Chapter Notes

Equilibrium, Excess Demand, Excess Supply

In a perfectly competitive market, both buyers and sellers act in their own self-interest. Consumers want to maximize their satisfaction, and firms want to maximize their profits. A market finds its balance when these two goals are compatible.

This balance point is called equilibrium. It's a situation where the plans of all consumers and firms in the market match perfectly. In other words, the total quantity of a good that all firms want to sell is exactly equal to the total quantity that all consumers want to buy.

• Equilibrium Price (p*): The specific price at which market demand equals market supply.
• Equilibrium Quantity (q*): The quantity of a good that is bought and sold at the equilibrium price.

When the market is not in equilibrium, one of two situations occurs:

• Excess Demand: This happens when, at a certain price, the quantity demanded by consumers is greater than the quantity supplied by firms. Think of it as a "shortage."
• Excess Supply: This happens when, at a certain price, the quantity supplied by firms is greater than the quantity demanded by consumers. This is a "surplus."

Equilibrium, therefore, is a state of zero excess demand and zero excess supply. Whenever the market is out of balance, the price will naturally tend to change to bring it back to equilibrium.

Out-of-equilibrium Behaviour

Economist Adam Smith described an 'Invisible Hand' that guides perfectly competitive markets. This "hand" is not a real thing, but a metaphor for the natural forces of the market that push prices toward equilibrium.

• In a situation of excess demand (a shortage), consumers who can't get the product are willing to pay more. This competition among buyers pushes the price up.
• In a situation of excess supply (a surplus), firms with unsold goods will lower their prices to attract buyers. This competition among sellers pushes the price down.

These price adjustments continue until the market reaches the equilibrium point where supply equals demand.

Market Equilibrium: Fixed Number of Firms

Let's first look at a market where the number of firms is fixed. The market demand curve (DD) slopes downward, showing that consumers buy less as the price rises. The market supply curve (SS) slopes upward, showing that firms sell more as the price rises.

The equilibrium is found where the supply and demand curves intersect. This is the only point where the quantity firms want to sell is the same as the quantity consumers want to buy.

• If the price is below equilibrium (like p₁ in the text's diagram): There will be excess demand. Consumers want to buy more than firms are selling. This shortage puts upward pressure on the price. As the price rises, demand decreases and supply increases, moving the market toward equilibrium.
• If the price is above equilibrium (like p₂ in the text's diagram): There will be excess supply. Firms are producing more than consumers are willing to buy. This surplus forces firms to lower their prices to sell their inventory. As the price falls, demand increases and supply decreases, again moving the market toward equilibrium.

• Demand: qD = 200 – p
• Supply: qS = 120 + p

To find the equilibrium, we set demand equal to supply: 200 – p* = 120 + p* 80 = 2p* p* = 40

The equilibrium price is Rs 40 per kg. To find the equilibrium quantity, we plug this price back into either equation: q* = 200 – 40 = 160 The equilibrium quantity is 160 kg.

Now, what if the price was different?

• If the price were Rs 25 (below equilibrium), demand would be 175 kg, but supply would only be 145 kg. This is a situation of excess demand.
• If the price were Rs 45 (above equilibrium), demand would be 155 kg, but supply would be 165 kg. This is a situation of excess supply.

Wage Determination in Labour Market

We can use the same supply and demand analysis to understand how wages are determined in a labor market. The main difference is who supplies and who demands.

• Supply of Labour: Households are the suppliers. They decide how many hours of work to offer.
• Demand for Labour: Firms are the demanders. They hire labor to produce goods and services.

Demand for Labour A profit-maximizing firm will hire labor up to the point where the extra cost of one more worker equals the extra benefit that worker brings in.

• The extra cost is the wage rate (w).
• The extra benefit is the Marginal Revenue Product of Labour (MRP_L), which is the extra revenue the firm gets from the output of one additional worker (MRP_L = Marginal Revenue × Marginal Product).
• In a perfectly competitive market, price equals marginal revenue, so this is called the Value of Marginal Product of Labour (VMP_L).

A firm will keep hiring as long as VMP_L > w. Because of the law of diminishing marginal product, the VMP_L eventually falls as more workers are hired. This means that at a higher wage, firms will demand less labor, so the demand curve for labor is downward sloping.

Supply of Labour An individual's decision to work is a trade-off between income and leisure. A higher wage has two effects:

1. Substitution Effect: Leisure becomes more expensive (the opportunity cost of not working is higher), so the person works more.
2. Income Effect: The person is richer and can afford more of everything, including leisure. So, they may choose to work less.

At low wages, the substitution effect usually dominates, and people work more as wages rise. At very high wages, the income effect might dominate, causing the individual's supply curve to bend backward. However, the overall market supply curve for labor is upward sloping, because higher wages attract more people into the workforce.

The equilibrium wage rate is determined where the market demand for labor intersects the market supply for labor.

Shifts in Demand and Supply

Equilibrium can change if the underlying conditions for supply or demand change. These changes are shown as shifts in the demand or supply curves.

Demand Shift

A shift in the demand curve means that at every price, consumers want to buy a different amount than before.

