The Speculator’s Edge, Five

The Speculator’s Edge, Five

Basic Economic Concepts essential to Speculation

5) The Law of Market Equilibrium

The law of market equilibrium states that markets tend to equilibrium, a state in which neither the buyers nor the sellers see any need to change the price or quantity of the goods they are trading. This occurs at the price at which goods clear – that is, where producers sell as much as they are willing and able to sell and consumers buy as much as they are willing and able to buy, and further trading ceases.

How and why the law of equilibrium works may be easily seen if we combine our supply-and-demand schedules as follows:

                    Quantity          Quantity

Price            Demanded       Supplied       Effect on Price Structure

$1.50/lb        500 lbs             6000 lbs        Sellers will compete to fill limited demand,

                                                                    lowering prices

$1.00/lb       1000 lbs            5000 lbs         Sellers will compete to fill limited demand,

                                                                    lowering prices

$.50/lb          2500 lbs           2500 lbs         Equilibrium price occurs and trade is

                                                                     maximized

$.25/lb          5000 lbs           1000 lbs         Buyers will compete for limited supply,

                                                                     raising prices

$.10/lb          6000 lbs             200 lbs         Buyers will compete for limited supply,

                                                                     raising prices

Note that the equilibrium price in the above example is $.50 per pound of cotton, and, at that price, the maximum trade of 2500 pounds will take place. Assuming static conditions, once this 2500 pounds of cotton has been exchanged, no further trade will occur.

If the price were higher than the equilibrium price, producers would compete with each other for the relatively limited demand of consumers. Producers compete by lower price. The price would fall to equilibrium. (Surplus conditions)

If the prices were under the equilibrium price, consumers would bid prices up (or producers would simply raise them to ration goods) until demand and supply came into line at equilibrium. (Shortage conditions)

At equilibrium, there is neither a shortage nor a surplus. Here, producers sell all that they are willing to sell and consumers buy all that they are willing to buy. When distribution is complete, the market is said to “clear” and further trading ceases.

You might be thinking, why doesn’t the market ever seem to go to equilibrium and clear in the real world?

Although there is some academic debate on the extent to which equilibrium is ever achieved, at least one important school says that the market in fact is always at equilibrium. Even in highly organized, actively traded markets like those found on U.S. securities and commodities exchanges, trading ceases frequently – sometimes for an instant and sometimes for significant periods. Ultimately, however, conditions change. People’s needs change. They eat, then grow hungry all over again. They are born and they die. Their valuations change. A price that a moment ago was too high for a potential buyer now looks good, so he or she buys. As life goes on, the price structure of goods must fluctuate.

6) Shifts in Demand and Supply

If for some reason, demand for cotton increased under conditions of static supply, the equilibrium price of cotton would shift (rise) from $.50 per pound to $.75 per pound.

Of course, the supply for cotton could shift as well. If the supply for cotton dramatically increased, the producers, whose cost of production has been suddenly reduced would be willing to sell more cotton at reduced prices. The increase in supply under static demand would cause the equilibrium price to fall from $.50 per pound to $.35 per pound.

The Speculator’s Edge,

Albert Peter Pacelli