MARKET EQUILIBRIUM

Notes on Market Equilibrium

5.1 Understanding Market Equilibrium

Market equilibrium occurs when the quantity of a good demanded by consumers equals the quantity supplied by producers. The price at which this balance occurs is known as the equilibrium price (p*) and the corresponding quantity is the equilibrium quantity (q*).

5.1.1 Equilibrium Conditions

In a perfectly competitive market:

• Demand Curve: Shows the relationship between price and quantity demanded.
• Supply Curve: Shows the relationship between price and quantity supplied.
• At equilibrium, the demand equals supply: qD(p) = qS(p)**.

Example: If the demand for wheat is 200 - p and supply is 120 + p, then setting these equal allows us to find the equilibrium price:

• [200 - p = 120 + p \Rightarrow 2p = 80 \Rightarrow p* = 40]
• Substituting back, [q* = 200 - 40 = 160]

5.1.2 Out-of-Equilibrium Behavior

When prices are outside of equilibrium:

• Excess Demand: Occurs when demand exceeds supply at a given price. This typically pushes prices up.
• Excess Supply: Occurs when supply exceeds demand at a given price. This typically pushes prices down.
• The market self-corrects through the “Invisible Hand” which helps drive prices towards equilibrium.

5.2 Effects of Shifts in Demand and Supply

• A shift in demand can occur due to changes in consumer income, preferences, or the price of related goods.

  • Rightward Shift: Increases price and quantity; indicating higher demand.
  • Leftward Shift: Decreases price and quantity; indicating lower demand.

• A shift in supply can occur due to changes in production costs, technology, or the number of suppliers.

  • Rightward Shift: Decreases price and increases quantity; indicating higher supply.
  • Leftward Shift: Increases price and decreases quantity; indicating lower supply.

5.3 Market Equilibrium with Entry and Exit

In a market with free entry and exit:

• Firms will enter if they can make profits and exit if they incur losses.
• Equilibrium price will equal the minimum average cost (AC) when firms are earning normal profits.
• Example: If the equilibrium price equals 20 and the average cost is also 20, firms will supply a total quantity such that market demand is met.

5.4 Government Price Controls

• Price Ceiling: A maximum price set below the equilibrium price that can lead to excess demand, resulting in shortages. Consumers may resort to black markets.
• Price Floor: A minimum price set above the equilibrium price that can lead to excess supply, resulting in surpluses. The government may buy surplus products to maintain price levels.

Applications of supply and demand curves in real-world scenarios illustrate the effects of government interventions on market equilibrium, highlighting the importance of balance in the market.

1. Equilibrium: The point where market demand equals market supply.
2. Excess Demand: Occurs when demand exceeds supply; leads to price increase.
3. Excess Supply: Occurs when supply exceeds demand; leads to price decrease.
4. Market Adjustment: The market self-corrects through price changes driven by excess demand or supply.
5. Shift in Demand: Right shift increases price and quantity; left shift decreases both.
6. Shift in Supply: Right shift decreases price, increases quantity; left shift increases price, decreases quantity.
7. Free Entry/Exit: Equilibrium price aligns with minimum average cost when firms can freely enter or exit.
8. Price Ceiling: Sets a maximum price; can create shortages and excess demand.
9. Price Floor: Sets a minimum price; can create surpluses and excess supply.
10. Invisible Hand: Market forces that guide prices towards equilibrium.