(8th edition) (the pearson series in economics) robert pindyck, daniel rubinfeld microecon 633

608 PART 4 • Information, Market Failure, and the Role of Government

Karen’s Food

10F

OK

6C
Price Line
P

James’s
Clothing

Karen’s
Clothing

C

2

UJ
A
UK2
OJ

James’s Food

1

1
UK

UJ
P'

6C
10F

F IGURE 16.7

COMPETITIVE EQUILIBRIUM
In a competitive market the prices of the two goods determine the terms of exchange among consumers.
If A is the initial allocation of goods and the price line PP’ represents the ratio of prices, the competitive
market will lead to an equilibrium at C, the point of tangency of both indifference curves. As a result, the
competitive equilibrium is efficient.

• excess demand When the
quantity demanded of a good
exceeds the quantity supplied.
• excess supply When the
quantity supplied of a good
exceeds the quantity demanded.

to trade with. The market is therefore in disequilibrium because the quantities of
food and clothing demanded are not equal to the quantities supplied.
This disequilibrium should be only temporary. In a competitive market, prices
will adjust if there is excess demand in some markets (the quantity demanded of
one good is greater than the quantity supplied) and excess supply in others (the
quantity supplied is greater than the quantity demanded). In our example, each

Karen’s quantity demanded for food is greater than each James’s willingness to
sell it, whereas each Karen’s willingness to trade clothing is greater than each
James’s quantity demanded. As a result of this excess quantity demanded for
food and excess quantity supplied of clothing, we can expect the price of food to
increase relative to the price of clothing. As the price changes, so will the quantities demanded by all those in the market. Eventually, the prices will adjust until
an equilibrium is reached. In our example, the price of both food and clothing
might be 2; we know from the previous analysis that when the price of clothing is equal to the price of food, the market will be in competitive equilibrium.
(Recall that only relative prices matter; prices of 2 for clothing and food are
equivalent to prices of 1 for each.)
Note the important difference between exchange with two people and an
economy with many people. When only two people are involved, bargaining
leaves the outcome indeterminate. However, when many people are involved,