EQUILIBRIUM OF SUPPLY AND DEMAND

Equilibrium in general is defined as the state of rest or balance from which there is no tendency
for change. In economics, equilibrium normally refers to equilibrium in a market. .Market
equilibrium is that point where where quantity demanded is exactly equal to the quantity
supplied. (DD = SS).

Market demand and supply schedule:

Price Quantity Quantity

Demanded Supplied
1 50 10

2 40 20

3 30 30

4 20 40

5 10 50

EXPLAINATION OF SCHEDULE: In the above schedule we can examine three components i.e
price, quantity demanded, quantity supplied. In the schedule we can see inverse relationship
between price & quantity demanded and direct relationship between price and quantity
supplied. Equilibrium price is 3, where quantity demand (30) is equals to quantity supplied (30).

Market equilibrium can also be illustrated with help of Figure:

 In the above diagram Equilibrium price is OP. At price OP ( 3) , the quantity demanded is equal
to quantity supplied, D=S. At other prices, there is no equality between quantity demanded
and quantity supplied. In both the cases either the consumer or the firms are dissatisfied and
tend to change the price.

Excess Supply: (S>D) At any price above the equilibrium price OP (3), supply is greater than
demand (S>D). Thus there is excess supply. When price is high, buyers prefer to reduce their
purchase. But sellers prefer to sell more as price is high. These contrasting behaviours of
buyers and sellers result in excess supply in the market which is the difference between the
quantity demanded and quantity supplied.

Excess demand: (D > S) similarly, if the price is below the equilibrium price OP (3), there will be
excess demand, D>S. In this case some of the buyers may try to bid up the price to buy some
more quantity when supply is less. This may also encourage sellers to supply more. Thus, in
both cases, the actions of buyers and sellers will move the price either upwards or downwards
and eliminate the excess demand or excess supply. Such actions also restore the demand-
supply balance to attain the market equilibrium. At equilibrium price, there is no force to
change the price or quantity demanded of a commodity.

Shift in Demand and Supply or changes in equilibrium price

The market equilibrium attained above is temporary. It cannot be retained for a long period. It
is because demand and supply conditions keep changing frequently. Any change in the
determinants of demand and supply will shift the demand curve and supply curve. These shifts
will also bring new equilibrium.

1. Shift in demand curve supply remaining constant:

The ‘other things’ that affect demand are also called as the determinants of demand. They
include income of the consumer, tastes, prices of substitutes goods etc. Changes in these
determinants will change demand independently of price. If income of the consumer increases,
they will buy more irrespective of the price. Similarly a fall in income will bring a fall in demand
even if there is no change in price.

In the above diagram on ‘X’ axis we measure quantity and on ‘Y’ axis we measure price. DD is
the original demand curve with equilibrium price OP and quantity OQ. For instance, a rise in
the income of consumer will shifts the demand forward forming a new demand curve D1 , D1
which meets the supply curve at point E1.therefore E1 is the new market equilibrium. And
new equilibrium price increase from OP to OP1 & equilibrium quantity also increases from OQ
to OQ1.

Similarly, any decrease in income shifts the demand curve backward forming a new demand
curve D2, D2 which meets the supply curve at point E2.therefore E2 is the new equilibrium
market equilibrium. And new equilibrium price decrease from OP to OP2 & equilibrium quantity
also increases from OQ to OQ2.

2. Shift in supply curve and demand remaining constant

As seen earlier, the supply curve shows the relationship between the price and quantity
supplied keeping the ‘other things’ constant. The ‘other things’ which affect supply includes
number of sellers in the market, factor prices, etc. These factors affect quantity supplied
independently of price.

Explanation:

In the above diagram on ‘X’ axis we measure quantity and on ‘Y’ axis we measure price. SS is
the original supply curve with equilibrium price OP and quantity OQ. Increase in supply Curve is
shown by shift of supply curve to the right (Forward) forming the new supply curve S1, S1 which
meets the demand curve at point E1 therefore E1 is the new market equilibrium. And new
equilibrium price increase from OP to OP1 & equilibrium quantity also increases from OQ to
OQ1.

Similarly, an increase in factor price will increase the cost of production and the supply curve
will shift to the left (backward) forming a new supply curve S2, S2 which meets the demand
curve at point E2, therefore E2 is the new market equilibrium. And new equilibrium price
decrease from OP to OP2 & equilibrium quantity also decreases from OQ to OQ2.

