Market Equilibrium

Equilibrium, Excess Demand, Excess Supply

In the previous chapters, we derived the market demand curve (representing the behaviour of consumers) and the market supply curve (representing the behaviour of firms). The interaction of these two opposing forces in a market determines the price and quantity at which a good is bought and sold. This point of balance is known as market equilibrium.

Equilibrium is defined as a situation where the plans of all consumers and firms in the market are matched, and the market clears. At the equilibrium price, the quantity that consumers are willing to buy is exactly equal to the quantity that firms are willing to sell. There is no tendency for the price or quantity to change. This equilibrium price is also known as the market-clearing price.

Mathematically, if $Q^d(P)$ is the market demand function and $Q^s(P)$ is the market supply function, the equilibrium price ($P^*$) and equilibrium quantity ($Q^*$) are found where:

$ Q^d(P^*) = Q^s(P^*) = Q^* $

Market Equilibrium: Fixed Number Of Firms

Let's consider a perfectly competitive market where the number of firms is fixed. The market demand curve is downward sloping, and the market supply curve is upward sloping. The point where these two curves intersect determines the equilibrium.

Out-of-equilibrium Behaviour

What happens if the market is not at equilibrium? The market has a natural tendency to adjust back to equilibrium through the price mechanism.

Excess Demand (Shortage)

Excess demand exists when, at a given price, the quantity demanded is greater than the quantity supplied ($Q^d > Q^s$). This happens if the prevailing price is below the equilibrium price ($P < P^*$). In this situation, there are too many buyers chasing too few goods. This competition among buyers will push the price up. As the price rises:

• Quantity demanded will fall (movement up along the demand curve).
• Quantity supplied will rise (movement up along the supply curve).

This process continues until the price reaches the equilibrium level $P^*$, where excess demand is eliminated.

Excess Supply (Surplus)

Excess supply exists when, at a given price, the quantity supplied is greater than the quantity demanded ($Q^s > Q^d$). This happens if the prevailing price is above the equilibrium price ($P > P^*$). Here, firms are unable to sell all they want to at the current price. To clear their unsold stock, firms will start to lower the price. As the price falls:

• Quantity supplied will fall (movement down along the supply curve).
• Quantity demanded will rise (movement down along the demand curve).

This process continues until the price reaches $P^*$, where the surplus is eliminated and the market is back in equilibrium.

Answer:

Wage Determination In Labour Market

The principles of demand and supply can also be applied to factor markets, like the labour market. In this market, households are the suppliers of labour, and firms are the demanders of labour. The 'price' of labour is the wage rate.

• The demand curve for labour is downward sloping because firms will hire more workers at lower wage rates.
• The supply curve of labour is typically upward sloping because more people are willing to work (or work more hours) at higher wage rates.

The equilibrium wage rate and the level of employment are determined at the intersection of the demand and supply curves for labour.

Shifts In Demand And Supply

The equilibrium price and quantity change whenever there is a shift in either the demand curve or the supply curve.

Demand Shift

If the demand curve shifts, the supply curve remaining unchanged:

• An increase in demand (rightward shift) leads to a higher equilibrium price and a higher equilibrium quantity.
• A decrease in demand (leftward shift) leads to a lower equilibrium price and a lower equilibrium quantity.

Supply Shift

If the supply curve shifts, the demand curve remaining unchanged:

• An increase in supply (rightward shift) leads to a lower equilibrium price and a higher equilibrium quantity.
• A decrease in supply (leftward shift) leads to a higher equilibrium price and a lower equilibrium quantity.

Simultaneous Shifts Of Demand And Supply

When both demand and supply curves shift at the same time, the effect on either price or quantity will be certain, while the effect on the other will be indeterminate (it could increase, decrease, or remain the same) depending on the relative magnitude of the shifts.

Market Equilibrium: Free Entry And Exit

A key feature of perfect competition is the free entry and exit of firms in the long run. This has a profound impact on the long-run equilibrium.

• If existing firms in the market are earning supernormal profits (Price > Average Cost), new firms will be attracted to the industry. The entry of new firms will increase the market supply (shifting the supply curve to the right). This will cause the market price to fall until all supernormal profits are competed away.
• If existing firms are making losses (Price < Average Cost), some firms will exit the industry. The exit of firms will decrease the market supply (shifting the supply curve to the left). This will cause the market price to rise until the losses are eliminated.

Therefore, in the long-run equilibrium under perfect competition, firms earn only normal profit (zero economic profit). The long-run equilibrium price will be equal to the minimum of the Long-Run Average Cost (LRAC) curve.

$ P = \text{minimum LRAC} $

Applications

Sometimes, the government intervenes in the market to regulate prices if it feels the equilibrium price is either too high for consumers or too low for producers. This is done through price controls.

Price Ceiling

A price ceiling is a government-imposed maximum price that can be charged for a good or service. It is set below the equilibrium price to make essential goods affordable for the poor.

Examples in India: Pricing of essential medicines, rent control acts in some cities, capping the price of wheat or rice.

Consequences:

• Shortage: At the low ceiling price, quantity demanded exceeds quantity supplied, creating a persistent shortage ($Q^d > Q^s$).
• Rationing: Since there is a shortage, the government often has to resort to rationing the limited supply, for example, through fair-price shops.
• Black Markets: A black market may emerge where the good is sold illegally at a price higher than the ceiling price, defeating the purpose of the control.

Price Floor

A price floor is a government-imposed minimum price that must be paid for a good or service. It is set above the equilibrium price to protect the income of producers.

Examples in India: The Minimum Support Price (MSP) for agricultural crops like wheat and rice is a classic example of a price floor. The government guarantees to buy any surplus from farmers at this price.

Consequences:

• Surplus: At the high floor price, quantity supplied exceeds quantity demanded, creating a persistent surplus ($Q^s > Q^d$).
• Government Purchase: To make the price floor effective, the government usually has to buy the entire surplus from the producers. This leads to the creation of large buffer stocks, which are expensive to maintain.

Key Concepts

• Market Equilibrium: A state where market demand equals market supply, and there is no tendency for price or quantity to change.
• Equilibrium Price: The price at which quantity demanded equals quantity supplied.
• Equilibrium Quantity: The quantity bought and sold at the equilibrium price.
• Excess Demand (Shortage): A situation where quantity demanded is greater than quantity supplied, occurring at a price below equilibrium.
• Excess Supply (Surplus): A situation where quantity supplied is greater than quantity demanded, occurring at a price above equilibrium.
• Free Entry and Exit: A feature of perfect competition that ensures firms earn only normal profit in the long run.
• Price Ceiling: A legal maximum price, set below equilibrium, leading to shortages.
• Price Floor: A legal minimum price, set above equilibrium, leading to surpluses.
• Minimum Support Price (MSP): A price floor policy for agricultural products in India.

Summary

This chapter explained how the forces of demand and supply interact to determine the market equilibrium price and quantity. In a perfectly competitive market, equilibrium occurs where the market demand curve intersects the market supply curve. Any deviation from this equilibrium, in the form of excess demand or excess supply, creates pressure on the price to adjust and bring the market back to balance.

We analysed how the equilibrium is affected by shifts in demand and supply. The long-run equilibrium in a perfectly competitive market is characterised by zero economic profit due to the free entry and exit of firms, which pushes the price down to the minimum of the long-run average cost.

Finally, we examined the application of this model to understand government interventions like price ceilings (which cause shortages) and price floors (which cause surpluses). These tools help us analyse the real-world consequences of policies aimed at controlling market prices.