TOPIC 7

MARKET EQUILIBRIUM, THE PRICE

MECHANISM AND MARKET
EFFICIENCY
Siti Norashikin Misman, Economics Unit, KMB
 SUBTOPICS
1) Equilibrium

2) The effect of changes in demand and

supply upon the equilibrium

3) The role of the price mechanism

4) Market efficiency
Siti Norashikin Misman, Economics Unit, KMB
 LEARNING OBJECTIVES
At the end of this chapter, students should be able to;
1) Define and explain the concept of equilibrium
2) Explain the effect of changes in demand and supply upon equilibrium
3) Explain the concepts of excess demand and excess supply
4) Illustrate diagrams on the shifting of the demand and supply curves.
5) Explain the role of the price mechanism
6) Explain the concept of consumer and producer surplus
7) Explain the concept of social/community surplus
8) Explain the concept of allocative efficiency

Siti Norashikin Misman, Economics Unit, KMB

 EQUILIBRIUM

Definition:
A state of rest, self-perpetuating in
the absence of any outside
disturbance.

Siti Norashikin Misman, Economics Unit, KMB

 EQUILIBRIUM
DIAGRAM

Diagram 1: The market for coffee

Siti Norashikin Misman, Economics Unit, KMB

 EQUILIBRIUM
From Diagram 1,
1) At the price Pe, the quantity Qe is both demanded and supplied.
2) Market is in equilibrium at the price Pe as the Qd is equal to Qs.
3) Everything produced in the market will be sold.
4) Pe is the equilibrium price or market price or market-clearing price.
5) The equilibrium in this situation is ‘self-righting’, i.e, if you try to move
away from it, without an outside disturbance, it will return to the original
position.

Siti Norashikin Misman, Economics Unit, KMB

 EQUILIBRIUM
SELF-RIGHTING SYSTEM
SITUATION 1: THE PRODUCERS TRY TO RAISE THE EQUILIBRIUM
PRICE FOR NO EXTERNAL REASON.

Siti Norashikin Misman, Economics Unit, KMB

Diagram 2: The market for coffee
 FROM DIAGRAM 2,
• At P1, the Qd will fall to Q1 and Qs will increase to Q2.
• Lead to excess supply.
Excess supply: Surplus
Qs > Qd
• To eliminate the surplus, the producers will need to lower the
price.
• ↓P, ↑Qd (law of demand)
• ↓P, ↓ Qs (law of supply)
• Eventually, the Qd=Qs, back to the equilibrium price of Pe and
quantity Qe.
• This situation is called as a ‘self-righting’ system.
Siti Norashikin Misman, Economics Unit, KMB
 EQUILIBRIUM
SELF-RIGHTING SYSTEM
SITUATION 2: THE PRODUCERS TRY TO LOWER THE EQUILIBRIUM
PRICE.

Siti Norashikin Misman, Economics Unit, KMB Diagram 3: The market for coffee
 FROM DIAGRAM 3,
• At P2, the Qd will increase to Q4 and Qs will decrease to Q3.
• Lead to excess demand.

Excess demand: Shortage

• To Qdthe
eliminate the shortage, > Qs
producers will need to raise the
price.
• ↑ P, ↓ Qd (law of demand)
• ↑ P, ↑ Qs (law of supply)
• Eventually, the Qd=Qs, back to the equilibrium price of Pe and
quantity Qe.
• Once again, the situation is ‘self-righting’
THE EFFECT OF CHANGES IN DEMAND
& SUPPLY UPON THE EQUILIBRIUM

• The equilibrium may be moved by any outside

disturbance.

The outside disturbance:

change in one of the determinants of
demand and supply.

• The outside disturbance will lead to a shift of

either of the curves (left or right).
Siti Norashikin Misman, Economics Unit, KMB
 THE EFFECT OF CHANGES IN DEMAND
& SUPPLY UPON THE EQUILIBRIUM
Example 1
Effects of an increase in income to the Qs Qd

demand for foreign holidays (normal

goods)
↑ Income, ↑ D for foreign holidays,
ceteris paribus.
Thus, the demand curve will shift to
the right.

Diagram 4: The market for foreign

holidays

Siti Norashikin Misman, Economics Unit, KMB

 FROM DIAGRAM 4,
• Pe and Qe is the original equilibrium price and quantity.
• Due to an increase in income which is a determinant of demand, demand is
likely to increase, ceteris paribus. The demand curve shifted to the right from
DI to D2 (assuming that foreign holiday is a normal good) .
• At Pe (original price), Qd > Qs : excess demand (shortage)- refer to Diagram 4
• Shortage: Qe to Q2
• To eliminate the shortage, price has to be increased from Pe to Pe1 where the
Qd=Qs. The quantity of foreign holidays will increase from at Qe to Qe1.

