MARKET EQUILIBRIUM

The movement of price, upward or downward, continues till such a price is reached at which
demand becomes just equal to supply. This is called equilibrium price. The equilibrium of
market refers to a situation where demand and supply balance each other.

There are two kinds of markets, perfect market, in which number of sellers is perfect
competition, prevail and imperfect market wherein monopoly (single seller) or monopolistic
competition some sellers are present. In both types of markets, the basic principle of
determination of price is the same i.e. equality of demand and supply. However, there is some
difference in details He market equilibrium under perfect competition only.

How the forces of demand and supply bring about equilibrium can be illustrated a simple
example of a market of wheat.
Table: 1

The table shows that when price of wheat is Rs. 2 per kg., quantity demanded is 18 million tons.
But at this price no body is willing to grow or sell wheat. Price rises. Suppose it goes to Rs.4.
Can this price stay in the market? The answer is no. The producers and sellers consider this price
still quite low. Some refuse to sell any quantity while others offer very small quantity for sale. At
this price, the quantity demanded is in excess of quantity supplied. The buyers feel that there is a
shortage of wheat. They compete with each other to get the required quantity and offer a higher
price. So, competition among buyers pushes up price. It affects demand and supply differently.
Demand contracts, while supply expands. At Rs. 8 per kg., the quantity demanded is just equal to
quantity supplied. Because now there is no force to change this price, it will stay. If due to some
reason, the price happens to rise above Rs. 8, the forces set in which bring down price back to
equilibrium point. Suppose the price is Rs.12. At this price: demand is 8 million tons and supply
20 million tons. There is excess of supply: 1.5 there is surplus. The sellers find it difficult to sell
the desired quantity at current price. To induce more sales, the sellers compete with each other
and offer a lower price. As a result of the action of sellers, market price falls. This process
continues till the price is back at equilibrium level. Then there is no tendency for change in price.

The market equilibrium is explained by a simple graph. In fig.1 quantity demanded and supplied
are indicated on x-axis and price on y-axis.

Fig. 1

DD is the downward sloping market demand curve. Its negative slope indicates that more
quantity will be demanded at lower prices. SS is the upward sloping supply curve. It represents
that a rise in price will lead to expansion of supply. When price is Op both quantity demanded
and quantity supplied are equal at Oq. This price is the equilibrium price and Oq is equilibrium
quantity. Under the given conditions of demand and supply, no other price can be determined. At
any other price, equality of demand and supply will not be achieved. For example, let us suppose
the price is Op1. At this price demand is Bp1 while supply is Tp1. So there is excess supply equal
to BT quantity. This surplus supply pushes down the price. On the other hand if price is Op2,
there is excess demand equal to MN. This will result in rise of price. Thus only Op price can
stay.

Every market shows one of the three situations

 Shortage i.e. D > S and P tends
 Surplus i.e. D < S and P tends
 Balance i.e. D = S and P tends
Equilibrium price is the only price at which both households (buyers) and firms (sellers) are
satisfied with their plans.

Effect of changes in Demand or Supply on Price

It is the interaction of forces of demand and supply that determines market price. However, once
a particular price is settled, it does not mean that it will continue to stay permanently. Both
supply and demand are governed by such factors which do not remain constant, so either demand
or supply or both may change any time. Changes of demand and supply affect the equilibrium
market price and quantity. In this regard, the general rule is that:

 Rise of demand pushes up the price while fall of demand depresses it.
 Rise of supply lowers the price and fall of supply raises it.

Effect of change in Demand

Table 2 shows how a rise and fall of demand influences price. Columns 2 and 3 indicate original
demand and supply position. The two forces are equal at price Rs. 5.
Table: 2

Initially, the price settled in the market is Rs. 5. Later, due to some reason, demand rises. New
demand is shown in column 4. Now if the previous equilibrium price of Rs. 5 continues, the
buyers are willing to buy more than the sellers want to sell. So a competition among buyers starts
and raises the price from Rs. 5 to a new equilibrium position i.e. Rs. 6. If demand falls as given
in column 5, the price falls to Rs. 4, to establish equality of demand and supply at 80.

A similar table can be constructed to show the effect of changes in supply on market equilibrium.
The position of market equilibrium under different demand and supply conditions becomes very
clear with the help of the following diagrams:

CHANGES IN MARKET CONDITIONS — Graphic Method

Effect of change in Demand (Shift of Demand Curve)
Fig. 6.2 illustrates DD and SS as original demand and supply curves.

The equilibrium is at point E. Op and Oq are equilibrium price and quantity respectively.
Now, there is a rise in demand and its new position is D1, while supply remains unchanged. New
equilibrium is at E1. We see that rise in demand has resulted in higher price Op1 and larger
quantity Oq1 than before. On the other hand, when demand falls to D2 position both price and
quantity decrease to become Op2 and Oq2 respectively.

