Market Equilibrium

Introduction to Equilibrium

This chapter synthesizes the analysis of consumer behavior (the demand side) and firm behavior (the supply side) to understand how prices and quantities are determined in a perfectly competitive market. The central concept is market equilibrium.

An equilibrium is a state of balance or rest, where the opposing forces within a market exactly offset each other. It is a situation where the plans of all participants in the market are consistent and mutually compatible, such that there is no inherent tendency for change. In the context of a market, this means the market "clears."

In a state of market equilibrium:

• The aggregate quantity that all firms wish to sell at a certain price (market supply) is precisely equal to the aggregate quantity that all consumers wish to buy at that same price (market demand).
• The price at which this equality occurs is called the equilibrium price, denoted as $p^*$.
• The corresponding quantity that is bought and sold at this price is called the equilibrium quantity, denoted as $q^*$.

The formal condition for equilibrium is:

$q^D(p^*) = q^S(p^*)$

where $q^D(p^*)$ is the market demand and $q^S(p^*)$ is the market supply at the equilibrium price $p^*$.

---

Excess Demand and Excess Supply

When the market price is not at the equilibrium level, the plans of buyers and sellers do not match, leading to a state of disequilibrium characterized by either excess demand or excess supply.

• Excess Demand (Shortage): This situation arises when, at a given price, the quantity demanded by consumers is greater than the quantity supplied by firms ($q^D > q^S$). This typically occurs when the price is below the equilibrium price.
• Excess Supply (Surplus): This situation arises when, at a given price, the quantity supplied by firms is greater than the quantity demanded by consumers ($q^S > q^D$). This typically occurs when the price is above the equilibrium price.

Therefore, equilibrium can be defined as a situation of zero excess demand and zero excess supply.

---

The Role of the 'Invisible Hand'

In a perfectly competitive market, there is no central authority that sets prices. Instead, prices adjust naturally to bring the market to equilibrium. This self-correcting mechanism, famously described by Adam Smith as the 'invisible hand', works through the independent actions of self-interested buyers and sellers.

• In a situation of excess demand (shortage): Consumers are unable to buy all they want at the current price. This competition among buyers puts upward pressure on the price. Some consumers will be willing to offer a higher price to secure the good. As the price rises, two things happen: firms are incentivized to supply more (a movement up along the supply curve), and consumers demand less (a movement up along the demand curve). This process continues, narrowing the gap of the shortage, until the price reaches the equilibrium level, $p^*$, where the shortage is eliminated.
• In a situation of excess supply (surplus): Firms are unable to sell all they want at the current price, leading to unsold inventory. To get rid of their surplus stock, firms will compete by lowering their prices. As the price falls, consumers are encouraged to buy more (a movement down along the demand curve), and firms reduce their production (a movement down along the supply curve). This process continues, shrinking the surplus, until the price settles at the equilibrium level, $p^*$, where the surplus is eliminated.

Equilibrium with a Fixed Number of Firms

In this section, we analyze how the market reaches equilibrium in the short run, where the number of firms in the industry is assumed to be fixed. New firms cannot enter, and existing firms cannot exit.

---

Graphical Representation of Equilibrium

The market equilibrium is graphically determined at the point of intersection of the market demand curve (DD) and the market supply curve (SS).

• The market demand curve (DD) is downward sloping, reflecting the law of demand.
• The market supply curve (SS) is upward sloping, reflecting the law of supply.
• The point where the two curves intersect, point E, represents the market equilibrium.
• The price on the vertical axis corresponding to point E is the equilibrium price, $p^*$.
• The quantity on the horizontal axis corresponding to point E is the equilibrium quantity, $q^*$.

Analysis of Disequilibrium

• If the prevailing price is above equilibrium (e.g., at $p_2$): At this higher price, firms are willing to supply a larger quantity ($q_2$), but consumers are only willing to buy a smaller quantity ($q'_2$). This creates an excess supply or surplus ($q_2 - q'_2$). To sell their unsold goods, firms will compete by lowering prices, causing the market price to fall towards $p^*$.
• If the prevailing price is below equilibrium (e.g., at $p_1$): At this lower price, consumers are willing to buy a larger quantity ($q_1$), but firms are only willing to supply a smaller quantity ($q'_1$). This creates an excess demand or shortage ($q_1 - q'_1$). Consumers who are unable to get the good will compete by offering higher prices, bidding the market price up towards $p^*$.

