Explain the impact of excess demand on market outcomes.

Excess demand in a market leads to price increases, shortage of goods, and potential market inefficiencies.

Excess demand, also known as a shortage, occurs when the quantity demanded of a good or service exceeds its supply at the current price. This imbalance between demand and supply has significant implications for market outcomes.

Firstly, excess demand exerts upward pressure on prices. According to the law of demand and supply, when demand exceeds supply, buyers are willing to pay more to secure the limited quantity of the good or service available. This willingness to pay more leads to an increase in the price of the good or service until it reaches a new equilibrium where quantity demanded equals quantity supplied. This price increase can lead to inflation, especially if the good or service in question is a significant component of the consumer price index.

Secondly, excess demand can lead to a shortage of goods. When demand outstrips supply, not all consumers who want to buy the good or service at the current price can do so. This shortage can lead to non-price competition among buyers, such as queuing, which can be inefficient and lead to a misallocation of resources.

Thirdly, excess demand can lead to potential market inefficiencies. In a perfectly competitive market, the market equilibrium is efficient because it maximises the total surplus, which is the sum of consumer and producer surplus. However, when there is excess demand, the market is not in equilibrium and total surplus is not maximised. This results in a deadweight loss, which is a measure of inefficiency.

Furthermore, persistent excess demand can signal that the market is not functioning properly. It may indicate that there are barriers to entry preventing new firms from entering the market and increasing supply, or that there is a lack of competition among existing firms. In such cases, government intervention may be necessary to correct the market failure and restore efficiency.

In conclusion, excess demand has significant implications for market outcomes. It leads to price increases, shortage of goods, and potential market inefficiencies. Understanding these impacts is crucial for both businesses and policymakers in making informed decisions.