608 PART • Information, Market Failure, and the Role of Government Karen’s Food 10F OK 6C Price Line P James’s Clothing Karen’s Clothing C UJ A UK2 OJ James’s Food 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 for clothing and food are equivalent to prices of 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,