---

Algebraic Example of Equilibrium

Answer:

---

Application: Wage Determination in a Competitive Labour Market

The demand-supply framework is a versatile tool that can be applied to factor markets, such as the market for labour, to determine the price of that factor (the wage rate).

• Demand for Labour: The demand for labour comes from firms. A profit-maximizing firm will hire workers up to the point where the cost of hiring an additional worker (the wage rate, w) equals the benefit from that worker. This benefit is the Value of Marginal Product of Labour (VMPL). The VMPL is the additional output produced by the last worker (Marginal Product of Labour, MPL) multiplied by the price of the output (P). So, the firm hires until $w = VMPL = P \times MPL$. Because of the law of diminishing marginal product, the MPL falls as more labour is hired. Consequently, the VMPL curve, which is the firm's demand curve for labour, is downward sloping.
• Supply of Labour: The supply of labour comes from households. Individuals face a trade-off between working to earn income and enjoying leisure. Generally, a higher wage rate increases the opportunity cost of leisure, inducing individuals to supply more hours of work. Thus, the market supply curve for labour is typically upward sloping.

The equilibrium wage rate ($w^*$) and the equilibrium level of employment ($l^*$) are determined at the intersection of the market demand curve for labour and the market supply curve for labour.

Impact of Shifts in Demand and Supply

Market equilibrium is not static. It changes whenever there is a shift in either the demand curve or the supply curve. These shifts are caused by changes in the underlying determinants of demand and supply (other than the good's own price). This type of analysis is known as comparative statics, where we compare the initial equilibrium with the new equilibrium after a change.

---

Shifts in Demand

A shift in the demand curve occurs when a non-price determinant of demand changes. These factors include consumer income, tastes and preferences, prices of related goods (substitutes and complements), or the number of consumers in the market.

Rightward Shift (Increase in Demand)

An increase in demand (e.g., due to a rise in consumer income for a normal good) shifts the demand curve to the right, from $DD_0$ to $DD_1$.

1. Initial Disequilibrium: At the original equilibrium price $p_0$, the quantity demanded now exceeds the quantity supplied. This creates an excess demand or shortage.
2. Price Adjustment: The shortage puts upward pressure on the price as consumers compete for the limited supply.
3. Movement to New Equilibrium: As the price rises, two things happen: the quantity supplied increases (a movement up along the supply curve $SS_0$), and the quantity demanded decreases (a movement up along the new demand curve $DD_1$). This process continues until the market reaches a new equilibrium point, G.

The new equilibrium is characterized by a higher equilibrium price ($p_1 > p_0$) and a higher equilibrium quantity ($q_1 > q_0$).

Leftward Shift (Decrease in Demand)

A decrease in demand (e.g., due to a fall in the price of a substitute good) shifts the demand curve to the left, from $DD_0$ to $DD_2$.

1. Initial Disequilibrium: At the original price $p_0$, the quantity supplied now exceeds the quantity demanded, creating an excess supply or surplus.
2. Price Adjustment: The surplus puts downward pressure on the price as firms try to sell their excess inventory.
3. Movement to New Equilibrium: As the price falls, quantity supplied decreases and quantity demanded increases until the market reaches a new equilibrium point, F.

The new equilibrium is characterized by a lower equilibrium price ($p_2 < p_0$) and a lower equilibrium quantity ($q_2 < q_0$).

Conclusion: When the supply curve is held constant, a shift in demand causes the equilibrium price and quantity to move in the same direction.

---

Shifts in Supply

A shift in the supply curve occurs when a non-price determinant of supply changes. These factors include input prices, technology, government taxes, or the number of firms.

Rightward Shift (Increase in Supply)

An increase in supply (e.g., due to an improvement in technology) shifts the supply curve to the right, from $SS_0$ to $SS_1$.

1. Initial Disequilibrium: At the original price $p_0$, this creates an excess supply (surplus).
2. Price Adjustment: The surplus forces firms to lower their prices to attract more buyers.
3. Movement to New Equilibrium: The falling price leads to an increase in quantity demanded and a decrease in quantity supplied until a new equilibrium is reached at point F.

