Market Equilibrium

Market equilibrium is also known as market clearing price, it refers to perfect balance in the market supply and demand, that is market equilibrium means when supply is equal to demand.

When the market is at equilibrium the price of product will remain same unless some external factors change the level of supply or demand.

According to market economy, there is a single price which brings demand and supply in to balance called the equilibrium price.

Therefore market equilibrium is a situation in which supply of an item is exactly equal to its demand. Since there is neither surplus nor shortage in the market, the price tends to remain stable in this situation.

Here, S is the supply curve and D is the demand curve, they intersect at price E, which is the equilibrium price.

When at a given price the market demand exceeds market supply then there is excess demand for a commodity in the market.

If price is below the equilibrium price then the demand will be greater than supply, due to which there will be shortage.

If there is shortage, the firm will increase the prices as well as supply. With rise in price there will be movement along the demand curve and the demand will fall.

In the given graph at equilibrium price P the demand was Q, now when the price falls to P₀ the demand increases to Q₁, which is greater than supply so there is a shortage in supply ranging from Q to Q₁. To meet this demand, the price is raised from P₀ to P₁ due to which the demand falls from Q₁ to Q₀

When at a given price, the supply of a commodity is greater than market demand then there is excess supply for a commodity in the market.

When price will be above equilibrium price, then supply will be greater than demand it will result in surplus. To deal with the surplus, the firms will reduce price as well as supply which will increase the demand and the surplus will be eliminated.

If the price prevailing in the market is above the equilibrium price –

Then the demand will be less than the supply, it means a situation of excess supply will be in the market

If the price prevailing in the market is below the equilibrium price –

Then there will be more demand and less supply, it means situation of excess demand or shortage of supply.

In a perfectly competitive market equilibrium price is determined by the market forces of demand and supply.

Market equilibrium is determined when market demand is equal to market supply.

Market demand is the total demand for a commodity by all the buyers in the market. Demand curve slopes downward due to the law of demand.

Market supply is the total of supplies of a commodity by all the firms in the market, its curve slope upward due to law of supply.

Equilibrium price is where the market demand curve and market supply curve intersect each other that is where market demand is equal to market supply.

The schedule and graph given below will help to understand the concept -

The equilibrium price is Rs 9 where market demand is equal to market supply

In the above question the equilibrium price is Rs 9, where market demand is equal to market supply at 60 units.

If this equilibrium price of Rs 9 is above the minimum of average cost then it means the firm is earning supernormal profit, this situation will attract new firms in the market and with the new entrants the supply will increase.

The increase in supply will result in fall in price until it becomes equal to the minimum of average cost and so the supernormal profit will be wiped out and all the firms will earn normal profit.

When free entry and exit of firms is allowed equilibrium is determined by the intersection of demand curve and P is equal to minimum average cost line.

The change in equilibrium price and quantity in following two cases are explained below –

(a) Both demand and supply curves shift in the same direction?

When both demand and supply curve shift in the same direction there can be six types of cases. All of them are being explained with the help of following table –

(b) Demand and supply curves shift in opposite directions?

When demand and supply curve shift in the opposite directions, there can be six types of cases. All of them are being explained with the help of following table –

When free entry and exit is permitted in a perfectly competitive market the market will always supply at a price where no firm earns abnormal profit or suffers abnormal loss. Therefore the market price will be the price which is equal to the minimum average cost.

The equilibrium quantity is determined at the intersection of market demand curve with price line, where price is equal to minimum average cost.

The feature of free entry and exit of firms in the market ensures that all the firms are earning normal profit, which means the market price is always equal to the minimum of LAC.

No new firm will be attracted to enter the market and no existing firm will leave, if the price is equal to the minimum of LAC. Thus the number of firms is determined by the equality of price and minimum of LAC.

The equilibrium number of firms in a market where free entry and exit is permitted is determined by equilibrium quantity supply per firm.

Equilibrium number of firms = Equilibrium Quantity / Supply of each firm

Example – Suppose the equilibrium price is P₁ and equilibrium quantity is q₁, Output of each firm is q₁f (as all firms are identical).

Equilibrium number of firms (N ) = q₁/q₁f

If the number of firms is fixed, when income of consumer will increase, the demand will also increase because the consumer would pay higher price but the supply will remain same, so there will be a rise in equilibrium price. As a result the demand curve will shift rightward. It will be true only in case of normal goods.

Suppose, the original equilibrium price was P at point E where, supply curve SS intersected with demand curve DD. With increase in income of consumer the demand curve shifted to D₁D₁ and as the supply is same so the equilibrium point shifted to E₁ and thus the price rises to P₁

If the number of firms is fixed, when there is decrease in consumer's income equilibrium price will decrease because the consumer would pay less due to less income. As a result the demand curve will shift leftward. It will be true only in case of normal goods.