• Rightward Shift (Increase in Demand): If the demand curve shifts to the right (e.g., from DD₀ to DD₂), it creates excess demand at the old price. This pushes the price up. The new equilibrium will have a higher price and a higher quantity.
• Leftward Shift (Decrease in Demand): If the demand curve shifts to the left (e.g., from DD₀ to DD₁), it creates excess supply at the old price. This pushes the price down. The new equilibrium will have a lower price and a lower quantity.

Causes of Demand Shifts:

• Increase in Consumer Income: For a normal good like clothes, if people's salaries go up, they will demand more at every price, shifting the demand curve to the right.
• Increase in the Number of Consumers: If more people enter the market, the total demand for the product will increase, shifting the curve to the right.

Supply Shift

A shift in the supply curve means that at every price, firms want to sell a different amount than before.

• Leftward Shift (Decrease in Supply): If the supply curve shifts to the left (e.g., from SS₀ to SS₂), it creates excess demand at the old price, pushing the price up. The new equilibrium will have a higher price and a lower quantity.
• Rightward Shift (Increase in Supply): If the supply curve shifts to the right (e.g., from SS₀ to SS₁), it creates excess supply at the old price, pushing the price down. The new equilibrium will have a lower price and a higher quantity.

Causes of Supply Shifts:

• Increase in Input Prices: If the cost of a key material used in production goes up, firms will supply less at every price, shifting the supply curve to the left.
• Increase in the Number of Firms: If more firms start producing the good, the total market supply will increase, shifting the curve to the right.

Simultaneous Shifts of Demand and Supply

Sometimes, both curves shift at the same time. The final outcome depends on the direction and size of the shifts.

• Both shift right (Demand & Supply Increase): The equilibrium quantity will definitely increase. The effect on price is uncertain—it could increase, decrease, or stay the same depending on which shift is larger.
• Both shift left (Demand & Supply Decrease): The equilibrium quantity will definitely decrease. The effect on price is uncertain.
• Demand shifts right, Supply shifts left: The equilibrium price will definitely increase. The effect on quantity is uncertain.
• Demand shifts left, Supply shifts right: The equilibrium price will definitely decrease. The effect on quantity is uncertain.

Market Equilibrium: Free Entry and Exit

Now, let's consider a long-run situation where new firms can enter the market and existing firms can leave. We assume all firms are identical.

The key implication of free entry and exit is that, in the long run, firms can only earn normal profit.

• If firms are making supernormal profit (more than normal), new firms will be attracted to the market. This entry increases market supply, which drives the price down until the extra profit is gone.
• If firms are making losses (less than normal profit), some will exit the market. This exit decreases market supply, which drives the price up until the remaining firms are back to earning normal profit.

This process ensures that the market price will always settle at the minimum average cost (min AC) of production. At this price, firms are covering all their costs (including opportunity costs) but are not making any extra profit.

The equilibrium quantity is then determined by whatever the market demands at that specific price. The number of firms in the market will adjust to produce exactly that quantity. Equilibrium Number of Firms = (Total Market Demand at p=minAC) / (Quantity Supplied by One Firm at p=minAC)

Shifts in Demand (with Free Entry and Exit)

When firms can enter and exit freely, the effect of a demand shift is very different.

• Rightward Shift (Increase in Demand): An increase in demand will initially create a shortage and cause the price to rise, leading to supernormal profits. This will attract new firms. As they enter, supply increases, pushing the price back down to the original level (p₀ = min AC).
• Leftward Shift (Decrease in Demand): A decrease in demand will create a surplus, causing prices to fall and firms to incur losses. This will cause some firms to exit. As they leave, supply decreases, pushing the price back up to the original level.

Applications

Demand and supply analysis helps us understand the effects of government intervention in the market.

Price Ceiling

A price ceiling is a government-imposed maximum price on a good or service. It is set below the equilibrium price to make necessary items (like wheat, rice, or sugar) more affordable for the population.

Effects of a Price Ceiling:

• Because the price is held artificially low, the quantity demanded will be higher than the equilibrium quantity, while the quantity supplied will be lower.
• This creates a situation of excess demand, or a persistent shortage of the good.

Consequences:

• Rationing: To manage the shortage, the government may issue ration coupons to limit how much each person can buy, often through fair price shops.
• Long Queues: Consumers may have to wait in long lines to purchase the limited goods available.
• Black Markets: A black market may emerge where people illegally buy and sell the good at a price higher than the ceiling, closer to what the market would have naturally set.

Price Floor

A price floor is a government-imposed minimum price. It is set above the equilibrium price, typically to protect the income of producers or workers.

Examples:

• Agricultural Price Supports: The government sets a minimum price for crops to ensure farmers receive a certain income.
• Minimum Wage Legislation: The government sets a minimum hourly wage that employers must pay their workers.

Effects of a Price Floor:

• Because the price is held artificially high, the quantity supplied will be greater than the equilibrium quantity, while the quantity demanded will be lower.
• This creates a situation of excess supply, or a surplus of the good.

Consequences:

• In the case of agricultural price supports, the government often has to buy the surplus crop to prevent the price from falling.
• In the case of a minimum wage, it can lead to unemployment, as firms are willing to hire fewer workers at the higher wage than there are people looking for jobs (an excess supply of labor).