Market Equilibrium

MARKET EQUILIBRIUM
Prof. Prabha Panth
17-04-201617/04/2016 Prabha Panth

What determines market price?
• Classical economists: cost of production
determines market price.
• Utilitarians thought that demand determined
market price.
• Marshall pointed out that both D and S are
needed to determine market price.
• D and S are like two blades of a pair of
scissors, both are needed to cut material.
217/04/2016 Prabha Panth

Market
• Market is where willing buyers meet willing
sellers, for exchange of goods and services.
• Could be local, national or international markets.
• Refers to Perfect Competition, or a Free Market,
without Government controls.
• Both buyers and sellers agree to the market price.
• At equilibrium, Qd = Qs.
• The market is cleared, i.e. at the given price there
is no surplus of supply,
• Or unsatisfied demand, or shortages.

Market Equilibrium
• Supply and demand are opposing forces.
• When P increases D decreases, but S
increases.
• When P decreases D increases, but S
decreases.
• But there could be one price at which D = S.
• This is the point of Market Equilibrium.
• With Equilibrium P and Equilibrium Q.

Market Equilibrium
P (Rs) Qd
(Kgs)
Qs
(Kgs)
1 10 2
2 8 4
3 6 6
4 4 8
5 2 10
* At P = Re.1, Qd = 10 Kgs, Qs = 2
Kgs. Deficiency of S.
Since D > S, sellers increase P.
When P D falls, but S increases.
This goes on till P = Rs.3.
At this point Qd=Qs = 6 Kgs. This
is Equilibrium Price.
* At a higher price, Rs.5, Qd=2 Kgs,
but Qs=10 Kgs. Surplus S.
As S > D, P falls.
As P falls, Qd increases, and Qs
decreases.
This goes on till the Equilibrium
P Rs.3 is reached.
*Equilibrium quantity = Qd = Qs = 6
Kgs.

D and S equations
• Let Qd = 14 -2P, and Qs = 4 + 2P
• What are Equilibrium P and Q?
• We know that at equilibrium Qd = Qs,
14 – 2 P = 4 + 2P
Or 10 = 4P
Or P = 10/4 = Rs.2.5
Equilibrium P = Rs.2.50
Substituting P = 2.5 to get Q:
14 – 2 (2.5) = 14 – 5 = 9 Kgs (Qd)
4 + 2(2.5) = 4 + 5 = 9 Kgs (Qs)
Equilibrium Q = 9 Kgs

Equilibrium with Shifts in Demand
Curve
Rs
0 Qx
D1
D1S
S
P’
Q’
E
D2
D2
P1
F
Q1
If Market D 
shifts to the
right, but no
change in S.
Then the new
equilibrium = F,
price increases
to P1 and
quantity to Q1,
If Market D, or
shifts to the left,
No change in
supply,
Then both
equilibrium P
and Q decrease.

Market Equilibrium
Rs
Qx
0
D
D
S
S
P=5
d =2 s =10
D < S,
surplus, P
P=1 d =10s=2 D > S,
deficit, P
P=3
E
Qd=Qs=6

Shifts in Supply Curve
Rs
0
Qx
P’
E
Q’
D
DS
S
S1
S1
P1
F
Q1
If total S,
shifts to the
right, no
change in D,
Then new
equilibrium= F,
price falls to P1,
and Q increases
to Q1.
Opposite effect
when S shifts to
the left.

Stability, Uniqueness and Existence of
Market Equilibrium

Stable Equilibrium
• Stable Equilibrium: when any disturbance to the
equilibrium generates forces that bring the
system back to the original position.
• In certain situations, the price and Q do not
return to the original position.
• This is called Unstable Equilibrium.
• This occurs when D or S curves do not have their
characteristic shapes,
• Then P and Q will move progressively away from
the original equilibrium.

Stable Market Equilibrium
Rs
Qx
0
D
D
S
S
P=5
d =2 s =10
D < S,
surplus, P
P=1 d =10s=2 D > S,
deficit, P
P=3
E
Qd=Qs=6

Unstable Equilibrium
Rs
0
Qx
D
D
S
S
P’
E
Q’
P1
d1
s1
When D > S, P
increases
Rising D-curve
(luxuries).
• E is equilibrium.
• If P is higher, P1, D >
S, so P rises.
• If P is lower, P0, D <
S, price falls.
• So the system can
never come back to
the former
equilibrium.
When D < S, P
decreases
s2
d2
P0

Unstable Equilibrium
Rs
0 Qx
D
D
S
S
P’
E
Q’
P0
s1
d1
When D < S, P
decreases
s2 d2
When D > S, P
increases
Falling S-curve
(decreasing costs).
• E is equilibrium.
• If P is lower, P0,
D < S, so P falls.
• If P is higher at
P1, D >S, price
rises.
• So the system
can never come
back to the former
equilibrium.

Uniqueness of Equilibrium
• Will there be only one
market P and Q?
• Empirical analysis
shows that the
smooth and
customary shapes of D
and S may not exist.
• Possible to have
multiple equilibria.
• Then which is the
actual equilibrium?
S
Rs
0
Q
D
D
S
a
b
c

Existence of Equilibrium
• Does equilibrium exist at all?
• It can exist if D and S curves cut each
other in the positive quadrant only.
• This is correct theoretically,
• But D and S curves, drawn from collected
data may not cut each other at all.
• Then there is no equilibrium.

Rs
0
Q
P
D
S Here though D
and S have their
normal shapes,
they do not
intersect in the
positive
quadrant.
Equilibrium P is
negative.
So equilibrium
does not exist
E
Q1
17
No Equilibrium

Q
0
Rs
D
S
P
 Q
E
Here D and S do
not intersect in
the positive
quadrant.
Equilibrium Q is
negative.
So equilibrium
does not exist

What other factors determine prices?
Price
1.Competition
2. Costs
3. Demand
4. Life cycle
5. Sales
channels
6. Government
policy

Questions
I. Short answers:
1. Define Market Equilibrium, and depict it with the
help of a diagram.
2. Estimate the market P and Q from the following
equations: Qd = 45 – 10P, and Qs=5+10P
3.Is equilibrium always unique? Show with the help
of a diagram.

II. Essay Questions:
1. What are the characteristics of Market
equilibrium? Draw diagrams to illustrate your answer.
2. Explain with the help of diagrams, the equilibrium
P and Q, when (a) D curve shifts to the right, S
constant, and (b) when S curve shifts to the left, D
constant.
3. What is unstable equilibrium? Under what
conditions does it exist. Illustrate.
4. When is it not possible to achieve market
equilibrium? Draw diagrams to illustrate your answer.

Market Equilibrium

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Market Equilibrium