Market Equilibrium

03/05/2023 Prabha Panth

MARKET EQUILIBRIUM

Prof. Prabha Panth

03/05/2023


What determines market price?

• Classical economists: cost of production determines market price.

• Utilitarians thought that demand determined market price.

• Marshall pointed out that both D and S are needed to determine market price.

• D and S are like two blades of a pair of scissors, both are needed to cut material.

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Market• Market is where willing buyers meet willing sellers, for

exchange of goods and services.• Could be local, national or international markets.• Refers to Perfect Competition, or a Free Market, without

Government controls.• Both buyers and sellers agree to the market price.• At equilibrium, Qd = Qs.• The market is cleared, i.e. at the given price there is no

surplus of supply,• Or unsatisfied demand, or shortages.

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Market Equilibrium

• Supply and demand are opposing forces.• When P increases D decreases, but S

increases.• When P decreases D increases, but S

decreases.• But there could be one price at which D = S.• This is the point of Market Equilibrium.• With Equilibrium P and Equilibrium Q.

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Market EquilibriumP (Rs) Qd

(Kgs)Qs

(Kgs)1 10 2

2 8 4

3 6 6

4 4 8

5 2 10

* At P = Re.1, Qd = 10 Kgs, Qs = 2 Kgs. Deficiency of S.

Since D > S, sellers increase P. When P D falls, but S increases. This goes on till P = Rs.3. At this point Qd=Qs = 6 Kgs. This

is Equilibrium Price.* At a higher price, Rs.5, Qd=2 Kgs,

but Qs=10 Kgs. Surplus S. As S > D, P falls. As P falls, Qd increases, and Qs

decreases. This goes on till the Equilibrium

P Rs.3 is reached.*Equilibrium quantity = Qd = Qs = 6

Kgs.5


D and S equations• Let Qd = 14 -2P, and Qs = 4 + 2P• What are Equilibrium P and Q?• We know that at equilibrium Qd = Qs,

14 – 2 P = 4 + 2POr 10 = 4P

Or P = 10/4 = Rs.2.5Equilibrium P = Rs.2.50

Substituting P = 2.5 to get Q:14 – 2 (2.5) = 14 – 5 = 9 Kgs (Qd)

4 + 2(2.5) = 4 + 5 = 9 Kgs (Qs)Equilibrium Q = 9 Kgs

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Equilibrium with Shifts in Demand Curve

Rs

0 Qx

D1

D1S

S

P’

Q’

E

D2

D2

P1 F

Q1

If Market D shifts to the right, but no change in S.Then the new equilibrium = F, price increases to P1 and quantity to Q1,If Market D, or shifts to the left, No change in supply,Then both equilibrium P and Q decrease.

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Market Equilibrium

Rs

Qx0

D

D

S

S

P=5d =2 s =10

D < S, surplus, P

P=1 d =10s=2 D > S, deficit, P

P=3 E

Qd=Qs=68


Shifts in Supply Curve

Rs

0Qx

P’

E

Q’

D

DS

S

S1

S1

P1F

Q1

If total S, shifts to the right, no change in D,Then new equilibrium= F, price falls to P1, and Q increases to Q1.Opposite effect when S shifts to the left.

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Stability, Uniqueness and Existence of Market Equilibrium

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Stable Equilibrium

• Stable Equilibrium: when any disturbance to the equilibrium generates forces that bring the system back to the original position.

• In certain situations, the price and Q do not return to the original position.

• This is called Unstable Equilibrium.• This occurs when D or S curves do not have their

characteristic shapes, • Then P and Q will move progressively away from the

original equilibrium.

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Stable Market Equilibrium

Rs

Qx0

D

D

S

S

P=5d =2 s =10

D < S, surplus, P

P=1 d =10s=2 D > S, deficit, P

P=3 E

Qd=Qs=612


Unstable Equilibrium

Rs

0Qx

D

D

S

S

P’E

Q’

P1 d1s1

When D > S, P increases

Rising D-curve (luxuries).• E is equilibrium.• If P is higher, P1, D > S, so P rises.• If P is lower, P0, D < S, price falls.• So the system can never come back to the former equilibrium.

When D < S, P decreases

s2

d2P0

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Unstable Equilibrium

Rs

0 Qx

D

D

S

S

P’E

Q’

P0s1

d1

When D < S, P decreases

s2 d2

When D > S, P increases

Falling S-curve (decreasing costs).• E is equilibrium.• If P is lower, P0, D < S, so P falls.• If P is higher at P1, D >S, price rises.• So the system can never come back to the former equilibrium.

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Uniqueness of Equilibrium

• Will there be only one market P and Q?

• Empirical analysis shows that the smooth and customary shapes of D and S may not exist.

• Possible to have multiple equilibria.

• Then which is the actual equilibrium?

S

Rs

0Q

D

D

S

a

b

c

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Existence of Equilibrium

• Does equilibrium exist at all?• It can exist if D and S curves cut each other

in the positive quadrant only.• This is correct theoretically, • But D and S curves, drawn from collected

data may not cut each other at all.• Then there is no equilibrium.

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Rs

0Q

P

D

S Here though D and S have their normal shapes, they do not intersect in the positive quadrant. Equilibrium P is negative. So equilibrium does not exist

E

Q1

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No Equilibrium


Q0

Rs

D

S

P

Q

E

Here D and S do not intersect in the positive quadrant. Equilibrium Q is negative. So equilibrium does not exist

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What other factors determine prices?

Price

1.Competition2. Costs

3. Demand

4. Life cycle5. Sales channels

6. Government policy


QuestionsI. Short answers:

1. Define Market Equilibrium, and depict it with the help of a diagram.

2. Estimate the market P and Q from the following equations: Qd = 45 – 10P, and Qs=5+10P

3.Is equilibrium always unique? Show with the help of a diagram.

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II. Essay Questions:1. What are the characteristics of Market equilibrium? Draw diagrams to illustrate your answer.2. Explain with the help of diagrams, the equilibrium P and Q, when (a) D curve shifts to the right, S constant, and (b) when S curve shifts to the left, D constant.3. What is unstable equilibrium? Under what conditions does it exist. Illustrate.4. When is it not possible to achieve market equilibrium? Draw diagrams to illustrate your answer.

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Education

Market Equilibrium