The new equilibrium has a lower equilibrium price ($p_1 < p_0$) and a higher equilibrium quantity ($q_1 > q_0$).

Leftward Shift (Decrease in Supply)

A decrease in supply (e.g., due to an increase in the price of a key input) shifts the supply curve to the left, from $SS_0$ to $SS_2$.

1. Initial Disequilibrium: At the original price $p_0$, this creates an excess demand (shortage).
2. Price Adjustment: The shortage allows firms to raise their prices.
3. Movement to New Equilibrium: The rising price leads to a decrease in quantity demanded and an increase in quantity supplied until a new equilibrium is reached at point G.

The new equilibrium has a higher equilibrium price ($p_2 > p_0$) and a lower equilibrium quantity ($q_2 < q_0$).

Conclusion: When the demand curve is held constant, a shift in supply causes the equilibrium price and quantity to move in opposite directions.

---

Simultaneous Shifts in Demand and Supply

When both the demand and supply curves shift at the same time, the net effect on equilibrium price and quantity depends on the direction and relative magnitude of the shifts. In these cases, the change in one variable (either price or quantity) will be certain, while the change in the other will be uncertain or "indeterminate."

Shift in Demand	Shift in Supply	Effect on Equilibrium Quantity	Effect on Equilibrium Price
Increase (Rightward)	Increase (Rightward)	Increases (Certain)	Indeterminate (Depends on relative shifts)
Decrease (Leftward)	Decrease (Leftward)	Decreases (Certain)	Indeterminate (Depends on relative shifts)
Increase (Rightward)	Decrease (Leftward)	Indeterminate (Depends on relative shifts)	Increases (Certain)
Decrease (Leftward)	Increase (Rightward)	Indeterminate (Depends on relative shifts)	Decreases (Certain)

Analysis of Simultaneous Shifts

• Case 1: Both Demand and Supply Increase (Shift Right). The increase in demand pushes quantity up, and the increase in supply also pushes quantity up. Therefore, the equilibrium quantity will definitely increase. However, the increase in demand pushes the price up, while the increase in supply pushes the price down. The final effect on price is indeterminate and depends on which shift is larger.
• Case 2: Both Demand and Supply Decrease (Shift Left). The decrease in demand pushes quantity down, and the decrease in supply also pushes quantity down. Therefore, the equilibrium quantity will definitely decrease. The effect on price is indeterminate as the two shifts have opposing effects on price.
• Case 3: Demand Increases (Shifts Right) and Supply Decreases (Shifts Left). The increase in demand pushes the price up, and the decrease in supply also pushes the price up. Therefore, the equilibrium price will definitely increase. However, the increase in demand pushes quantity up, while the decrease in supply pushes quantity down. The final effect on quantity is indeterminate.
• Case 4: Demand Decreases (Shifts Left) and Supply Increases (Shifts Right). The decrease in demand pushes the price down, and the increase in supply also pushes the price down. Therefore, the equilibrium price will definitely decrease. The effect on quantity is indeterminate as the two shifts have opposing effects.

Market Equilibrium with Free Entry and Exit

This section analyzes the long-run market equilibrium in a perfectly competitive market. The key feature of the long run is that there are no barriers to entry or exit, allowing the number of firms in the industry to adjust fully to market conditions. For simplicity, we assume that all firms in the market, both existing and potential, are identical, meaning they all have the same cost structure.

---

The Implication of Free Entry and Exit: The Zero-Profit Condition

The freedom of entry and exit is a powerful mechanism that ensures a specific outcome in the long run: all firms in the industry will earn zero economic profit. This is also known as the zero-profit condition. Earning zero economic profit means that firms are earning just enough to cover all their costs, including the opportunity cost of the resources provided by the owner. In other words, they are earning a normal profit, which is the minimum return required to keep the firm in that particular business.

