How does the Intersection of Supply and Demand Determine Equilibrium Price and Quantity of a Product?
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 Q2. 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.