Suppose, the original equilibrium price was P₁ at point E₁ where, supply curve SS intersected with demand curve D₁D₁. With decrease in income of consumer the demand curve shifted to DD and as the supply is same so the equilibrium point shifted to E and thus the price falls to P.

Shoes and socks are complementary items, they are used together so change in price of one will affect the demand of another.

The rise in price of shoes will decrease the demand of socks and vice versa.

It has been further explained with help of demand schedule and graph –

When the price of socks was P the demand for socks was Q represented by demand curve DD and equilibrium point of demand and supply was E.

Supply being same, when the price of shoes rises to P₁ the demand falls to Q₁ represented by the demand curve D₁D₁ and equilibrium point of demand and supply shifts to E₁.

Tea and coffee are substitute to each other so the change in price of coffee will have a direct impact on the demand for tea. Increase in price of coffee will increase the demand for tea and decrease in the price of coffee will decrease the demand of tea.

Now with help of the following diagram we will explain it.

Here at price P of coffee the demand for tea is Q, when the price of coffee rises to P₁ the demand for tea rises to Q₁ which shifts the equilibrium point from E to E₁

Here at price P of coffee the demand for tea is Q, when the price of coffee falls to P₁ the demand for tea falls to Q₁ which shifts the equilibrium point from E to E₁

a) If the price of input of a firm will increase, the cost of production will also increase, which will decrease the profit margin due to which the supply will fall. This will lead to leftward shift in the supply curve. The demand curve remaining the same, the new equilibrium will occur at E₁ with higher equilibrium price P₁ and lower quantity of output Q₁.

b) If the price of input of a firm will decrease, the cost of production will reduce which will increase the profit margin and the firms will supply more. This will shift the supply curve rightward. Demand curve remaining the same, the new equilibrium will occur at E₁ with lower equilibrium price P₁ and higher quantity of output Q₁.

X and Y are substitute goods so the change in price of Y will have a direct impact on the demand for X. Increase in price of Y will increase the demand for X and decrease in the price of Y will decrease the demand of X.

Tea and coffee are substitute to each other so the change in price of coffee will have a direct impact on the demand for tea. Increase in price of coffee will increase the demand for tea and decrease in the price of coffee will decrease the demand of tea.

The effect of rightward shift of both demand and supply curve on equilibrium price and quantity can be explained in following three manners –

1. Where demand and supply increase in same proportion - In this case the equilibrium price will remain unchanged.

In the given graph the original demand curve shifts from DD to D₁D₁ and supply curve from SS to S₁ S₁ due to which the equilibrium point shifts from E to E₁ but the equilibrium price is same i.e. P.

2. Where demand increases more than the increase in supply - In this case the equilibrium price will rise.

In the given graph the original demand curve shifts from DD to D₁D₁ and supply curve from SS to S₁ S_1. The increase in demand curve is more than that in the supply curve due to which the equilibrium point shifts from E to E₁ which increases the equilibrium price to P₁.

3. Where demand increases less than the increase in supply - In this case the equilibrium price will fall.

In the given graph the original demand curve shifts from DD to D₁D₁ and supply curve from SS to S₁ S_1. The increase in supply curve is more than that in the demand curve due to which the equilibrium point shifts from E to E1 which decreases the equilibrium price to P₁.

The difference between supply and demand curves in labour market than that in the goods market are stated below

a) In goods market the demand is made by consumers or household while in labour market demand is made by firms.

b) In goods market the supply of goods is made by firms where as in labour market the supply of labour is made by households.

c) In goods market firms act as suppliers where is in labour market household acts as suppliers.

A profit maximising firm will employ labour up to the point where extra wages paid to the last unit of labour is equal to the additional benefit earned by employing that unit of labour.

That is when marginal cost of labour is equal to marginal benefit by labour or wage rate is equal to marginal revenue product.

The optimal amount of labour is determined in a perfectly competitive market as

VMP_L = W

Where,

VMP_L = Value of Marginal Product of Labour

W = Wage rate

The wage rate in labour market is determined by the intersection of demand for and supply of labour just like in goods market. The rate at which the demand for labour and supply of labour will be at equilibrium will be the wage rate.

Here, OW will be the wage rate in a perfectly competitive market, where supply curve of labour intersects the demand curve of labour.

Price ceiling means deciding the lower prices as compared to the market price of goods. In India there are several goods on which government has imposed price ceiling so as to keep them available within the reach of the people below poverty line such as kerosene oil, sugar, wheat, rice, etc.

The consequences of price ceiling as stated below –

a) Excess demand - Due to artificially imposed prices, which is lower than the equilibrium price will lead to excess demand

b) Fixed quota - The consumer gets a fixed quantity of goods which is often less than their individual requirement due to which the consumer remains unsatisfied.

c) Inferior goods - Often it has been found that the goods that are rationed are inferior in quality and adulterated.

d) Black marketing - The needs of a consumer remains unfulfilled due to quota fixed by government and such consumers are ready to pay higher prices for additional quantity which leads to black marketing and artificial shortage in market.

