Question

Explain the chain effects, if the prevailing market price is below the equilibrium price.

Answer 1

If the prevailing market price is below the equilibrium price, then there occurs the situation of excess demand.

Let us assume that the market price $P$ is below the equilibrium price $P^e$. According to the demand curve, quantity demanded is $q^{\prime }d$. Whereas, according to the supply curve, the quantity supplied is $q^{\prime }s$. So, it can be seen that there emerges the situation of excess demand equivalent to $(q^{\prime }d-q^{\prime }s)$. This excess demand will increase competition among the buyers; consequently, the buyers will tend to buy output at higher price (due to the competition), which as a result will increase the market price. The market price will continue to rise until it becomes $P$, where the equilibrium is restored.