DPUE

Economics

Chapter 5

Micro Economics
 Chapter-5: Market Equilibrium.

In perfect competition buyers and sellers are price takers.

 Market Equilibrium: An equilibrium can be defined as a situation in which the plans
are all consumers a firm’s in the market match and market clears.
 Equilibrium Price: The price at which equilibrium is reached is called equilibrium
price.
 Equilibrium quantity: It is the quantity which is bought and sold at equilibrium price.
Difference between excess demand and excess supply:
If at a price market supply is greater than market demand, there is an excess supply in
the market.
If at a price market demand exceeds market supply, there is an excess demand.
From the time of Adam Smith (1723-1790), it has been maintained that in a perfectly
competitive market a ‘Invisible Hand’ is at play which changes price whenever there is
imbalance in the market. Our intuition also tells us that this ‘Invisible Hand’ should raise the
prices in case of ‘excess demand’ and lower the prices in case of ‘excess supply’.

Market equilibrium with fixed number of firms:

Here the equilibrium price is determined by the intersection of market demand curve
and market supply curve.
Figure illustrates equilibrium for a perfectly competitive market when there are fixed
number of firm’s. SS denotes the market supply curve and DD denotes market demand curve
for a commodity.
Graphically, an equilibrium point is a point where the market demand curve intersects
the market supply curve. At equilibrium market demand equals market supply. At any other
point either there is excess demand or there is excess supply.
 In the figure, if the prevailing price is p1, the market demand is q1, the market supply is
q1’.Hence there is excess demand (q1’ q1). Similarly, if the market price is p2, the market supply
(q2) will exceed market demand (q2’).
At p*, market demand equals market supply. So p* is the equilibrium price and
corresponding quantity q* is the equilibrium quantity.

The demand and supply curves of wheat are given by the following equations:
Demand for wheat. qD = 200-P and supply of wheat qS= 120+ P
Here qD= quantity demanded, qS=quantity supplied and P= price of wheat per kg in rupees.
At equilibrium qD=qS
So, 200-P=120+P
200-120=P+P
80=2P
P=80/2=40
a) Equilibrium price P= Rs. 40.
b) The equilibrium quantity is obtained by substituting the equilibrium price P=40 into
either the demand or the supply curve’s equation.
So,
qD =200-P qS=120+P
qD = 200-40 qS=120+40
qD =160 qS =160
qD=qS
c) At a price less than equilibrium price P.
Say P= Rs. 25
qD=200-P qS =120+ P
qD=200-25 qS =120+25
qD=175 qS =145
qD > q S
d) At a price greater than equilibrium price P.
Say P= Rs. 45
qD=200-P qS =120+ P
qD=200-45 qS =120+45
qD=155 qS =165
qD ˂ qS
Wage determination in the labour market:
By labour we mean the hours of work provided by labourer.
The wage rate is determined by the intersection of the demand and supply curves of
labour where the demand for labour equals supply of labour.
The graph shows wage is determined at the point where the labour demand and supply
curves intersect.

Marginal Product of Labour (MRPL):

 Wage rate (W) is the extra cost of hiring one more unit pf labour.
 Marginal Product (MPL) can be defined as the extra output produced by one more unit of
labour.
 Marginal Revenue (MR) is the additional earning of a firm by selling each extra unit of
output.
 Hence for each extra unit of labour, he gets an additional benefit equal to marginal revenue
times marginal product which is called Marginal Product of Labour (MRPL).
So,
W= MRPL and
MRPL = MR x MPL

Simultaneously shifts of Demand and Supply:

Simultaneously shifts of Demand and Supply curves in four possible ways:
1. Both supply and demand curves shifts rightwards.
2. Both supply and demand curves shifts leftwards.
3. Supply curve shifts leftward and demand curve shifts rightward.
4. Supply curve shifts rightward and demand curve shifts leftward.
The impact on equilibrium price and quantity in all the above cases are listed in table.
 Shift In Shift in Quantity Price
supply Demand
Leftward Leftward Decreases May Increase, Decrease
or remain unchanged
Rightward Rightward Increases May Increase, Decrease
or remain unchanged
Rightward Leftward May Increase, Decrease Decreases
or remain unchanged
Leftward Rightward May Increase, Decrease Increases
or remain unchanged

Simultaneous shifts of Demand and Supply curves in 4 possible ways are represented in the
diagram below.

