ECON1001 WEEK 5 Monday 25th March 2019

Lecture 5: Equilibrium and Welfare

5.1 Equilibrium
 Remember Aggregate Demand

Adding these individual demand curves up would give us the AS curve where 𝑃 = 𝑀𝐵

 Remember Aggregate Supply: N firms

Adding these supply curves up would us AS where 𝑃 = 𝑀𝐶

ECON1001 WEEK 5 Monday 25th March 2019

 Supply and Demand in a competitive market: Market Equilibrium

• (q*, p*) is the equilibrium quantity and price
• There is only 1 point in which the market is demanding the same quantity as firms are supplying.
• At P*, it is the market clearing price. At this price, everything being produced/supplied is being sold
• Q* = Qs(p*) = Qd(p*) : is the quantity traded in a competitive market

EXAMPLE: Draw the supply and demand diagram, and find the equilibrium point of

𝑄𝑠 = 𝑝 − 50 𝑎𝑛𝑑 𝑄𝑑 = 150 − 𝑝
Rearranging for P to be at the front

𝑃 = 𝑄𝑠 + 50 𝑎𝑛𝑑 𝑃 = 150 − 𝑄𝑑
Graph these two equations

Solving it analytically by equating Qd = Qs

𝑝 − 50 = 150 − 𝑝
2𝑃 = 200
𝑃 = 100
𝑊ℎ𝑒𝑛 𝑃 = 100, 𝑠𝑢𝑏 𝑖𝑛𝑡𝑜 𝑒𝑖𝑡ℎ𝑒𝑟 𝑄𝑠 𝑜𝑟 𝑄𝑑
𝑄𝑠 = 100 − 50
𝑄 = 50
ECON1001 WEEK 5 Monday 25th March 2019

What happens when we are out of equilibrium? Remember that we are in a competitive market and 1 seller or 1
buyer cannot change the price on their own because they do not have market power.

 Excess supply where P’ > P*

• At a price that is higher than the market price, firms will be interested in supplying more but there will be
less demand from consumers.
• This is excess supply since Qd < Qs
• At P’, firms will be forced to lower their price since and consumers will increase their demand.
• The price will naturally fall back on its equilibrium price at P*

 Excess demand where P’’ < P*

• As people compete for limited supply, the price will be forced up.
• For example, if concert tickets go on sale cheap, more people will want to attend, those that buy a lot of
tickets can resell them at a higher price, forcing it back to P*.
• Hence, price can be artificially out of equilibrium but will naturally return

Summary – in a competitive market, P’ and P’’ are not stable solutions in the long run. In equilibrium, supply (Qs) =
demand (Qd) and everyone who wants a unit can get one.

However, the price can artificially be outside equilibrium in the long run due to government interventions

• Price floor – e.g. agriculture – setting minimum price

• Price ceilings – e.g. drugs – maximum price
ECON1001 WEEK 5 Monday 25th March 2019

5.2 Comparative statics – moving into a new equilibrium

In equilibrium, p* and q* do not change unless S or D change. Then how do changes in S or D affect the equilibrium
prices and quantities?

 Increase in Supply  Increase in Demand

 Decrease in Supply  Decrease in Demand

 Changes in both supply and demand

o Decrease in supply and increase in demand
ECON1001 WEEK 5 Monday 25th March 2019

As seen in the two diagrams, prices will increase regardless but the change in quantity will depends on how large the
increase in demand is.

EXAMPLE: How do changes in demand and supply affect equilibrium?

𝑄𝑠 = 𝑝 − 50 → 𝑄𝑠 = 𝑝 − 25
𝑄𝑑 = 150 − 𝑝 → 𝑄𝑑 = 200 − 𝑝
Rearrange the new equations for P to be at the front

𝑃 = 𝑄𝑠 + 25
𝑃 = 200 − 𝑄𝑑
Graph

Solving analytically - Equating the new QS=Qd

𝑃 − 25 = 200 − 𝑃
2𝑃 = 225
𝑃 = 112.5
𝑄𝑠 = 112.5 − 25
𝑄 = 87.5
ECON1001 WEEK 5 Monday 25th March 2019

5.3 Welfare Analysis

Trade generates welfare gains among consumers (consumer surplus) and producers (producer surplus)

𝑻𝒐𝒕𝒂𝒍 𝒔𝒖𝒓𝒑𝒍𝒖𝒔 = 𝑷𝑺 + 𝑪𝑺

 Consumer Surplus

Think back to diminishing marginal benefit

 Producer Surplus

• Note: for the last unit sold/ brought CS=PS=0

𝟏
• We can calculate the surplus using area of the triangle 𝑨𝑩
𝟐

 Concept- Parento Efficiency

Since equilibrium is about efficiency, the competitive market p* and q* maximises total gains of trade at TS= CS + PS.
That is, it is not possible to make the producer better off without it being at the expense of the consumer and vice
versa. Thus, the competitive equilibrium is Parento efficiency