Home › Learning Hub › IB DP Economics › 2.3 Competitive market equilibrium
2.3

Competitive market equilibrium

Unit 2 · Microeconomics · SL and HL

Put demand and supply on one diagram and you get the market equilibrium: the price at which the plans of buyers and sellers match. This page shows how shortages and surpluses push prices towards equilibrium, the four jobs the price does along the way, and why the competitive equilibrium is allocatively efficient: the benchmark against which every market failure in the rest of Unit 2 is measured.

🎯What you need to be able to do

  • Draw and explain market equilibrium, and show how shifts in demand and supply create excess demand (shortage) or excess supply (surplus) and a new equilibrium.
  • Explain the functions of the price mechanism: resource allocation, signalling, incentive and rationing.
  • Explain consumer surplus, producer surplus and social/community surplus, with a diagram.
  • Explain why the competitive equilibrium is allocatively efficient: social surplus is maximized where marginal benefit equals marginal cost.
  • HL Calculate consumer and producer surplus from a diagram.

📚The economics

Market equilibrium

A market is in equilibrium when quantity demanded equals quantity supplied. At the equilibrium price there is no tendency for the price to change: every buyer willing to pay that price finds a seller, and every seller willing to accept it finds a buyer. The market “clears”.

Demand and supply for a good with equilibrium E at 5 dollars and 70 kilograms. At 4 dollars, quantity demanded is 80 and quantity supplied 50, a shortage of 30. At 6 dollars, quantity demanded is 60 and quantity supplied 90, a surplus of 30.
Below equilibrium there is a shortage; above it, a surplus. Both push the price back towards $5.
Excess demand (shortage)
At a price below equilibrium, Qd > Qs. Buyers compete for the limited goods, sellers see queues and empty shelves, and the price is bid up. As it rises, quantity demanded contracts and quantity supplied extends until they are equal.
Excess supply (surplus)
At a price above equilibrium, Qs > Qd. Unsold stock piles up, so sellers cut prices. As the price falls, quantity demanded extends and quantity supplied contracts until the surplus disappears.

Changes in equilibrium

When a determinant of demand or supply changes, the curve shifts, the old price no longer clears the market, and a shortage or surplus pushes the price to a new equilibrium.

Demand shifts right from D1 to D2 against a fixed supply curve. At the original price P1 there is a shortage, shown between the supply curve and the new demand curve. The price rises to P2 and the new equilibrium E2 has a higher quantity Q2.
An increase in demand: shortage at the old price, then a new equilibrium at a higher price and quantity.
Demand increases
P ↑, Q ↑
Demand decreases
P ↓, Q ↓
Supply increases
P ↓, Q ↑
Supply decreases
P ↑, Q ↓

If both curves shift, the effect on one variable is certain and on the other depends on the size of the shifts. For example, if demand and supply both increase, quantity certainly rises, but price may rise, fall or stay the same.

The functions of the price mechanism

In a free market nobody decides what to produce; prices do the coordinating. The price mechanism does four jobs at once:

  • Signalling. Prices carry information. A rising price signals that a good has become scarcer relative to demand; a falling price signals a surplus. Producers and consumers do not need to know why.
  • Incentive. Prices give reasons to act. A higher price makes supplying more profitable, so producers expand output; for consumers it is an incentive to economize or switch to substitutes.
  • Rationing. When a good is scarce, the rising price rations it among buyers: those willing and able to pay the most get it, and quantity demanded falls to match what is available.
  • Resource allocation. Together these move land, labour and capital towards the goods consumers value most and away from those they value less. When demand for electric vehicle batteries soared, the price of nickel rose, drawing investment into nickel mining and smelting in Sulawesi.

Consumer surplus, producer surplus and social surplus

Consumer surplus
the difference between the highest price consumers are willing to pay and the price they actually pay. The area below the demand curve and above the price.
Producer surplus
the difference between the price producers receive and the lowest price they are willing to accept. The area above the supply curve and below the price.
Social (community) surplus
consumer surplus + producer surplus: the total benefit to society from the market.
Demand D equals MB from 12 dollars and supply S equals MC from 1.5 dollars, meeting at 5 dollars and 70 kilograms. The blue triangle above the price is consumer surplus, half times 70 times 7, equal to 245. The red triangle below the price is producer surplus, half times 70 times 3.5, equal to 122.5. Social surplus is 367.50 dollars, maximized where MB equals MC.
At the competitive equilibrium, social surplus is as large as it can be.

Allocative efficiency

The demand curve shows the marginal benefit (MB) of each unit to consumers; the supply curve shows the marginal cost (MC) of producing it. Allocative efficiency is achieved when resources produce the combination of goods society values most, which happens where MB = MC.

