MICRO.

ECO – XI – 5
Market Equilibrium
 Definition: Market equilibrium is a situation where the quantity of a commodity that all firms
wish to sell (market supply) equals the quantity that all consumers in the market wish to buy
(market demand). In simpler terms, supply equals demand.

 Equilibrium Price (p) and Equilibrium Quantity (q):** The price at which this balance is
achieved is the equilibrium price, and the corresponding quantity bought and sold is the
equilibrium quantity. Graphically, it's the point where the market demand curve intersects
the market supply curve.

 Excess Demand: Occurs when, at a given price, the market demand is greater than the
market supply. This leads to some consumers being unable to buy the desired quantity,
creating upward pressure on prices.

 Excess Supply: Occurs when, at a given price, the market supply is greater than the market
demand. This means some firms cannot sell their desired quantity, leading to downward
pressure on prices.

 The 'Invisible Hand': In a perfectly competitive market, Adam Smith's concept suggests that
market forces act to correct imbalances. In case of excess demand, prices tend to rise, and in
case of excess supply, prices tend to fall, naturally pushing the market towards equilibrium.
This assumption of the 'Invisible Hand' guiding the market to equilibrium is maintained
throughout the chapter.

Market Equilibrium with a Fixed Number of Firms

 Here, the market supply curve is derived by aggregating the supply curves of individual firms,
assuming the number of firms remains constant.

 Graphical Representation: Figure 5.1 illustrates this equilibrium. The intersection of the
downward-sloping market demand curve (DD) and the upward-sloping market supply curve
(SS) determines the equilibrium price (p*) and quantity (q*).

 Price Adjustments:

o Price above equilibrium (p₂): Excess supply exists (q₂ > q'₂). Firms lower prices to sell
their output, leading the market back to p*.

o Price below equilibrium (p₁): Excess demand exists (q₁ > q'₁). Consumers are willing
to pay more, pushing the price up towards p*.

 Algebraic Determination: Equilibrium price and quantity can be found by equating the
market demand equation (qD(p)) with the market supply equation (qS(p)) and solving for 'p'
(equilibrium price, p*). Substituting p* back into either equation gives the equilibrium
quantity (q*). Example 5.1 provides a numerical illustration.

Shifts in Demand and Supply

  Changes in factors other than the price of the commodity (e.g., consumer income, tastes,
input prices, technology, number of consumers/firms) can cause the entire demand or
supply curve to shift.

 Demand Shift:

o Rightward Shift (increase in demand): At the initial equilibrium price, there will be
excess demand, leading to an increase in both equilibrium price and quantity (Figure
5.2a). Factors like increased consumer income (for normal goods) or an increase in
the number of consumers cause this.

o Leftward Shift (decrease in demand): At the initial equilibrium price, there will be
excess supply, leading to a decrease in both equilibrium price and quantity (Figure
5.2b).

 Supply Shift:

o Leftward Shift (decrease in supply): At the initial equilibrium price, there will be
excess demand, leading to an increase in equilibrium price and a decrease in
equilibrium quantity (Figure 5.3a). Factors like an increase in the price of an input
cause this.

o Rightward Shift (increase in supply): At the initial equilibrium price, there will be
excess supply, leading to a decrease in equilibrium price and an increase in
equilibrium quantity (Figure 5.3b). Factors like an improvement in technology or an
increase in the number of firms cause this.

 Simultaneous Shifts: When both demand and supply curves shift at the same time, the
impact on equilibrium price and quantity depends on the direction and magnitude of each
shift (Table 5.1 and Figure 5.4). The impact on one (price or quantity) might be unambiguous,
while the impact on the other depends on the relative magnitudes of the shifts.

Wage Determination in the Labour Market

 The principles of demand and supply can also be applied to the labour market.

 Demand for Labour: Comes from firms aiming to maximize profits. A firm will hire labour up
to the point where the wage rate (w) equals the Marginal Revenue Product of Labour
(MRPL). For a perfectly competitive firm, MRPL equals the Value of Marginal Product of
Labour (VMPL). Due to the law of diminishing marginal product, the demand curve for
labour is downward sloping. The market demand curve for labour is the aggregation of
individual firms' demand curves.

 Supply of Labour: Comes from households making a trade-off between income and leisure.
The individual labour supply curve can be backward bending at higher wage rates due to the
income effect outweighing the substitution effect. However, the market supply curve for
labour is generally upward sloping as more individuals are attracted to work at higher
wages.

 Equilibrium Wage (w) and Equilibrium Employment (l):** Determined by the intersection of
the market demand and supply curves for labour (Figure 5.1 on page 76).
Market Equilibrium with Free Entry and Exit

 This section considers a scenario where firms can freely enter or leave the market.

 Zero Economic Profit in Equilibrium: Free entry and exit imply that in the long run, no firm
earns supernormal profits or incurs losses. If firms are making supernormal profits, new
firms will enter, increasing supply and lowering price until profits return to normal. If firms
are making losses, some will exit, decreasing supply and raising price until losses are
eliminated.

 Price equals Minimum Average Cost (min AC): In the long-run equilibrium with free entry
and exit, the market price will be equal to the minimum of the average cost curve of the
firms. Each firm will earn only normal profit at this price.