Siti Norashikin Misman, Economics Unit, KMB

Explanation on the
diagram.
THE EFFECT OF CHANGES IN DEMAND
& SUPPLY UPON THE EQUILIBRIUM

Whenever there is a shift of

the demand or supply curve,
the market will, if left to act
alone, adjust to a new
equilibrium, market-clearing
price.

Siti Norashikin Misman, Economics Unit, KMB

THE EFFECT OF CHANGES IN DEMAND &
SUPPLY UPON THE EQUILIBRIUM
TEST YOUR UNDERSTANDING!
Example 2
Effects of an increase on subsidy to the production of wheat.
Draw the diagram & provide the explanation.

Siti Norashikin Misman, Economics Unit, KMB

THE EFFECT OF CHANGES IN DEMAND
& SUPPLY UPON THE EQUILIBRIUM
ANSWER
• ↑ Subsidy, ↓ Cost of production, ↑S of wheat, ceteris paribus.
• Thus, the supply of wheat will increase as cost of production is a
determinant of supply.
• From the diagram,
❑ Pe and Qe is the original equilibrium price and quantity.
❑ The supply curve shifted to the right from SI to S2.
❑ At Pe (original price), Qs > Qd : excess supply (surplus)
❑ Surplus: Qe to Q2
❑ To eliminate the surplus, price has to be decreased to from Pe to Pe1
where the Qd=Qs. Quantity of wheat will increase from Qe to Qe1.

Siti Norashikin Misman, Economics Unit, KMB

 EXERCISE 1
Using fully labelled diagrams, illustrate what will happen to the
equilibrium price and quantity in each of the market below.(Use the
answer in example 1 & 2, as your template but write in full sentences).
1) An early drought has severely damaged the olive harvests in Italy
(olive market).
2) An article about lack of purity of the source of water in a national
newspaper affects the demand for bottled water.
3) An increase in the population affects the demand for rice in Malaysia.
4) An decrease in the minimum wage affects the market of cars.

Siti Norashikin Misman, Economics Unit, KMB

 READING ASSIGNMENT

Siti Norashikin Misman, Economics Unit, KMB

 READING ASSIGNMENT

Siti Norashikin Misman, Economics Unit, KMB

 THE ROLE OF THE PRICE MECHANISM

• Price mechanism → forces of demand and supply

• Price mechanism is used to allocate scarce resources
Functions

To signal information
To ration scarce resources
To give incentives
Siti Norashikin Misman, Economics Unit, KMB
 THE ROLE OF THE PRICE
MECHANISM
1) To signal information to consumers and
producers- the signaling function

❖ Prices are set by the actions of consumers and producers

and so they reflect the changing circumstances in markets.
❖ ↑ P due to ↑D, give signal to producers that consumers wish
to buy this good.

Siti Norashikin Misman, Economics Unit, KMB

 THE ROLE OF THE PRICE
MECHANISM
2) To ration scarce resources- the
rationing function
❖ Prices help to allocate and ration scarce resources
❖ If demand for a good is significantly greater than supply,
prices will be relatively high and the low supply will be
rationed to those consumers who are prepared to pay the
high price.

Siti Norashikin Misman, Economics Unit, KMB

 THE ROLE OF THE PRICE
MECHANISM
2) To give incentives to consumers and producers-
the incentive function

For consumers,
❖ Lower prices give consumers an incentive to buy more of a
good because they will receive more utility (satisfaction)
from the good for their money spent.
❖ Higher price will act as a disincentive, since the utility in
relation to the money spent falls.

Siti Norashikin Misman, Economics Unit, KMB

 THE ROLE OF THE PRICE
MECHANISM
2) To give incentives to consumers and producers-
the incentive function

For producers,
❖ ↑ P due to ↑D, give signal to producers that consumers wish to buy this good.
❖ Producers are rational and wish to maximize their profits, give producers an
incentive to produce more of the goods, ↑ S, use more resources to produce the
goods.
❖ Producers will allocate more resources towards goods with a high demand since this
is where they will be able to make more profit.