  • For every unit below equilibrium, MB > MC: producing it adds more benefit than it costs, so society gains by producing it.
  • For every unit above equilibrium, MB < MC: it costs more than it is worth, so society loses by producing it.
  • So output at the competitive equilibrium, where MB = MC, maximizes social surplus. Any other output gives a smaller total: the lost surplus is a welfare (deadweight) loss.

This result depends on the demand and supply curves capturing all benefits and costs. When there are externalities (2.8), market power (2.11) or government-imposed prices (2.7), the market outcome is no longer efficient.

✏️Worked example HL

In a local market for shallots, demand is shown by a straight line from $12 (at zero quantity) and supply by a straight line from $1.50. They cross at a price of $5 and a quantity of 70 kg per day (see the diagram above).
(a) Calculate consumer surplus, producer surplus and social surplus.
(b) Using the same curves, the quantity demanded at $4 is 80 kg and the quantity supplied 50 kg. Calculate the shortage and explain how the market removes it.

(a) Both surpluses are triangles with base 70 kg.

\[ \text{CS} = \tfrac{1}{2} \times 70 \times (12 - 5) = \$245 \]
\[ \text{PS} = \tfrac{1}{2} \times 70 \times (5 - 1.5) = \$122.50 \]
\[ \text{Social surplus} = 245 + 122.50 = \$367.50 \text{ per day} \]

(b) Shortage = 80 − 50 = 30 kg per day. Buyers who cannot get shallots offer more, and sellers raise prices. As the price rises towards $5, quantity demanded contracts (80 → 70) and quantity supplied extends (50 → 70), until the shortage is gone.

Check it. Units: $ per kg × kg = $, so surpluses are money amounts per day. Consumer surplus is larger here because the demand curve is steeper relative to the price line than supply is — the triangle is taller (7 against 3.5) with the same base.
Forgetting the ½. With straight-line curves the surpluses are triangles, not rectangles. And read the intercepts off the price axis: the height of the consumer surplus triangle is the demand intercept minus the price, not the intercept itself.

📝Practise

Work through these on paper, then reveal the answer. Tagged questions are modelled on a real IB question from that session, with our own wording, numbers and context.

1. [2 marks, Paper 2 style] Define the term excess supply.
A situation where, at a given price (above equilibrium), the quantity supplied is greater than the quantity demanded; also called a surplus.
2. [4 marks, Paper 2 style] Using a demand and supply diagram, explain how the price mechanism would respond to a sharp rise in demand for face masks during a disease outbreak.
Demand shifts right. At the old price there is a shortage. The price rises, which signals scarcity, gives producers an incentive to expand output (movement up S) and firms to switch production lines to masks, and rations the limited supply to those most willing and able to pay. A new equilibrium is reached at a higher price and quantity. Diagram: D1, D2, S, shortage at P1, new P2, Q2.
3. [10 marks, Paper 1 (a) — modelled on May 2024 SL Paper 1 Q1(a)] Using diagrams, explain how cheaper soybean oil and a drought in plantation regions could each change the price of palm oil.

Demand side: choose one determinant and explain the chain. For example, a fall in the price of a substitute (soybean or sunflower oil) makes buyers switch away from palm oil: demand shifts left, creating excess supply at the old price, so the price falls to a new, lower equilibrium with a smaller quantity.

Supply side: for example, higher costs of factors of production (fertilizer and fuel prices, or wage rises on plantations), or an El Niño drought reducing yields: supply shifts left, creating a shortage at the old price, so the price rises and quantity falls.

Two diagrams, each with the shift, the shortage or surplus at the old price and the new equilibrium, plus correct terms (“decrease in demand”, “contraction of supply”), gain the top band.

4. Explain what happens to equilibrium price and quantity if demand for a good increases while supply decreases.
Both shifts push the price up, so price certainly rises. Quantity is indeterminate: the demand increase raises it and the supply decrease lowers it, so the outcome depends on which shift is larger.
5. HL Demand for a good runs from $20 (at Q = 0) and supply from $4 (at Q = 0). They cross at P = $12, Q = 400 units. Calculate consumer and producer surplus.
CS = ½ × 400 × (20 − 12) = $1600. PS = ½ × 400 × (12 − 4) = $1600. Social surplus = $3200.
6. Explain why producing beyond the competitive equilibrium quantity reduces social surplus.
Beyond the equilibrium, each extra unit has a marginal cost greater than its marginal benefit (the supply curve lies above the demand curve). Producing it uses resources worth more than the satisfaction it gives, so each such unit subtracts from social surplus. The lost area, the triangle between S and D beyond the equilibrium, is a welfare loss: the market is allocatively inefficient.

🔗Go deeper — other people’s work

These are external resources, not mine. If one stops working, tell me and everything above it on this page still stands.

  • F. A. Hayek, The Use of Knowledge in Society (1945) — the classic short essay on prices as signals.
  • Khan Academy — Consumer surplus, producer surplus and deadweight loss.
  • Marginal Revolution University — The price system series.