01 · Explore
Defining Market Equilibrium
In a perfectly competitive market, equilibrium is the point where the objectives of consumers and firms align perfectly.
Market equilibrium is defined as a situation where the plans of all consumers and firms in the market match and the market clears. At this point, the aggregate quantity that all firms wish to sell equals the quantity that all consumers wish to buy. In other words, market supply equals market demand.
The price at which this balance occurs is known as the equilibrium price (p*), and the quantity traded is the equilibrium quantity (q*). Mathematically, equilibrium is reached when qD(p*) = qS(p*). At any price other than the equilibrium price, the market experiences an imbalance.
If the market price is higher than the equilibrium price, market supply exceeds market demand, creating 'excess supply'. Conversely, if the price is lower than the equilibrium price, market demand exceeds market supply, leading to 'excess demand'. Equilibrium is therefore a state of zero excess demand and zero excess supply.
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Question
What occurs in a market when the prevailing price is higher than the equilibrium price?
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02 · Explore
Market Equilibrium with a Fixed Number of Firms
When the number of firms in a market is constant, equilibrium is determined by the intersection of the market demand and supply curves.
Under the assumption of a fixed number of firms, the market supply curve (SS) represents the total quantity all firms are willing to sell at various prices. The market demand curve (DD) represents the total quantity consumers are willing to buy. Graphically, equilibrium is the point where these two curves intersect.
If the market is out of equilibrium, an 'Invisible Hand' (a concept attributed to Adam Smith) acts to restore balance. If there is excess demand, consumers unable to get the product will offer higher prices, pushing the price up. As the price rises, quantity demanded falls and quantity supplied increases until they meet at p*.
If there is excess supply, firms unable to sell their desired output will lower their prices to attract buyers. As the price falls, quantity demanded increases and quantity supplied decreases until the market clears at the equilibrium point.
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Explain the role of the 'Invisible Hand' in a market with excess supply.
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03 · Explore
Calculating Equilibrium: A Numerical Example
Equilibrium can be determined algebraically by setting the demand function equal to the supply function.
Consider a market where the demand for wheat is qD = 200 - p and the supply is qS = 120 + p. To find the equilibrium price (p*), we set qD = qS. This gives us 200 - p* = 120 + p*. Solving for p*, we get 2p* = 80, which means p* = 40. The equilibrium price is Rs 40 per kg.
To find the equilibrium quantity (q*), we substitute p* = 40 into either equation. Using the demand curve: q* = 200 - 40 = 160 kg. Using the supply curve: q* = 120 + 40 = 160 kg. Thus, the equilibrium quantity is 160 kg.
We can also calculate excess demand or supply at non-equilibrium prices. At p = 25 (below equilibrium), qD = 175 and qS = 145, resulting in an excess demand of 30 kg. At p = 45 (above equilibrium), qD = 155 and qS = 165, resulting in an excess supply of 10 kg.
Equilibrium Price and Quantity Calculation
200 - p* = 120 + p* => 2p* = 80 => p* = 40
By equating market demand and market supply, we find the price where the market clears. Substituting this price back into the functions gives the equilibrium quantity.
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If qD = 100 - p and qS = 20 + p, find the equilibrium price.
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04 · Explore
Wage Determination in the Labour Market
The principles of demand and supply also apply to the labour market, where households supply labour and firms demand it.
In the labour market, 'labour' refers to the hours of work provided. Households are the suppliers, and firms are the demanders. The equilibrium wage rate (w*) is determined where the labour supply curve (SL) and labour demand curve (DL) intersect.
A profit-maximising firm hires labour up to the point where the wage rate equals the Marginal Revenue Product of Labour (MRPL). MRPL is the additional benefit from an extra unit of labour, calculated as Marginal Revenue (MR) multiplied by the Marginal Product of Labour (MPL). Since a perfectly competitive firm is a price taker (MR = P), MRPL is equal to the Value of Marginal Product of Labour (VMPL), which is Price times MPL.
The labour demand curve is downward sloping because of the law of diminishing marginal product. As wages increase, firms must ensure VMPL also increases to maintain profitability, which requires employing fewer workers. The individual labour supply curve may be backward-bending at very high wages due to the trade-off between income and leisure, but the aggregate market supply curve is generally upward sloping.
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At what point does a competitive firm stop hiring additional labour?
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05 · Explore
Impact of Shifts in Demand
Changes in consumer income or the number of consumers can shift the demand curve, altering the market equilibrium.
A rightward shift in the demand curve (increase in demand) occurs when factors like consumer income (for normal goods) or the number of consumers increase. At the original price, this shift creates excess demand. Consumers compete for the limited supply, driving the price up. The new equilibrium results in both a higher price and a higher quantity.
A leftward shift in the demand curve (decrease in demand) occurs if consumer income falls or the number of buyers decreases. This creates excess supply at the initial price. Firms lower prices to sell their stock, leading to a new equilibrium with a lower price and a lower quantity.
It is important to note that when only the demand curve shifts, the equilibrium price and quantity always move in the same direction as the shift.
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How does an increase in the number of consumers affect the equilibrium price and quantity of a good?
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06 · Explore
Impact of Shifts in Supply
Changes in production costs or the number of firms shift the supply curve, affecting price and quantity in opposite directions.