3. Both demand & supply increase in same proportion:

Explanation

Increase in Demand = Increase in Supply

When increase in demand is proportionately equal to increase in supply, then rightward shift in
demand curve from DD to D1D1 is proportionately equal to rightward shift in supply curve from
SS to S1S1. The new equilibrium is determined at E1. As both demand and supply increase in
the same proportion, equilibrium price remains the same at OP, but equilibrium quantity rises
from OQ to OQ1.

4. Both demand & supply Decrease in same proportion:

Explanation

Decrease in Demand = Decrease in Supply

When decrease in demand is proportionately equal to decrease in supply, then leftward shift in
demand curve from DD to D1D1 is proportionately equal to leftward shift in supply curve from
SS to S1S1. The new equilibrium is determined at E1 As demand and supply decrease in the
same pro-portion, equilibrium price remains same at OP, but equilibrium quantity falls from OQ
to OQ1.

ELASTICITY OF DEMAND:

 Elasticity of demand measures the degree of responsiveness of the quantity demanded

of a commodity to a given change in any of the determinants of demand.
 By responsiveness we mean the proportion by which the quantity demanded of a
commodity changes, in response to a given change in any of its determinants.

Elasticity of demand = Percentage change in quantity demanded

Percentage change in Price

 Elastic demand: Is the one when the response of demand is greater with a small
proportionate change in the price.
 Inelastic demand: is the one when there is relatively a less change in the demand with
a greater change in the price.

Types of Elasticity of Demand:

1. Price elasticity of demand

2. Income elasticity of demand

3. Cross elasticity of demand

1. Price elasticity of demand

Price elasticity of demand is defined as a measurement of percentage change in quantity

demanded in response to a given percentage change in own price of the commodity.
OR
The change in quantity demanded of a product due to change in its price is known as Price
elasticity of demand.

Ep = The percentage change in quantity demanded

The percentage change in price

Types/ degrees of price elasticity of demand

The price elasticity of demand has been divided into five types:

1. Perfectly elastic demand

2. Perfectly inelastic demand

3. Relatively elastic demand

4). Relatively inelastic demand

5). Unitary elastic demand

1. Perfectly Elastic Demand: (ep =∞)

When a small change in price of a product causes a major change in its demand, it is said to be
perfectly elastic demand. In perfectly elastic demand, the demand curve is parallel to ‘X-axis.
It can be interpreted from the above graph that at price OP, demand is infinite at price P
consumers are ready to buy as much quantity of the product as they want.

2. Perfectly Inelastic Demand: (ep = 0).

Perfectly Inelastic Demand refers to the situation when change in price causes no change in
quantity demanded.
OR
A perfectly inelastic demand is one when there is no change in the quantity demanded of a
product with change in its price. In perfectly inelastic demand, the demand curve is parallel to
‘Y-axis.

It can be interpreted from above graph that the movement in price from OP to OP 1 and OP to
OP2 does not show any change in the quantity demanded of a product (OQ). The demand
remains constant for any value of price. In case of essential goods, such as salt, the demand
does not change with change in price. Therefore, the demand for essential goods is perfectly
inelastic.

3. Relatively Elastic Demand: (ep>1)

Relatively elastic Demand refers to the situation when change in price brings about more than
proportionate change in quantity demanded.
It can be interpreted from graph that the proportionate change in demand from OQ1 to OQ2 is
relatively larger than the proportionate change in price from OP1 to OP2. For example if the
price decreases to 25% than the quantity demanded increases from 75%.

4. Relatively Inelastic Demand: (ep<1)

Relatively inelastic Demand refers to the situation when change in price brings about less than
proportionate change in quantity demanded.

It can be interpreted from above graph that the proportionate change in demand from OQ1 to
OQ2 is relatively smaller than the proportionate change in price from OP to OP1.

5. Unitary Elastic Demand: (ep=1)

Unitary elastic Demand refers to the situation when change in price brings about exactly
proportionate change in quantity demanded.
It can be interpreted from above graph that change in price OP1 to OP2 produces the same
change in demand from OQ1 to OQ2. Therefore, the demand is unitary elastic.

Methods of measuring price elasticity of demand

1. Percentage Method: According to this method price elasticity is estimated by

dividing the percentage change in quantity demanded by the percentage change in
price of the commodity.

Ep = The percentage change in quantity demanded

The percentage change in price

ep = % ∆ Qty. Demanded
%∆P

2. Point Method

∆Q P1
∆P Q1
Calculate the price elasticity of demand (using percentage method) for the following data and
identify the type of it.
Price Quantity
Demanded
20 10
40 80

***problems solution refer to the class notes