In the figure (a) it can be understood that due to rightward shifts in both demand and
supply curves, the equilibrium quantity increases but the equilibrium price remains the same
and in figure (b) equilibrium quantity remains unchanged but price decreases because of
leftward shift in demand curve and a rightward shift in supply curve.

Implication of Free Entry and Exit of a Firm on Market Equilibrium:

Here, for simplicity, we assume that all the firms in the market are identical. This
assumption implies that in equilibrium no firm earns supernormal profit or incurs loss by
remaining in production; in other words, the equilibrium price will be equal to the minimum
average cost of the firms.
 Suppose, at the prevailing market price, each firm is earning supernormal profit. The
possibility of earning supernormal profit will attract some new firms. As new firms
enter the market supply curve shifts rightward. However, demand remains unchanged.
 This causes market price to fall. As prices fall, supernormal profits are eventually wiped
out. At this point, with all firms in the market earning normal profit, no more firms
will have incentive to enter.
 Similarly, if the firms are earning less than normal profit at the prevailing price, some
firms will exit which will lead to an increase in price, and with sufficient number of
firms, the profits of each firm will increase to the level of normal profit. At this point,
no more firm will want to leave since they will be earning normal profit here. Thus,
with free entry and exit, each firm will always earn normal profit at the prevailing
market price.
 Therefore, free entry and exit of the firms imply that the market price will always be
equal to the minimum average cost, that is P = min AC.

Price Determination with Free Entry and Exit. With free entry and exit in a perfectly
competitive market, the equilibrium price is always equal to min AC and the equilibrium
quantity is determined at the intersection of the market demand curve DD with the price line
P= min AC.

Applications of supply –demand analysis:

 Price ceiling: Price ceiling is the government imposed upper limit on the price of a
good or service. It is generally imposed on necessary items like rice, wheat, kerosene,
sugar etc. It is fixed below the market determined price because some section of the
population is not able to afford these goods.
Often it becomes necessary for the government to regulate the prices of certain
goods and services when their prices are either too high or too low when comparison to
the expected levels.
Let us examine the effects of price ceiling on market equilibrium through the example
of market for wheat. Figure shows the market supply curve SS and the market demand
curve DD for wheat.
 Effect of Price Ceiling in Wheat Market. The equilibrium price and quantity are p*
and q* respectively. Imposition of price ceiling at pc gives rise to excess demand in the
wheat market.
Hence, though the intention of the government was to help the consumers, it could
end up creating shortage of wheat. Ration coupons are issued to the consumers so that no
individual can buy more than a certain amount of wheat and this stipulated amount of
wheat is sold through ration shops which are also called fair price shops.
 Price Floor: The government imposed lower limit on the price that can be charged for a
particular good or service is known as price floor. Fall in price below a particular level is
not desirable in case of certain goods. Hence the government sets the floors or minimum
prices for these goods and services.
Well known examples for Price Floor are:
1. Agricultural price support programmes: The government imposes a lower limit
on the purchase price for some of the agricultural goods through an agricultural
price support programme.
2. The minimum wage legislation: the minimum wage legislation, the government
ensures that the wage rate of the labourers does not fall below a particular level and
here again the minimum wage rate is set above the equilibrium wage rate.
 Effect of Price Floor on the Market for Goods. The market equilibrium is at (p*,
q*). Imposition of price floor at pf gives rise to an excess supply.

Points to remember:
 In perfect competition buyers and sellers are price takers.
 A situation where plans of all consumers and firms in the market match is Equilibrium
situation.
 The firms earn super normal profit as long as the price is greater than the minimum of
average cost.
 In a perfectly competitive market, equilibrium occurs when market demand equals market
supply.
 In labour market households are the suppliers of labour.
 Possibility of supernormal profit attracts new firms.

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