This long-run equilibrium is achieved through the following adjustment process:

• If firms are earning supernormal profits ($p > \text{min AC}$): The existence of economic profits acts as a signal to outsiders. Since there are no barriers to entry, new firms will be attracted to the industry to seek these profits. As new firms enter, the market supply curve shifts to the right. This increase in market supply, with demand remaining unchanged, puts downward pressure on the market price. The entry of new firms will continue, and the price will keep falling, until all supernormal profits are competed away. This process stops when the price has fallen to the level of the minimum average cost ($p = \text{min AC}$), at which point firms are only earning a normal profit.
• If firms are incurring losses ($p < \text{min AC}$): If the market price is below the average cost, firms are not covering all their production costs (including the opportunity cost) and are making an economic loss. Since there are no barriers to exit, some of the least efficient or most pessimistic firms will leave the industry. As firms exit, the market supply curve shifts to the left. This decrease in market supply, with demand remaining unchanged, puts upward pressure on the market price. The exit of firms will continue, and the price will keep rising, until the losses are eliminated. This process stops when the price has risen to the level of the minimum average cost ($p = \text{min AC}$), allowing the remaining firms to once again earn a normal profit.

Therefore, the powerful force of entry and exit ensures that, in the long-run equilibrium, the market price must settle at a level equal to the minimum point of a representative firm's long-run average cost (LRAC) curve.

$p_{LR} = \text{min LRAC}$

---

Equilibrium Determination in the Long Run

In the long run, the equilibrium is determined in a two-step process:

1. The equilibrium price ($p_0$) is determined solely by the cost side of the market. It is "pinned" at the level of the minimum average cost of a typical firm. This implies that the long-run industry supply curve is a perfectly elastic (horizontal) line at this price.
2. The equilibrium quantity ($q_0$) is then determined by the demand side. It is the amount that consumers are willing to purchase at the price $p_0$, found where the market demand curve intersects the horizontal long-run supply curve.

The equilibrium number of firms ($n_0$) is not fixed but is an outcome of the equilibrium process. It is the number of firms required to produce the total market quantity $q_0$. Since all firms are identical and each produces the quantity $q_{0f}$ that corresponds to its minimum average cost, the number of firms is:

$n_0 = \frac{\text{Total Market Quantity}}{\text{Quantity per Firm}} = \frac{q_0}{q_{0f}}$

---

Impact of a Shift in Demand with Free Entry and Exit

The long-run adjustment mechanism fundamentally changes how the market responds to a shift in demand compared to the short-run (fixed firms) case.

• A rightward shift in demand (Increase in Demand): Let's say consumer incomes rise, shifting the market demand curve to the right from $DD_0$ to $DD_1$.

  1. Short-Run Effect: Initially, the price rises above $p_0$, and existing firms increase their output along their short-run marginal cost curves, earning supernormal profits.
  2. Long-Run Adjustment: These profits attract new firms into the industry. The entry of new firms shifts the market supply curve to the right. This increase in supply pushes the price back down.
  3. New Long-Run Equilibrium: The entry of firms continues until the price is driven all the way back down to the original level, $p_0 = \text{min AC}$. The new equilibrium is at point F.

  The final result is a significant increase in equilibrium quantity (to $q_1$) and an increase in the number of firms (to $n_1$), with no change in the long-run equilibrium price.

• A leftward shift in demand (Decrease in Demand): If demand shifts left to $DD_2$.

  1. Short-Run Effect: The price falls below $p_0$, causing existing firms to incur losses.
  2. Long-Run Adjustment: These losses induce some firms to exit the industry. The exit of firms shifts the market supply curve to the left, which pushes the price back up.
  3. New Long-Run Equilibrium: The exit of firms continues until the price is restored to the original level, $p_0 = \text{min AC}$.

  The final result is a significant decrease in equilibrium quantity (to $q_2$) and a decrease in the number of firms (to $n_2$), with no change in the long-run equilibrium price.

Conclusion: In a perfectly competitive market with free entry and exit, the long-run industry supply is perfectly elastic. A shift in demand has a full and pronounced effect on the equilibrium quantity and the number of firms, but no effect on the long-run equilibrium price, which is always determined by the minimum average cost of production.

Applications of Demand-Supply Analysis

The supply-and-demand model is a powerful analytical tool for evaluating the effects of government interventions in the market. While a perfectly competitive market leads to an efficient equilibrium, the resulting price may be considered socially undesirable (either "too high" for consumers or "too low" for producers). In such cases, governments may choose to intervene through price controls. Here we examine two common forms: price ceilings and price floors.