In short run the number of firms is fixed where as in long run the number of firms is not fixed.

Now with help of following two graphs we will explain the effect in short run market –

In short run, when number of firms is fixed –

Graph 1.1 - DD represents the demand curve and E is the initial equilibrium, where demand and supply intersect each other.

Now when the demand increases the demand curve shifts to D1D1, new equilibrium E1 arises where supply curve and demand curve intersect each other at price P1 and equilibrium quantity Q1. This means both equilibrium price and quantity rises.

Graph 1.2 - DD represents the demand curve and E is the initial equilibrium, where demand and supply intersect each other.

Now when the demand decreases the demand curve shifts to D2D2, new equilibrium E2 arises where supply curve and demand curve intersect each other at price P2 and equilibrium quantity Q2. This means both equilibrium price and quantity falls.

Now with help of following two graphs we will explain the effect in long run market –

In long run, when number of firms is not fixed, but free entry and exit is allowed –

Graph 2.1 - DD represents the demand curve and E is the initial equilibrium, where P = Min AC

Now when the demand increases the demand curve shifts to D1D1, new equilibrium E1 arises where price is same and equilibrium quantity is Q1. This means equilibrium price remains same but equilibrium quantity rises.

Graph 2.2 - DD represents the demand curve and E is the initial equilibrium, where P = Min AC.

Now when the demand decreases the demand curve shifts to D2D2, new equilibrium E2 arises where price is same and equilibrium quantity is Q2. This means equilibrium price remains same but equilibrium quantity falls.

Given –

q^D = 700 – p

q^S = 500 + 3p for p ≥ 15

= 0 for 0 ≤ p < 15

From the given data we can see that the market supply is zero for the price range Rupees 0 to Rupees 15 because it is less than the minimum of average variable cost, so no firm will produce any positive level of output and the market supply curve will be zero.

At equilibrium, q^D = q^S

700 – p = 500 + 3p

200 = 4p

P = 50

Therefore, the equilibrium price is Rs 50.

At equilibrium price, the equilibrium quantity will be

q^S = 500 + 3p

= 500 + 3 (50)

= 650 units.

Therefore, the equilibrium quantity is 650 units.

(a) What is the significance of p = 20?

For the price between zero to 20 no form is going to produce anything because the price is below minimum of LAC, so at the price of rupees 20 the price line is equal to minimum of LAC.

(b) At what price will the market for X be in equilibrium? State the reason for your answer.

As free entry and exit of firms is allowed the minimum of AVC is at Rs 20 which is also the equilibrium price because in long run all firms earn zero economic profit. So at any price lower than Rs 20 the firm will move out of the market.

(c) Calculate the equilibrium quantity and number of firms.

q^s = 8 + 3p

= 8 + 3 (20)

= 68 units

q^D = 700 – p

= 700 – 20

= 680 units

No. Of Firms = q^D / q^s = 10

(a) Find the equilibrium price and quantity.

At equilibrium point q^D = q^S

1000 – p = 700 + 2p

300 = 3p

p = 100

Therefore, equilibrium price is Rs 100

q^D = 1,000 – p

= 1000 – 100

= 900 units

Therefore, equilibrium quantity is 900 units

(b) Now suppose that the price of an input used to produce salt has increased so that the new supply curve is

q^S = 400 + 2p

How does the equilibrium price and quantity change? Does the change conform to your expectation?

Now for equilibrium price

1000 – p = 400 + 2p

600 = 3p

p = 200

Therefore, equilibrium price is Rs 100

q^s = 400 + 2p

= 800

Therefore, equilibrium quantity is 800 units

The equilibrium quantity has decreased because the cost of production has increased which will shift the marginal cost curve leftward and move the supply curve towards the left, the leftward shift in the supply curve will result in increase in equilibrium price and fall in equilibrium quantity.

(c) Suppose the government has imposed a tax of Rs 3 per unit of sale of salt. How does it affect the equilibrium price and quantity?

The imposition of tax of Rs 3 per unit of salt sold will raise the cost of producing salt. This

will shift the supply curve leftwards and the quantity supplied equation will become

q^s= 700 + 2 (p - 3)

At equilibrium point q^D = q^S

1000 – p = 700 + 2 (p – 3)

1000 – p = 700 + 2p - 6

1000 – 694 = 3p

p = 102

Therefore, equilibrium price is Rs 102

q^d = 1000 – p

= 1000 – 102

= 898

Therefore, equilibrium quantity is 898 units

If the government imposes price ceiling by controlling the rent that is fixing the maximum price that can be charged as the rent of apartment it will decline the equilibrium price due to

• Excess demand of apartment and

• Black marketing by Builders