Chapter 5 Market Equilibrium

Equilibrium, Excess Demand, Excess Supply

In a perfectly competitive market, buyers and sellers interact, each pursuing their self-interested objectives (consumers maximizing preference, firms maximizing profit). Market equilibrium is a state where the plans of all buyers and sellers match, and the market clears.

In equilibrium, the aggregate quantity that firms wish to supply (market supply) equals the aggregate quantity that consumers wish to buy (market demand).

The price at which this occurs is the equilibrium price (p*), and the corresponding quantity bought and sold is the equilibrium quantity (q*).

Mathematically, $(p^*, q^*)$ is an equilibrium if $q_D(p^*) = q_S(p^*)$.

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If the market price is not at the equilibrium level, there will be an imbalance:

• Excess Supply: Occurs at a price where market supply is greater than market demand ($q_S > q_D$). This leads to a surplus of the commodity.
• Excess Demand: Occurs at a price where market demand is greater than market supply ($q_D > q_S$). This leads to a shortage of the commodity.

Equilibrium can also be defined as a situation of zero excess demand and zero excess supply.

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Out-of-equilibrium Behaviour

When the market is not in equilibrium (excess demand or supply exists), there is a tendency for the price to change. This dynamic is often described by the concept of an 'Invisible Hand' in perfectly competitive markets.

In case of excess demand, some buyers are willing to pay more, and the price tends to rise. As price rises, quantity demanded falls and quantity supplied increases, moving the market towards equilibrium.

In case of excess supply, some sellers are unable to sell their desired quantity and will lower their prices. As price falls, quantity demanded rises and quantity supplied falls, moving the market towards equilibrium.

This adjustment process, driven by the 'Invisible Hand', is assumed to guide the market towards equilibrium.

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Market Equilibrium: Fixed Number Of Firms

When the number of firms in the market is fixed, market equilibrium is determined by the intersection of the market demand curve (DD) and the market supply curve (SS).

The intersection point gives the equilibrium price (p*) and equilibrium quantity (q*).

At any price above p*, there is excess supply ($q_S > q_D$), leading to downward pressure on price. At any price below p*, there is excess demand ($q_D > q_S$), leading to upward pressure on price.

Example 5.1 provides a numerical illustration of finding the equilibrium price and quantity by equating algebraic demand and supply functions. It also shows how to calculate excess demand and excess supply at prices below and above equilibrium.

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Wage Determination In Labour Market

The labour market differs from the goods market in the roles of suppliers and demanders: households supply labour, and firms demand labour. Wage rate is the price of labour.

Wage determination under perfect competition in the labour market uses demand-supply analysis, similar to goods markets.

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Shifts In Demand And Supply

Equilibrium price and quantity change when either the demand curve, the supply curve, or both shift due to changes in underlying factors (consumer income/preferences, prices of related goods, technology, input prices, number of firms, etc.).

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Demand Shift

If the demand curve shifts while the supply curve remains unchanged (fixed number of firms):

• Rightward Shift in Demand: At the initial price, there is excess demand. Price tends to rise. New equilibrium is at a higher price and higher quantity.
• Leftward Shift in Demand: At the initial price, there is excess supply (due to reduced demand). Price tends to fall. New equilibrium is at a lower price and lower quantity.

The direction of change in equilibrium price and quantity is the same as the direction of the demand shift (Figure 5.2).

Examples: Increase in consumer income (for a normal good) or increase in number of consumers shifts demand right, leading to higher price and quantity.

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Supply Shift

If the supply curve shifts while the demand curve remains unchanged:

• Rightward Shift in Supply: At the initial price, there is excess supply. Price tends to fall. New equilibrium is at a lower price and higher quantity.
• Leftward Shift in Supply: At the initial price, there is excess demand (due to reduced supply). Price tends to rise. New equilibrium is at a higher price and lower quantity.

The direction of change in equilibrium price and quantity is opposite to the direction of the supply shift (Figure 5.3).

Examples: Increase in input prices shifts supply left, leading to higher price and lower quantity. Increase in the number of firms shifts supply right, leading to lower price and higher quantity.

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Simultaneous Shifts Of Demand And Supply

When both demand and supply curves shift at the same time, the impact on equilibrium price and quantity depends on the direction and magnitude of the shifts (Figure 5.4, Table 5.1).

