FACULTY OF LAW,

ALIGARH MUSLIM UNIVERSITY

ECONOMICS
ASSIGNMENT towards the fulfilment of General Class Test- 1 Session 2020-21

TOPIC – Economic Equilibrium

NAME – MD. SABEEH AHMAD
CLASS – B.A.LL. B Semester III
FACULTY ROLL NO. – 19BALLB003
ENROLMENT NO. – GJ-3428
CONTACT NO.- 8791797417

SUPERVISING TEACHER – Dr. Md. Rahmatullah

Associate Professor, Faculty of Law,
Aligarh Muslim University, Aligarh
 ACKNOWLEDGEMENT

At times like these when the Covid-19 situation prevalent not just in the University but the
entire world, it is indeed difficult for teachers and students alike to guide and for students, be
guided. In spite of such challenging times I am fortunate enough to have teachers who have
left no stone unturned to provide me and the entire students fraternity with utmost guidance
with a dedication unparalleled. I am thankful to Dr Md Rahmatullah Sir, Associate Professor,
Faculty of Law, Aligarh Muslim University for his thorough help and approval throughout the
duration of making this assignment. Challenging times call for difficult decisions. And without a
speck of doubt the entire teaching fraternity have not only done their part but have gone beyond
the normal to ensure the students aren’t at a loss.
At the same time, I am also grateful to my friends, both in the Faculty of Law and otherwise
who have helped me in procuring resources for this assignment. I hope the hard work put in
this assignment is relevant and contributory to the subject and my personal academics.
ECONOMIC EQUILIBRIUM

Equilibrium is a concept borrowed from the physical sciences, by economists who conceive of
economic processes as analogous to physical phenomena such as velocity, friction, heat, or fluid
pressure. When physical forces are balanced in a system, no further change occurs. For example,
consider a balloon. To inflate a balloon, you blow air into it, increasing the air pressure in the
balloon by forcing air in. The air pressure in the balloon rises above the air pressure outside the
balloon; the pressures are not balanced. As a result, the balloon expands, lowering the internal
pressure until it equals the air pressure outside. Once the balloon expands enough so that the air
pressure inside and out have are in balance it stops expanding; it has reached equilibrium.

Equilibrium is a state of balance in an economy, and can be applied in a number of contexts. In

elementary micro-economics, market equilibrium price is the price that equates demand and
supply in a particular market. In this situation the market ‘clears’ at the equilibrium price –
everything that is taken to market by producers is taken out of the market by consumers. This
situation is commonly referred to as ‘partial’ equilibrium.

In introductory macro-economics, national income is in equilibrium when aggregate demand

(AD) equals aggregate supply (AS).

Disequilibrium occurs when a variable change to create an excess of demand or supply, causing
a ‘movement’ to a new equilibrium position. A sudden change is called an economic shock.

General equilibrium theory attempts to show how all markets move towards a co-ordinated
equilibrium – this situation was first described by French 19th century economist Leon Walrus.

MICRO-ECONOMIC EQUILIBRIUM
MACRO-ECONOMIC EQUILIBRIUM

SHORT RUN
A short run competitive equilibrium is a situation in which, given the firms in the market, the
price is such that total amount the firms wish to supply is equal to the total amount the
consumers wish to demand.

More precisely, a short run competitive equilibrium consists of a price p and an output yi for each
firm i such that, given the price p, the amount each firm i wishes to supply is yi and the sum
iyi of all the firms outputs is equal to the total amount Qd(p) demanded.

If the firms in the industry have different cost functions, then the aggregate supply function will
look something like this:
Now suppose that there are n firms, all with the same cost function, and hence the same short run
supply function, say ys. Then a short run competitive equilibrium is a price p and an output y for
each firm such that

y = ys(p) and ny = Qd(p).

LONG RUN
The long-run equilibrium of a perfectly competitive market occurs when marginal revenue
equals marginal costs, which is also equal to average total costs.

LONG RUN EQUILIBRIUM OF COMPETITIVE FIRM AND INDUSTRY

For a firm to earn optimum profits, it is important that it achieves a long run equilibrium. If all
firms in an industry achieve a long run equilibrium, then the industry achieves the same too. In
this article, we will try to understand the conditions governing the long run equilibrium of a firm
and the industry.

(1) LONG RUN EQUILIBRIUM OF THE FIRM

In the long run, a firm achieves equilibrium when it adjusts its plant/s to produce output at the
minimum point of their long-run Average Cost (AC) curve. This curve is tangential to the market
price defined demand curve. In the long run, a firm just earns normal profits. If a firm earns
supernormal profits in the short run, then the industry will attract new firms into it.

Eventually, this leads to a fall in prices of the goods and an increase in prices of the factors as the
industry expands. These changes continue until the AC curve is tangential to the demand curve.
On the other hand, if firms make losses in the short-run, then they leave the industry in the long-
run. This results in a rise in price and a drop in costs as the industry contracts. These changes
continue until the remaining firms in the industry cover their total costs and normal profits.
 OP is the price and the firm is making supernormal profits by working with the plant whose cost
is SAC1. Therefore, the firm has an incentive to build new capacity and move along its LAC.
Simultaneously, the excess profits attract new firms to the industry.

This leads to an increase in the quantity supplied, shifting the supply curve to the left and a fall in
the price, until it reaches the point OP1. At OP1, the firms and the industry are in long run
equilibrium.

