Excess demand occurs when the quantity demanded exceeds the quantity supplied. In this situation, the market price is below the equilibrium price. And, when the mechanism works, the price will rise towards its new equilibrium.
The term we also call a shortage.
The shortage is one of the two conditions of market disequilibrium. The opposite situation is excess supply. The latter occurs when the quantity supplied exceeds the quantity demanded.
Calculating the excess demand
For example, we have an supply function Qs = 10 + 2P and a demand function Qd = 20 – 0.5P.
By definition, equilibration is reached when the quantity demanded is equal to the quantity supplied or Qd = Qs. Let’s determine the equilibrium price first.
Qd = Qs → 20 – 0.5P = 10 + 2P → 2.5P = 10 → P = 4.
Furthermore, at the price P = 4, the quantity demanded is 18 (20 – 0.5*4), equivalent to the quantity supplied of 18 (10 + 2*4).
Excess demand occurs when the price is lower than the equilibrium price. Say, the price of the product is 2. The quantity demanded will be equal to 19 (20 – 0.5*2), while the quantity supplied is 14 (10 + 2*2). So, at that price, the market experienced a shortage of 5 units.
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What happens when the market experiences excess demand?
Excess demand pressures prices to rise. There is more demand in pursuit of less available goods. As prices rise, suppliers will start to produce more, but demand from buyers will decrease.
When the market mechanism works, and there is no external intervention, for example, price control by the government, the market will go to its new equilibrium.
Price increases encourage some buyers to reduce demand. They consider the price too expensive, more than what they are willing to pay. Therefore, gradually, market demand decreases.
On the other hand, producers see rising prices as an opportunity to make more money. They are willing to sell more and increase their output. As a result, market supply increases.
Declining demand and increasing supply will continue until the market goes to a new equilibrium.
However, when there is government control, for example, the price ceiling, the price will not rise. The market mechanism will not work to move the market towards its new equilibrium. As a result, excess demand will continue.
What causes excess demand?
In general, several scenarios that cause a shortage:
- Demand is growing higher than supply
- Demand is becoming a little high, but supply has stagnated or even fallen, for example, due to weather disturbances
- Demand is stagnant, but supply is falling
- Price control by the government
The economy is prospering
Prosperous economic conditions encourage increased consumer income. They are also optimistic about their job prospects and future income. As a result, their consumption of goods and services increases.
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Change in demographic
Demand for goods and services also increases as the population increases. The explosion of the birth of a baby, like Baby Booming in the United States, is an example. At the beginning of the period, the demand for children’s goods increased dramatically as the number of children under five increased.
In contrast, in Japan, the demand for medical personnel to care for seniors has increased in recent years. That’s because the growth of the old population is unmatched by the young population. As a result, the number of medical personnel is insufficient.
Government intervention
Government intervention can also cause shortages. Examples are price ceilings and government restrictions on the sale of specific products or services, such as cannabis.
Regarding the price ceiling, the government sets a maximum price for a product, which is below its equilibrium price. Suppliers can not set prices higher than it. As a result, excess demand exists, and market mechanisms cannot work to rebalance demand and supply.
How to detect a shortage?
For some products, estimated demand and supply data may be unavailable. However, that does not mean you can not detect a shortage. In general, you could monitor some market signals to indicate it. When the market faces a shortage,
- Prices continue to climb as demand exceeds supply
- Long queues are abnormal because more buyers are chasing less available goods
- Low or zero inventory in a row
- The delivery date is very late due to the low supply, exceeding what the manufacturer can supply.
Please note, the data here is supply, not production. The supply consists of production plus inventory. Inventories represent old unsold output, while production represents a new output. Therefore, you need to look at both data in the supply-demand analysis.
Furthermore, supply and demand for goods do not only come from domestic but abroad. Therefore, you should consider import and export trends when analyzing.
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