• If both shift right or both shift left, the change in quantity is unambiguous (increases if both right, decreases if both left), but the change in price is ambiguous (depends on which shift is larger).
• If they shift in opposite directions (demand right, supply left; or demand left, supply right), the change in price is unambiguous (increases if demand right/supply left, decreases if demand left/supply right), but the change in quantity is ambiguous (depends on which shift is larger).

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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Market Equilibrium: Free Entry And Exit

When firms can freely enter and exit a perfectly competitive market (long run analysis), the equilibrium price is determined by the firms' minimum average cost (min AC). In equilibrium, firms earn only normal profit.

If price is above min AC, firms earn supernormal profits, attracting new firms. Supply increases, price falls until supernormal profits are zero. If price is below min AC, firms incur losses, causing some to exit. Supply decreases, price rises until losses are zero (firms earn normal profit).

Thus, with free entry and exit, the equilibrium price is always equal to the minimum average cost of the firms: $p = \text{min AC}$. The equilibrium quantity is determined by the market demand at this price (Figure 5.5).

The equilibrium number of firms is determined by dividing the total equilibrium quantity by the output level of a single firm at min AC.

Example 5.2 provides a numerical illustration of finding equilibrium price, quantity, and number of firms under free entry and exit.

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Shifts In Demand

With free entry and exit, shifts in demand curves impact only the equilibrium quantity and the number of firms, not the equilibrium price, which remains anchored at min AC (Figure 5.6).

• Rightward Shift in Demand: Creates excess demand at min AC. Price initially rises, attracting new firms. Supply increases until price returns to min AC. New equilibrium has a higher quantity and more firms.
• Leftward Shift in Demand: Creates excess supply at min AC. Price initially falls, causing some firms to exit. Supply decreases until price returns to min AC. New equilibrium has a lower quantity and fewer firms.

Compared to fixed number of firms, shifts in demand have a larger impact on equilibrium quantity but no impact on equilibrium price when entry and exit are free.

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Applications

Demand-supply analysis can be applied to study government interventions in markets, such as price controls.

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Price Ceiling

A price ceiling is a government-imposed maximum allowable price for a good, set below the market equilibrium price to make necessary goods affordable (e.g., wheat, rice). At the price ceiling, the quantity demanded exceeds the quantity supplied, creating excess demand (shortage).

This can lead to queues, rationing systems (like ration shops/fair price shops with coupons), and the potential emergence of a black market where goods are sold at prices above the ceiling.

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Price Floor

A price floor is a government-imposed minimum price for a good or service, set above the market equilibrium price to support producers or ensure minimum earnings (e.g., agricultural price support, minimum wage legislation). At the price floor, the quantity supplied exceeds the quantity demanded, creating excess supply (surplus).

In agricultural support programs, the government might buy the surplus output at the floor price to prevent prices from falling. In minimum wage legislation, the excess supply of labor means unemployment.

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Key Concepts

Equilibrium

Excess demand

Excess supply

Marginal revenue product of labour

Value of marginal product of labour

Price ceiling

Price floor

Summary

• In a perfectly competitive market, equilibrium occurs where market demand equals market supply.

• With a fixed number of firms, equilibrium price and quantity are determined by the intersection of demand and supply curves.

• Firms hire labour where marginal revenue product of labour equals wage rate.

• With a fixed number of firms, a rightward (leftward) demand shift increases (decreases) both equilibrium price and quantity. A rightward (leftward) supply shift decreases (increases) price and increases (decreases) quantity.

• Simultaneous shifts' impact depends on direction and magnitude. Price is ambiguous when both shift in the same direction; quantity is ambiguous when they shift in opposite directions.

• With free entry and exit, equilibrium price equals minimum average cost (firms earn normal profit).

• With free entry and exit, demand shifts impact quantity and firm numbers (in the same direction as demand change) but not equilibrium price, which stays at min AC.

• Demand shifts have a larger quantity effect with free entry/exit compared to fixed firm numbers, but no price effect.

• Price ceiling below equilibrium causes excess demand/shortage.

• Price floor above equilibrium causes excess supply/surplus.

Exercises

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Suggested Readings

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