Steve Bain

What is Excess Supply?

Excess supply of a good or service is a situation that occurs when, for some reason, the price is too high to clear the market. In most situations this will result in a buildup of unsold goods, which will cause firms to cut production and lower their prices, but in some cases prices may be fixed.

The classic example of a price that may be fixed above the market clearing rate is that of the labor market and a minimum wage, which I will analyse below.

First of all, lets look again at the standard equilibrium diagram depicting consumer and producer surplus as presented on my page about excess demand.

Market Equilibrium Supply and Demand

Consumer surplus occurs for all output above the market clearing price of p* and below the demand curve, i.e. the blue area as illustrated.

Producer surplus occurs for all output below the market clearing price, but above the supply curve, i.e. the green area.

The most efficient price and output combination for society is given by the market clearing price p* with an output quantity of q*. Any other combination will lead to some surplus value being lost i.e. a 'deadweight loss'. This is clearly the case with any market that experiences excess supply, as I will now explain.

Excess Supply Graph in the Labor Market

In the excess supply graph below we can illustrate what happens in a labor market where a minimum wage has been set that is above the market clearing wage. The price in the labor market refers to the price that must be paid to workers i.e. the wage. The quantity is the number of people employed in that labor market.

If there was no minimum wage and the market was allowed to clear then the wage rate would be equal to p* and the quantity of people working would be q*.

The supply curve in this market relates to potential workers, because it is these people who supply their labor. For that reason, we can associate producer surplus with workers in the labor market. The consumers in this example are the employers, because they are the buyers of the services provided by the workers.

Excess Supply Graph

As we can see in the excess supply graph, when a minimum wage is fixed at a higher rate than the market clearing rate, we get a situation of unused labor. At a wage of pf, those people who find work are better off, as illustrated by the gray box, which is a transfer of surplus from employers (consumers) to workers because of the higher wage.

However, the quantity of workers demanded falls due to the extra cost, and this is illustrated by the lower quantity of qf compared to q*. Potential workers, on the other hand, will increase because more people are attracted to the labor market by the prospect of higher wages, so the quantity of jobs demanded rises to q.

Excess supply in the labor market is equal to q - qf, and this shows the quantity of unemployed workers i.e. the number of potential workers who want to work but cannot find a job.

Also note that, with qf less than q*, there is a deadweight loss (DWL 2) to producers (workers) who were previously employed at the lower market clearing rate, but are now effectively priced out of the market and made redundant.

DWL 1 represents lost surplus for employers. This is the surplus that they used to make from the workers at the old market clearing price of p*, but who cannot now be profitably employed due to the higher minimum wage of pf.

Worst Examples of Excess Supply

In the previous example of excess supply in the labor market, the deadweight losses to society were significant, but imagine how much worse it would have been if the unemployed workers had actually been given all the jobs that they wanted, but then never gotten paid!

In this situation the deadweight losses would have been far higher, and the extra red DWL 2 areas illustrated below would represent the extra losses.

Excess Supply over-production

Now, this is not likely to occur in the labor market because people won't work for free, but there are plenty of other markets where this can happen, and does happen, when the government imposes a price that is higher then the market clearing rate.

Imagine, for example, that farmers are told that the price for wheat after the next harvest will be fixed at pf, as in the diagram above. Those farmers might reasonably expect to sell all of their output at that price since each farm is small, producing only a tiny fraction of overall output in the market, and it has always managed to sell all of its output before.

The new higher fixed price for wheat simply encourages these farmers to produce a larger crop in order to maximize profits. Therefore, buoyed by the higher price, total supply in the wheat market will increase in all the way to q. Unfortunately for the farmers, consumers do not wish to purchase this much wheat at such an artificially high price, and their demand falls to qf.

Society will now have all the deadweight loss illustrated in the graph, and farmers will have mountains of unsold wheat.

Whilst this might sound like an abstraction from reality, it is actually common practice for many governments to pursue this kind of insane policy. The losses do not fall on the shoulders of farmers however, they fall to the taxpayers because they are forced to pay subsidies to the farmers for all the excess supply. For evidence of this, check out the link below to the EU Butter Mountain.


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