Excess supply occurs when the quantity supplied is higher than the quantity demanded. In this situation, price is above the equilibrium price, and, therefore, there is downward pressure on the price.
This term also refers to production surplus, overproduction, or oversupply.
Excess supply is the opposite of excess demand or shortage. Excess demand occurs when demand exceeds supply. Because it is below the equilibrium price, there is an upward pressure on the price (prices will tend to rise).
How to calculate excess supply
Say, the relationship between the quantity of a product’s supply and its price (P) is Qs = 10 + 2P. Meanwhile, the demand function is Qd = 20 – 0.5P.
By definition, the market reaches an equilibrium when the quantity supplied is equal to the quantity demanded or Qs = Qd.
For the first step, let us first determine the equilibrium price by equating the two equations:
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Qd = Qs → 20 – 0.5P = 10 + 2P → 2.5P = 10 → P = 4.
Next, at the equilibrium price P = 4, the quantity demanded is 18 units (20 – 0.5*4). It is equivalent to the quantity supplied of 18 (10 + 2*4).
As a definition, excess supply occurs when the price is higher than the equilibrium price. Say, the price of the product is 6. The quantity demanded will be equal to 17 (20 – 0.5*6), while the quantity supplied is 22 (10 + 2*6). So, at that price, the market faces a surplus of 5 units.
What happens when there is excess supply?
When there is oversupply, prices will fall because there is more supply than demand. When prices fall, producers are willing to supply less of the goods, thereby reducing output.
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Excess supply causes an increase in stock and associated costs. Facing higher costs forces producers to sell more. For this reason, they lower the selling price to stimulate demand and avoid further increases in inventories.
Lower price drives consumers to buy more. On the other hand, because inventories are still piling up, producers will tend to reduce their production levels. As a result, gradually, demand rises, and supply decreases. This process continues until the market reaches a new equilibrium, where the quantity supplied is equal to the quantity demanded.
The market mechanism (increased demand and decreased supply) will take place when the free market operates. There are no external interventions, for example, from the government.
However, when there are external interventions, the market mechanism cannot work, and the market will not reach a new equilibrium. Examples of such external interventions are price control by the government (price floor and price ceiling).
What are the causes of excess supply
In general, several scenarios causing an oversupply:
- Supply grows higher than demand growth
- Supply is stagnant, but demand is falling
- Supply is growing, but demand has stagnated or even fallen
- Government price controls
Supply can increase unexpectedly due to reasons such as weather factors and massive investment by producers.
Weather factors generally apply to some agricultural commodities. A more extended period of good weather will encourage more supply to the market. For example, when the rainy season is longer than the dry season, farmers continue to plant rice so that output will be abundant in the market. Likewise, unexpectedly high rainfall will drive crude palm oil yields higher, resulting in more supplies to the market than normal season.
The government can set a price floor above the equilibrium price. An example is a minimum wage.
On the one hand, the policy aims to ensure higher wages and a good standard of living for workers. On the other hand, it also causes excess supply since more individuals are willing to work (more labor supply) to get higher wages. And, producers cannot respond by lowering wages below the minimum level.
Massive investment in production facilities
Oversupply is also often associated with overinvestment. It happens when producers compete with one another to invest in production facilities that have a more significant proportion of fixed costs.
Such facilities usually require large output production to spread fixed costs and reach economies of scale.
Because such investment is considered to provide a long-term competitive advantage, once a company starts investing, its competitors will also follow suit. Thus, once the project is completed, it will add more supply to the market. The situation gets worse when demand stagnates or falls, causing enormous oversupply and making prices drop even more.
How do you find excess supply?
When supply and demand data exist, you can calculate oversupply. If it’s not available, you can deduce it from several market signals. Often, during oversupply:
- Prices are continuously falling
- There is no queue
- Inventory increases abnormally
- Utilization rates are low, but stocks are still high
- For the labor market, unemployment is unusually high
In the analysis, please remember, the data here is supply, not production. That means you should look at not only production data, but also inventory. Inventories represent the supply of old goods, while production represents the supply from the new output.
When production falls deeper than demand, but supply in the market is still significant, prices may at low level because total supply (production plus inventory) remains high.
Next, you also need to consider imports and exports in the supply-demand analysis. That’s because supply and demand come from not only domestic, but also abroad.