Effect of Change in Supply

Fig. 3

Fig. 3 shows the effect of change in supply. DD and SS are original demand and curves. The
equilibrium price and quantity are Op and Oq. When supply rises and the curve shifts to S1
position, price decreases to Op1 level and quantity exchanged increases to Oq1. If due to some
reason, supply decreases to S2 position, opposite effects are produced. Price has risen to Op2
while quantity has shrunk to Oq2.

Effect of Simultaneous Change in Demand and Supply

In this case many possibilities arise e.g. demand and supply increase in the same proportion or
one change more than the other. We can represent all these possibilities by making different
diagrams on the pattern discussed above.
Fig. 4 (a) Demand and Supply increase equally.

In this case, price remains the same but quantity increases.

(b) Demand increases more than supply.

Here the effect of rise in demand is more. Therefore, price and quantity both rise.

(c) Demand rises less than rise in supply.

Effect of decrease in demand is less than that of decrease in supply so and quantity exchanged
increases.
(d) Demand and Supply fall equally

There is no change in price but quantity traded falls.

(e) Demand falls more than the supply.

Influence of demand is greater than that of supply. So price falls.

(f) Supply falls more than fall of demand.

Since the relative fall in supply is greater, price has risen.

(g) Demand rises and supply falls
Direction of change in both supply and demand is such that price is pushed up.

Here we have that the influence of rise in demand is greater; therefore, quantity w has increased.
In case the influence of fall in supply is greater, the result may be Increase in quantity. But the
price will rise in both cases since rise in demand as well as fall in supply push up price.

MARKET PRICE

Market Price
Market price is the price settled by the forces of demand and supply when the period is
short, say, a day or two. It is so short that firms cannot adjust their production plans y change in
market demand. So, whatever quantity has already been produced and is available in or near the
market, will decide the level of price. We discuss this concept is available in or near in two
situations.

Market Price of Perishable Commodities

Perishable commodities are those cannot be stored or stocked for long. They have to be sold
as early as possible. Since the sellers cannot wait, if enough demand is too forthcoming, the price
extreme low. Take the case of tomatoes as given below. On a particular day with one ton each
have arrived at Lahore Vegetable Market. Since this sun the price will be decided by demand. Al
price Rs. 10 per kg, all the supply is solo supposed that instead of D1, the demand position is D2.
Since this demand is lo settles at a level of Rs.8.
Table: 3. Market Equilibrium

In terms of fig, we suppose that SS is the fixed market supply. It has zero elasticity so it is
vertical line. When demand is D1, the price is p1. If demand falls to D2. Price comes down to p2
level.
Market Price of Durable Goods
These goods can be stocked for some time. So if at some time the sellers feel that price is
unsatisfactory, they offer less for sale. However, if price is rising, the supply can be increased but
only up to the available stock and not more. Take the example of wheat as shown in table 4 and
fig.
Table: 4

Equilibrium price is determined at the point where Qd=Qs. Initially this is per kg. Now if
demand rises to D2 position, price rises to Rs.25. If demand further rises, only price will rise.
Quantity available for sale cannot be increased above 400. This is shown in above fig. If demand
falls, price will fall and stocked. When price comes to Rs.5, no quantity is offered for sale.
 Mathematical Market Equilibrium
Demand function shows the relationship between price and quantity demanded. At different
prices in the market, the people are willing to buy different quantities. When price is low, people
demand more and vice versa.

Similarly supply function shows the various quantities which the producers are willing to supply
at different prices of the commodity.

Under given circumstances, there will be a price at which the sellers are willing to sell as
much quantity as the buyers are willing to buy at that price. This is called market
equilibrium, and that price is called equilibrium price.
Or
Market equilibrium means a situation where Qs = Qd

If we are given supply and demand equations, we can find the equilibrium price and quantity as
illustrated below:

Example 1 Suppose Qd = 50 - 5P .................. (Demand equation)

Qs = 18 + 3P ................... (Supply equation)

Condition for market equilibrium Qs = Qd

Substituting values of Qs and Qd 18 + 3P = 50 - SP
3P + 5P = 50 - 18
8P = 32
P=4

This is market price or equilibrium price. If we put this value of p in either demand or supply
equation we get equilibrium quantity. Thus, Qd = 50 – 5(4) = 50 - 20 = 30
Because Qs = Qd = 30, the solution is P = 4 and Q = 30

Equilibrium price and quantity can also be found out by constructing a schedule or a graph. For
this purpose, we will have to put different values of p in the above given demand and supply
equations. We will then obtain in following schedule.

It is clear that the market equilibrium is at P = 4 and Q = 30. If we plot different values of price
and quantity to get graphs of demand and supply, same result is obtained.

In above fig. DD and SS are demand and supply curves intersecting at point E. Corresponding
to E, the price is 4 while the quantity is 30.