(1) CONDITION FOR LONG RUN EQUILIBRIUM OF A FIRM

For a firm to achieve long run equilibrium, the marginal cost must be equal to the price and the
long run average cost. That is, LMC = LAC = P. The firm adjusts the size of its plant to produce a
level of output at which the LAC is minimum. Now, we know that at equilibrium:

• Short-run marginal cost = Long-run marginal cost

• Short-run average cost = Long-run average cost

Therefore, in the long-run, we have: SMC = LMC = SAC = LAC = P = MR

Hence, at the minimum point of the LAC, the plant works at its optimal capacity and the minima
of the LAC and SAC coincide. Also, the LMC cuts the LAC at the minimum point and the SMC
cuts the SAC at the minimum point. Therefore, at the minimum point of the LAC, the equality
mentioned above is achieved.

(2) LONG RUN EQUILIBRIUM OF THE INDUSTRY

An industry attains long run equilibrium when:

i. All firms are in equilibrium (i.e. they earn only normal profits)

ii. There is no entry or exit from the market

From the above figure, we can see that at point E1, AR = MR = LAC = LMC. Notice that E1 is the
minimum point of the LAC curve. Therefore, at this point, the firm produces equilibrium output
(OM) at the minimum cost. In a perfect competition, in the long run, all firms have an optimum
size and charge the minimum possible price which just covers their marginal cost.

Hence, in such a scenario, the market mechanism leads to an optimal allocation of resources. The
following conditions associated with the long run equilibrium of an industry highlight such
optimality:

1. The output is produced at the minimum possible cost.

2. The selling price just covers the marginal cost. (i.e. MC = AR)

3. In the long run, plants are used at full capacity. Therefore, resources are not wasted. (i,e, MC
= AC)

4. Firms earn only normal profits. (i.e. AC = AR)

5. While the profits are normal, firms maximize their profits. (i.e. MC = MR)
Hence, in the long run, LAR = LMR = P = LMC = LAC. Also, the resources are utilized
optimally.

PARTIAL EQUILIBRIUM
When studying partial equilibrium, we consider the equilibrium in one market, taking as
exogenous prices in other markets and agents’ incomes, as well as preferences and technology.
The main advantage of this model is simplicity: the equilibrium price is found by equating
supply and demand. The model can also be used for welfare analysis, evaluating the effect of tax
changes or the introduction of tariffs. However, the assumption that we can analyse one market
independently of others can be dubious in some cases. As an alternative, economists sometimes
study general equilibrium. In this model, we fix preferences and technology and suppose agents
are endowed with goods and shares. We then solve for all prices simultaneously, equating supply
and demand in each market. While this approach is far more general (hence the name), it is
harder to analyse. To illustrate the difference between partial and general equilibrium consider
the worldwide market for cars.1 A partial equilibrium analysis would add up the world’s demand
for cars to form a market demand curve. It would also add up the different firms’ supply curves
to form a market supply curve. The price of cars can then be found where demand equals supply.
Intuitively, if the price were lower the would be excess demand and the price would be bid up; if
the price were higher there would be excess supply and competition among suppliers would
drive the price down. An exogenous increase in demand from China, due to Government
construction of highways, would then shift up the demand curve, raising equilibrium price and
quantity. In a general equilibrium model, there would be many other effects. First, the value of
car firms would rise, increasing the income of their shareholders. Second, the increased demand
for cars would push up the price of complements, such as oil. Third, there would be an increase
in demand for inputs, such as steel, so commodity prices would rise. Ultimately, there is no
single correct model: rather, there is a trade-off between complexity and realism which depends
on the markets at hand and the questions one is interested in.
PARTIAL EQUILIBRIUM ANALYSIS
• In a competitive equilibrium (CE), all agents must select an optimal allocation
given their resources: Firms choose profit-maximizing production plans given their
technology; Consumers choose utility-maximizing bundles given their budget
constraint.
• A competitive equilibrium allocation will emerge at a price that makes consumers’
purchasing plans to coincide with the firms’ production decision.

FIRM:
CONSUMER:

GENERAL EQUILIBRIUM
General Equilibrium Theory is a macroeconomic theory that explains how supply and demand in
an economy with many markets interact dynamically and eventually culminate in an equilibrium
of prices. The theory assumes that there is a gap between actual prices and equilibrium prices.
The goal of the theory is to identify the precise set of circumstances under which the equilibrium
price is likely to achieve stability.
GENERAL EQUILIBRIUM THEORY
Walras developed the general equilibrium theory to solve a much-debated problem in economics.
Up to that point, most economic analyses only demonstrated partial equilibrium—that is, the
price at which supply equals demand and markets clear—in individual markets. It was not yet
shown that equilibrium could exist for all markets at the same time in aggregate.
General equilibrium theory tried to show how and why all free markets tend toward equilibrium
in the long run. The important fact was that markets didn't necessarily reach equilibrium, only
that they tended toward it. As Walras wrote in 1889, “The market is like a lake agitated by the
wind, where the water is incessantly seeking its level without ever reaching it.”
General equilibrium theory builds on the coordinating processes of a free market price system,
first widely popularized by Adam Smith's "The Wealth of Nations" (1776). This system says
traders, in a bidding process with other traders, create transactions by buying and selling goods.
Those transaction prices act as signals to other producers and consumers to realign their
resources and activities along more profitable lines.
Walras, a talented mathematician, believed he proved that any individual market was necessarily
in equilibrium if all other markets were also in equilibrium. This became known as Walras’s
Law.

GENERAL EQUILIBRIUM: CONSUMER MARKET

• Consumer (1)

• Consumer (2)