Economics Chapter 2.5 – Market Equilibrium

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Chapter 2.5 – Market Equilibrium

Economics Chapter 2.5 – Market Equilibrium

This chapter combines the behaviors of consumers and firms under perfect competition to analyze market equilibrium using demand-supply analysis. It also examines the impacts of shifts in demand and supply on the equilibrium and discusses applications of demand-supply analysis in real-world situations.

5.1 Equilibrium, Excess Demand, and Excess Supply

  1. Equilibrium in a Competitive Market:
    • Definition: Market equilibrium is a state in which the quantity of a commodity that all firms wish to supply equals the quantity that all consumers wish to buy.
    • Equilibrium Price (p*) and Quantity (q*): At equilibrium, the equilibrium price is denoted as p∗p*p∗, and the equilibrium quantity as q∗q*q∗. They satisfy:

qD(p∗)=qS(p∗)

  1. Intuition: In a competitive market, equilibrium is the point where the demand and supply curves intersect, meaning both consumers’ and producers’ plans align, and the market clears (no shortage or surplus).
  2. Excess Demand:
    • Definition: Excess demand exists when the quantity demanded exceeds the quantity supplied at a given price.
    • Implications: When there is excess demand, some consumers cannot obtain the good at the current price and are willing to pay more, which pushes the price up towards the equilibrium.
  3. Excess Supply:
    • Definition: Excess supply occurs when the quantity supplied is greater than the quantity demanded at a given price.
    • Implications: With excess supply, sellers cannot sell all they want to at the current price, so they tend to lower prices, moving towards equilibrium.
  4. Zero Excess Demand-Zero Excess Supply Condition:
    • Equilibrium can also be described as a situation of zero excess demand and zero excess supply, where the market is balanced with no upward or downward pressure on price.
  5. Invisible Hand Mechanism:
    • Historical Context: This concept, attributed to Adam Smith, suggests that in a perfectly competitive market, prices adjust automatically through the “invisible hand,” bringing the market back to equilibrium by addressing shortages or surpluses.

5.1.1 Market Equilibrium: Fixed Number of Firms

  1. Demand and Supply Interaction:
    • Under a fixed number of firms, equilibrium in a competitive market is determined by the interaction of the market demand curve (consumer preferences) and the market supply curve (firms’ willingness to supply at different prices).
    • Graphical Illustration:
      • The equilibrium price and quantity are determined where the market demand curve (DD) intersects the market supply curve (SS).
  2. Market Adjustments for Disequilibrium:
    • Excess Demand: At prices below equilibrium, quantity demanded exceeds quantity supplied, leading to a price increase.
    • Excess Supply: At prices above equilibrium, quantity supplied exceeds quantity demanded, leading to a price decrease.
  3. Example:
    • Suppose the demand and supply functions for wheat are given as:

qD=200−p and qS=120+p

  1. By setting qD=qS, we find equilibrium price:

200 − p = 120 + p ⇒ 2p = 80 ⇒ p∗ = 40

  1. Substitute p∗p*p∗ into either equation to find equilibrium quantity q∗:

q∗ = 160

5.1.2 Market Equilibrium: Free Entry and Exit

  1. Implications of Free Entry and Exit:
    • Profit Normalization: In the long run, free entry and exit ensure that firms earn only normal profit, with the equilibrium price aligning with the minimum average cost (AC) of firms.
    • Market Adjustment:
      • Supernormal Profit: If firms earn supernormal profits (profit above normal profit), new firms enter, shifting the supply curve to the right and reducing price until only normal profit remains.
      • Losses: If firms incur losses, some exit the market, shifting the supply curve left and raising price until firms earn normal profit.
  2. Graphical Representation:
    • The equilibrium price (p) aligns with the minimum average cost of production for firms due to the entry and exit mechanism.
    • Determination of Equilibrium Quantity: Given p = min AC, the quantity demanded at this price determines the total equilibrium quantity.
  3. Example:
    • Suppose the market has a minimum average cost of Rs 20 and demand curve qD = 200 − p. If each firm’s supply curve is qSf = 10 + p:
      • The equilibrium price (p*) is Rs 20.
      • The total equilibrium quantity (q*) is:

q∗=200−20=180

5.2 Shifts in Demand and Supply

  1. Shifts in the Demand Curve:
    • Rightward Shift: An increase in demand, shifting the demand curve rightward, raises both the equilibrium price and quantity, initially creating excess demand until equilibrium is restored.
    • Leftward Shift: A decrease in demand, shifting the demand curve leftward, reduces both the equilibrium price and quantity, initially creating excess supply.
  2. Shifts in the Supply Curve:
    • Rightward Shift: An increase in supply, shifting the supply curve rightward, decreases equilibrium price and increases equilibrium quantity, initially creating excess supply.
    • Leftward Shift: A decrease in supply, shifting the supply curve leftward, increases equilibrium price and decreases equilibrium quantity, initially creating excess demand.
  3. Simultaneous Shifts in Demand and Supply:
    • Both Curves Shift Right: Increases in both demand and supply raise equilibrium quantity, but the effect on equilibrium price depends on the relative magnitudes of the shifts.
    • Both Curves Shift Left: Decreases in both demand and supply reduce equilibrium quantity, but the price effect depends on the shift magnitudes.
    • Opposite Direction Shifts: If demand shifts right and supply shifts left (or vice versa), the effect on equilibrium price and quantity varies depending on which shift is stronger.

5.2.1 Price Ceiling and Price Floor

  1. Price Ceiling:
    • Definition: A price ceiling is a government-imposed maximum price limit to keep goods affordable, commonly applied to essential items like food and fuel.
    • Impact: A price ceiling below the equilibrium price creates excess demand, leading to shortages.
    • Rationing Mechanism: To address the shortage, goods are often rationed, and in some cases, black markets may emerge as consumers seek additional quantities at higher prices.
  2. Price Floor:
    • Definition: A price floor is a government-imposed minimum price to protect sellers (e.g., minimum wage laws, agricultural price supports).
    • Impact: A price floor above the equilibrium price leads to excess supply, resulting in surpluses.
    • Government Intervention: In cases like agricultural price supports, the government may purchase the excess supply to maintain the floor price.

5.3 Summary of Key Concepts

  1. Equilibrium: Achieved where quantity demanded equals quantity supplied, with no upward or downward pressure on prices.
  2. Excess Demand and Supply: Disequilibrium conditions that prompt price adjustments.
  3. Demand and Supply Shifts: Lead to changes in equilibrium price and quantity, with the direction and extent of change depending on the nature of the shifts.
  4. Free Entry and Exit: Ensures that firms earn normal profits in the long run, with price equal to the minimum average cost.
  5. Price Ceiling and Floor: Government interventions to set price limits, which impact market equilibrium by creating shortages or surpluses.

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