A leftward shift in the supply curve (decrease in supply) can be caused by an increase in the price of an input (like raw materials). This increases the marginal cost of production. At the old price, there is now excess demand, which pushes the market price up and reduces the equilibrium quantity.
A rightward shift in the supply curve (increase in supply) occurs if input prices fall or the number of firms increases. This creates excess supply at the initial price. To clear the market, the price must fall, leading to a new equilibrium with a lower price and a higher quantity.
When only the supply curve shifts, the equilibrium price and quantity move in opposite directions. For example, an increase in supply leads to a lower price but a higher quantity.
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What is the effect of an increase in the price of an input on the market equilibrium?
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07 · Explore
Simultaneous Shifts in Demand and Supply
When both demand and supply shift at the same time, the effect on equilibrium depends on the direction and magnitude of the shifts.
There are four possible combinations of simultaneous shifts. If both curves shift in the same direction (e.g., both rightward), the change in quantity is certain (it increases), but the change in price depends on which shift is larger. If demand increases more than supply, price rises; if supply increases more, price falls.
If the curves shift in opposite directions (e.g., demand shifts right and supply shifts left), the change in price is certain (it increases), but the change in quantity depends on the magnitude of the shifts. If the increase in demand is exactly offset by the decrease in supply, the quantity remains unchanged.
These complex interactions are summarized in economic models to predict market trends when multiple external factors change simultaneously.
| Shift in Demand | Shift in Supply | Quantity | Price |
|---|---|---|---|
| Leftward | Leftward | Decreases | May increase, decrease or remain unchanged |
| Rightward | Rightward | Increases | May increase, decrease or remain unchanged |
| Leftward | Rightward | May increase, decrease or remain unchanged | Decreases |
| Rightward | Leftward | May increase, decrease or remain unchanged | Increases |
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If both demand and supply shift rightward, what can we say for certain about the new equilibrium?
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08 · Explore
Market Equilibrium: Free Entry and Exit
In the long run, the ability of firms to freely enter or leave a market ensures that all firms earn only normal profits.
The assumption of free entry and exit implies that if firms are earning supernormal profits, new firms will enter, increasing supply and lowering the price. If firms are incurring losses, some will exit, decreasing supply and raising the price. This process continues until the price equals the minimum average cost (min AC) of the firms.
Therefore, with free entry and exit, the equilibrium price is always fixed at p = min AC. At this price, each firm earns normal profit, and there is no incentive for further entry or exit. The equilibrium quantity is then determined by the market demand at this specific price.
The assumption of free entry and exit implies that in equilibrium, no firm earns supernormal profit or incurs loss. Therefore, the equilibrium price must be equal to the minimum average cost (min AC) of the firms.
The equilibrium number of firms (n0) is calculated by dividing the total market quantity (q0) by the output supplied by an individual firm (q0f) at the price p = min AC. Thus, n0 = q0 / q0f.
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What is the equilibrium price in a market with free entry and exit?
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09 · Explore
Demand Shifts with Free Entry and Exit
When firms can freely enter and exit, shifts in demand have a different impact compared to a market with a fixed number of firms.
If demand increases (shifts rightward) in a market with free entry and exit, it initially creates excess demand and pushes the price up. This allows firms to earn supernormal profits, which attracts new firms. The entry of new firms increases supply until the price is driven back down to the minimum average cost.
The final result of an increase in demand is that the equilibrium price remains unchanged at min AC, but the equilibrium quantity and the number of firms in the market increase. Conversely, a decrease in demand leads to a lower quantity and fewer firms, but the price remains the same.
In summary, with free entry and exit, demand shifts have a much larger effect on quantity and no effect on price, whereas with a fixed number of firms, both price and quantity change.
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How does a rightward shift in demand affect the equilibrium price when entry and exit are free?
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10 · Explore
Applications: Price Ceiling
Governments sometimes intervene in markets to protect consumers by setting a maximum price for essential goods.
A price ceiling is a government-imposed upper limit on the price of a good or service. It is typically applied to necessities like wheat, rice, or sugar and is set below the market-determined equilibrium price to make these goods affordable for lower-income groups.
While intended to help, a price ceiling below equilibrium creates excess demand (a shortage). At the lower price (pc), consumers want to buy more (qc) than firms are willing to supply (q'c). This shortage means not everyone who wants the good can get it.
To manage this shortage, governments often use rationing, where consumers are issued coupons to buy a limited amount of the good through 'fair price shops'. However, price ceilings can lead to long queues and the emergence of black markets where goods are sold illegally at higher prices.
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What is a major adverse consequence of a price ceiling?
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11 · Explore
Applications: Price Floor
Governments also set minimum prices to ensure producers, such as farmers or workers, receive a fair income.
A price floor is a government-imposed lower limit on the price that may be charged for a good or service. Common examples include agricultural price support programs and minimum wage legislation. The floor is usually set above the market equilibrium price.
Setting a price floor above equilibrium leads to excess supply (a surplus). In the labour market, a minimum wage above the equilibrium rate can lead to unemployment, as the quantity of labour supplied by households exceeds the quantity demanded by firms.
In agricultural markets, to prevent the price from falling due to the surplus, the government often has to purchase the excess produce at the floor price. This ensures farmers receive the intended support but requires significant government expenditure and storage capacity.
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What happens in the market when a price floor is set above the equilibrium price?
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