 Equilibrium Quantity Determined by Market Demand: At the price p = min AC, the total
quantity supplied in the market will be determined by the market demand at that price
(Figure 5.5).

 Number of Firms is Endogenous: The equilibrium number of firms is determined by the total
market demand at the equilibrium price and the quantity each firm supplies at that price.

 Impact of Demand Shifts: With free entry and exit, a shift in the demand curve leads to a
change in the equilibrium quantity and the number of firms in the same direction as the
demand shift, but the equilibrium price remains unchanged (Figure 5.6). This is because the
price is always anchored at the minimum average cost. The effect on quantity is more
pronounced compared to the fixed number of firms scenario.

Applications of Demand-Supply Analysis: Government Intervention

 This section examines two forms of government price control: price ceiling and price floor.

 Price Ceiling: A government-imposed maximum allowable price for a good or service, usually
set below the market equilibrium price to make essential goods affordable.

o Effect: Creates excess demand (shortage) as quantity demanded exceeds quantity

supplied at the ceiling price (Figure 5.7).

o Consequences: May lead to rationing, long queues, and the development of black
markets.

 Price Floor: A government-imposed minimum price that can be charged for a good or
service, often set above the market equilibrium price to support producers (e.g., in
agriculture) or labour (minimum wage).

o Effect: Creates excess supply (surplus) as quantity supplied exceeds quantity

demanded at the floor price (Figure 5.8).

o Consequences: In the case of agricultural support, the government may need to buy
the surplus.

Expected Prelims and Mains Questions

Prelims:

 Which of the following conditions defines market equilibrium in a perfectly competitive

market? (a) Price equals marginal cost (b) Quantity demanded equals quantity supplied (c)
Marginal revenue equals marginal cost (d) Average revenue equals average cost

 Imposition of a price ceiling below the equilibrium price in a market is likely to result in: (a)
Surplus (b) Shortage (c) Increase in supply (d) Decrease in demand

 Consider a perfectly competitive market for good X. If the income of consumers increases
and good X is a normal good, what will be the effect on the equilibrium price and quantity of
good X? (a) Price increases, quantity decreases (b) Price decreases, quantity increases (c)
Price and quantity both increase (d) Price and quantity both decrease

 In the long run, under perfect competition with free entry and exit, the equilibrium price will
be equal to: (a) Marginal cost (b) Average total cost (c) Minimum average cost (d) Average
variable cost

 The 'backward bending' supply curve of labour at higher wage rates is primarily due to the:
(a) Substitution effect dominating the income effect (b) Income effect dominating the
substitution effect (c) Law of diminishing marginal utility (d) Increased preference for leisure
at lower wages

Mains:

 Explain the concept of market equilibrium. Discuss the process through which equilibrium is
attained in a perfectly competitive market when there is (a) excess demand and (b) excess
supply.

 Analyze the impact of a rightward shift in both the demand and supply curves on the
equilibrium price and quantity. Under what conditions will the equilibrium price remain
unchanged?

 Discuss the implications of free entry and exit of firms on the long-run equilibrium in a
perfectly competitive market. How does a shift in demand affect the equilibrium price and
quantity in such a market?

 Critically evaluate the use of price ceilings and price floors as government interventions in
perfectly competitive markets. What are the potential benefits and drawbacks of each?

 Using the demand and supply framework, explain how wages are determined in a perfectly
competitive labour market. What factors could lead to a shift in the demand curve for
labour?

Keywords and Definitions

 Equilibrium: A situation where the plans of all consumers and firms in the market match, and
market demand equals market supply.

 Equilibrium Price (p):* The price at which market demand equals market supply.

 Equilibrium Quantity (q):* The quantity bought and sold at the equilibrium price.
  Excess Demand: A situation where, at a given price, the quantity demanded is greater than
the quantity supplied.

 Excess Supply: A situation where, at a given price, the quantity supplied is greater than the
quantity demanded.

 Invisible Hand: The self-regulating nature of the market where prices adjust to balance
supply and demand.

 Marginal Revenue Product of Labour (MRPL): The additional revenue a firm earns by
employing one more unit of labour (MR × MPL).

 Value of Marginal Product of Labour (VMPL): The market value of the additional output
produced by one more unit of labour (Price × MPL). In perfect competition, MRPL = VMPL.

 Price Ceiling: A government-imposed upper limit on the price of a good or service.

 Price Floor: A government-imposed lower limit on the price of a good or service.

 Free Entry and Exit: A market condition where firms can enter or leave the market without
significant barriers.

 Normal Profit: The minimum level of profit required to keep a firm in its current business in
the long run, covering all opportunity costs.

 Super-normal Profit: Profit earned by a firm above the normal profit level.

 Minimum Average Cost (min AC): The lowest point on the average cost curve.

Formulas and Graphs

Formula:

 Equilibrium Condition: qD(p*) = qS(p*)

 Excess Demand (ED): ED(p) = qD - qS

 Excess Supply (ES): ES(p) = qS - qD

 Marginal Revenue Product of Labour (MRPL): MRPL = MR × MPL

 Value of Marginal Product of Labour (VMPL): VMPL = Price × MPL