---

Price Ceiling

A price ceiling is a government-mandated legal maximum price that can be charged for a good or service. The primary objective is to make essential goods more affordable for low-income consumers, thus protecting them from prohibitively high market prices. Common examples include rent control on apartments, caps on the prices of essential medicines, and price limits on food grains like wheat and rice.

For a price ceiling to be effective or "binding," it must be set below the free-market equilibrium price. A price ceiling set above the equilibrium price is non-binding and has no effect, as the market price is already below the legal maximum.

Effects and Consequences of a Price Ceiling

While well-intentioned, a binding price ceiling disrupts the market's natural rationing function and leads to several predictable, often negative, consequences.

• Persistent Shortage (Excess Demand): This is the most direct and inevitable outcome. At the artificially low ceiling price ($p_c$), two things happen:
  1. The quantity demanded increases (from $q^*$ to $q_c$) because the good is now cheaper.
  2. The quantity supplied decreases (from $q^*$ to $q'_c$) because producers find it less profitable to produce the good.
  The resulting gap, where the quantity demanded is greater than the quantity supplied, creates a persistent shortage in the market.
• Non-Price Rationing: Since price can no longer allocate the scarce goods, other, often inefficient, mechanisms emerge to distribute the limited supply ($q'_c$). This can include:
  • Long Queues: Consumers may have to wait in long lines at shops, and the good is sold on a "first-come, first-served" basis. The time spent waiting is an additional non-monetary cost to the consumer.
  • Rationing Systems: To ensure a more equitable distribution, the government may implement a formal rationing system. In India, this is done through ration cards and Fair Price Shops, which entitle households to a fixed quantity of the price-controlled good per month.
• Emergence of Black Markets: The shortage creates a powerful incentive for illegal trade. Consumers who are unable to obtain the good through official channels, or who desire more than the rationed amount, may be willing to pay a much higher price. This gives rise to a "black market" where the good is sold illegally at a price that can be even higher than the original equilibrium price, defeating the purpose of the price control for those who use this market.
• Deterioration in Quality: Since producers cannot legally raise the price and their profit margins are squeezed, they may respond by cutting costs. This often leads to a reduction in the quality of the product or service offered.

---

Price Floor

A price floor is a government-mandated legal minimum price that must be paid for a good or service. The objective is to protect the income of producers (e.g., farmers) or suppliers of services (e.g., workers) by ensuring the price does not fall below a certain level. The most common examples are agricultural price support programs, such as the Minimum Support Price (MSP) in India, and minimum wage legislation.

For a price floor to be binding, it must be set above the free-market equilibrium price. A price floor set below the equilibrium is irrelevant as the market price is already higher.

Effects and Consequences of a Price Floor

A binding price floor also prevents the market from reaching equilibrium and creates its own set of consequences.

• Persistent Surplus (Excess Supply): At the artificially high floor price ($p_f$), two effects occur:
  1. The quantity supplied increases (from $q^*$ to $q'_f$) as producers are incentivized by the higher price to produce more.
  2. The quantity demanded decreases (from $q^*$ to $q_f$) as consumers are discouraged by the higher price.
  The resulting gap, where the quantity supplied exceeds the quantity demanded, creates a persistent surplus.
• Government Purchase of Surplus: To maintain the price floor and prevent it from collapsing under the weight of the surplus, the government often has to intervene and buy the entire excess supply ($q'_f - q_f$). In the case of agricultural price supports, this leads to the creation of large "buffer stocks" of food grains. This policy incurs significant costs for the government related to procurement, storage, transportation, and eventual disposal of the surplus, which may be sold at a loss in international markets or distributed through welfare schemes.
• Unemployment (in the case of Minimum Wage): When a minimum wage (a price floor for labour) is set above the equilibrium wage rate, it leads to an excess supply of labour. More people are willing to work at this higher wage than firms are willing to hire. This excess supply manifests as unemployment, where some workers who would have been employed at the lower equilibrium wage are now unable to find a job.

Answer:

Answer:

Answer:

Answer:

Answer:

Answer:

Answer:

Answer:

Answer:

Answer:

Answer:

Answer:

Answer:

Answer:

Answer:

Answer:

Answer:

Answer:

Answer:

Answer:

Answer:

Answer:

Answer:

Answer:

Answer:

Multiple Choice Questions

Short Answer Type Questions

Long Answer Type Questions