Excess Demand

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Excess Demand

Intuitively speaking, excess demand (ED) refers to a condition where, in a neoclassical framework without externalities, demand and supply do not match. In particular, there is ED when, in a certain market and for a given demand-and-supply curve, a certain price level p′ generates insufficient domestic production to offset the corresponding domestic demand. Analytically speaking, excess demand can be considered from both a microeconomic and macroeconomic point of view. In microeconomics, ED can be analyzed in a partial or in a general equilibrium framework.

The easiest way to illustrate ED is to start from a partial equilibrium analysis. Let’s assume that in a certain market the (inverse) demand-and-supply curves are represented by the following linear functions:

Demand (D): p = a –bq

Supply (S): p = c + dq

where p and q represent price and quantity respectively, and a, b, c, and d are real positive numbers. Clearly, the equilibrium occurs when the two schedules intersect. Therefore, we get:

In practice, when the price level is exactly p*, consumers demand the precise quantity that producers want to supply—that is, q*. Hence, ED is zero.

Let’s now suppose that for whatever reason the price is below its optimal value, that is, p′<p*. When this happens, as seen in Figure 1, consumers demand q^d, but producers want to supply q^s only, with q^s < q^d. Consequently, ED may be defined as:

Note that for a given value of a, b, c, and d, ED is increasing when p′ is getting smaller, while, needless to say, when p′ ≡ p*, ED is zero.

In a closed competitive economy, ED is an unstable equilibrium. In fact, since consumers cannot buy the precise amount they desire at p″, some of them are willing to offer a higher price. (Note that if producers supply q_s only, consumers might be willing to pay up to p^”, with p^” > p^’; see Figure 1.) However, when consumers start offering a higher price, producers have an incentive to increase their supply. In this way, the lack of balance is reduced; when the price is p*, demand equals supply, and eventually ED becomes zero.

In terms of social welfare—that is, in terms of consumer and producer surplus—when there is ED, one cannot draw any definitive conclusions for the economy as a whole, or for consumers and producers. If international commerce is allowed, if the goods are tradable, if there are no trade barriers, and if the economy is small—that is, domestic demand for foreign production does not affect international prices—consumers could fill up ED with imports. In this case, consumers would gain, while producers would be worse off. However, the economy as a whole would be better off, because gains would overcome losses.

In a general equilibrium framework, ED in a single market would imply that there must be a symmetric excess supply in other market(s). The simplest way to demonstrate this is to use the Edgeworth box. Let’s assume that in the economy there are only two goods, x and y, with p_x and p_y the price of x and y respectively. If the optimal consumption bundle—x^d and y^d —does not coincide with the production/endowment of the economy—x^s and y^s —then the value of the ED of x, p_x(x^d–x^s), must be equal to the value of excess supply of y, p_y(y^s–y^d), or vice versa.

Finally, in macroeconomics, ED indicates a condition where the aggregate demand (AD) exceeds the aggregate supply (AS). That is a condition that potentially stimulates both output and prices to rise. However, once full employment is reached, excess AD will only result in rising prices. In this case in fact, the increase of the price level P, implies that the real demand shifts back, and the economy returns to full employment equilibrium again.

SEE ALSO Excess Supply; Welfare Analysis