and Quantity of a Product?

Equilibrium price and quantity are determined by demand and supply curves. Supply curves used in this analysis show planned supply since, supply of quantity in the current period depends on price of the product in the previous period. In other words, depending on price of the product in one period, producers plan how much to produce in the next period and so, there exists a time lag between deciding the quantity to be produced at a particular price and actually obtaining that quantity.

It is to be noted here that intersection of demand and supply curves cannot ensure attainment of the equilibrium point. Equilibrium point is achieved only if slope of the demand curve is flatter than slope of the planned supply curve. Otherwise, the point of equilibrium will never be reached. Let us illustrate the process of attaining the equilibrium point.

Consider figure 6.3. Demand curve is denoted by ‘DD’ and planned supply curve is denoted by ‘SS’. Planned supply curve is steeper than the demand curve. Assume that initially price is fixed at P₁ at P₁ price; producers plan to supply Q₁ quantity in the next period. When quantity is supplied, it is observed that demand for the product at that price is P₁m. So, price of the product automatically comes down to P₂, so that quantity of demand matches the quantity supplied.

That is, to clear the market, price will come down to P₂. Now, the suppliers, considering P₂ as the price of the product, decide the quantity to be supplied in the next period. From the diagram; it is clear that at P₂ price Q₂ quantity will be supplied in the next period.

Consequently price increases to P₃ to equate demand with supply. This process is will continue until the equilibrium price P₀ is reached. Since price gradually converges to the point of equilibrium, this framework is called Convergent cobweb or damped oscillations.

The process of fluctuation in price of a convergent cobweb is summarized in Box 6.1.

In case, slope of the demand curve is steeper than the slope of the supply curve, instead of converging to equilibrium point, price continuously moves away from the equilibrium point.

Let us explain this point. Consider Figure 6.4. D₁D₁ is the demand curve and S₁S₁ is the supply curve and demand curve is steeper than the supply curve. Suppose, initially P₁ price is charged. At P₁ price, supply exceeds demand. Now, in order to sell Q₁ quantity, i.e., to clear the market, demand must be equated to Q₁ Q₁ quantity is demanded only when P₂ price is charged.

So price falls to P₂ Now, depending on P₂ price, the suppliers will decide the quantity to be produced in the next period. Figure 6.4 clearly shows that Q₂ quantity will be supplied at P₂ price.

To match demand with this quantity supplied, i.e., to clear the market, again price must appreciate to P₃ where demand is equal to Q_2. It is important to observe here that price oscillations result in deviation from the equilibrium. So, this framework is called Divergent cobweb or explosive oscillations.

The process of fluctuation in price of a Divergent Cobweb is summarized in Box 6.2.