A) Equilibrium price and quantity and how they are determined
The equilibrium price is determined by the forces of supply and demand. When the supply of a good is equal to the demand for that good then the market is able to clear. The price at which it does so is called the market clearing price. This is illustrated in the diagram below:
B) The use of supply and demand diagrams to depict excess supply and excess demand
If the price of the good is above the market equilibrium then there will be an excess in supply. On the other hand, if the price of the good is below the market equilibrium price then there will be an excess of demand. In either case, the market will not be operating at equilibrium and therefore won’t clear. There area between demand and supply and underneath/below the equilibrium point represents the excess supply/demand.
C) The operation of market forces to eliminate excess demand and excess supply
If there is excess supply, market forces will result in a contraction in supply and an extension in demand, causing a fall in price to its market clearing level. This shortage in demand will result in a decrease in the price of the good as firms will realise that they have to lower their prices if they are to sell all their goods. This is also combined with the fact that when firms start to lower their price, demand will also increase. The combination of a contraction in supply (fewer firms will be willing to supply at the same quantity given a decrease in price) and increase in demand will cause the market to reach equilibrium. If there is excess demand, market forces will result in an extension in supply and a contraction in demand, causing a rise in price to its market clearing level. This is because firms will spot this excess demand and recognise that they will have to increase prices in order to ration demand. Furthermore, as firms increase their prices, supplies will be willing to supply greater the good in greater quantities due to the profit motive. Both the contraction in demand an extension of supply will result in the market reaching equilibrium.
D) The use of supply and demand diagrams to show how shifts in demand and supply curves cause the equilibrium price and quantity to change in real-world situations
A decrease in the demand for a good/service will result in a decrease in quantity (Q to Q1) as well as a reduction in price (P to P1). If the firm was to keep the good/service at the same price then there would be an excess of supply. Therefore by reducing the price it encourages firms to produce less quantity of the good/service thus allowing the market to reach equilibrium.
An increase in the demand for a good/service will result in an increase in the price (P to P2) as well as an increase in quantity (Q to Q2). This is due to the fact that if the price of the good stayed the same then there would be an excess of demand. Therefore by increasing the price it helps to ration the demand for the good/service as well as incentivising suppliers to increase the quantity that they supply.
A decrease in the supply of a good/service will result in an increase in the price of the good as well as a decrease in quantity.