Siti Norashikin Misman, Economics Unit, KMB

 THE ROLE OF THE PRICE MECHANISM
CONCLUSION
In free market there is no central planning agency that
determine the amount of good need to be produced.
Thus, the increase in price acts as a signal to producers,
creating the incentive for producers to produce more of the
goods.
Existence of the ‘invisible hand’ that is moving the FOP
around to produce the goods and services wanted by the
buyers in the economy.
Siti Norashikin Misman, Economics Unit, KMB
 MARKET EFFICIENCY
CONSUMER SURPLUS VS PRODUCER SURPLUS

Diagram 1: Consumer surplus and producer surplus

Siti Norashikin Misman, Economics Unit, KMB
 MARKET EFFICIENCY

CONSUMER SURPLUS
DEFINITION
Extra satisfaction (or utility) gained by consumers from paying a
price that is lower than which they are prepared to pay.

Area abc (shaded triangle): Consumers are willing to pay at price

higher than the equilibrium price.

Eg; Consumers are willing to pay $15 but the equilibrium price is $10
→ CONSUMERS ARE GAINING.

Siti Norashikin Misman, Economics Unit, KMB

 MARKET EFFICIENCY
PRODUCER SURPLUS

DEFINITION
Excess of actual earnings that a producer makes from a given quantity
of output, over & above the amount the producer would be prepared to
sell for that output.

Area bcd (shaded triangle): Producers are willing to sell at a price

lower than the equilibrium price

Eg;
Producers are willing to sell at $5 but the equilibrium price is $10 →
Siti Norashikin Misman, Economics Unit, PRODUCERS
KMB ARE GAINING.
 EFFICIENCY ANALYSIS

Consumer Producer Community

Surplus Surplus surplus

Siti Norashikin Misman, Economics Unit, KMB

 ALLOCATIVE EFFICIENCY
❖ 3 basic economic questions
What to produce and in what quantities?
❖ When a market is in equilibrium (with no external influences & no
external effects) it is said to be socially efficient or in a state of
allocative efficiency.

Qd: Qs
Producers are producing goods that being
demanded by the consumers
Siti Norashikin Misman, Economics Unit, KMB
 DIAGRAM

Siti Norashikin Misman, Economics Unit, KMB

 ALLOCATIVE EFFICIENCY

This means that the resources are allocated in the most

efficient way from society’s point of view.

Community surplus: total benefit to society

At the equilibrium, Qd:Qs → community surplus is

maximized → allocative
Siti Norashikin Misman, Economics Unit, KMB efficiency
 ALLOCATIVE EFFICIENCY
From Figure 7.7:
At the equilibrium, where the demand
is equal to supply, community surplus
is maximised (the point of allocative
efficiency).
At this point, there is no other
combination of price and quantity on
the diagram that can give a greater
community surplus.
Therefore, it is the optimal allocation
of resources from the point of view of
society as a whole.

Siti Norashikin Misman, Economics Unit

 ALLOCATIVE EFFICIENCY
From Figure 7.7:
At the equilibrium, where the demand
is equal to supply, community surplus
is maximised (the point of allocative
efficiency).
At this point, there is no other
combination of price and quantity on
the diagram that can give a greater
community surplus.
Therefore, it is the optimal allocation
of resources from the point of view of
society as a whole.

Siti Norashikin Misman, Economics Unit

 ALLOCATIVE EFFICIENCY
For efficiency analysis, S : MSC.

The supply curve is determined by

the industry’s cost of production.
Thus, we assume that the costs of
the industry are equal to the costs to
the society.
Supply curve represents social cost
curve

MSC: Marginal social cost

Siti Norashikin Misman, Economics Unit

 ALLOCATIVE EFFICIENCY
For efficiency analysis, D : MSB.
The supply curve is determined by the
utility or benefit that the consumption
of a good or service brings to the
consumers.
Thus, we assume that the benefits in
the market is equivalent to the benefits
to the society.
Supply curve represents social benefit
MSC: Marginal social benefit

Siti Norashikin Misman, Economics Unit

 ALLOCATIVE EFFICIENCY
CONCLUSION
❑ The free market leads to
allocative efficiency.
❑ Community surplus is
maximized
❑ Optimal allocation of resources
from the society’s point of view
❑ D:S
❑ MSC:MSB

Siti Norashikin Misman, Economics Unit

 CALCULATION ON CONSUMER
SURPLUS AND PRODUCER SURPLUS

Siti Norashikin Misman, Economics Unit, KMB

 CALCULATION ON CONSUMER
SURPLUS AND PRODUCER SURPLUS
 CALCULATION ON CONSUMER
SURPLUS AND PRODUCER SURPLUS
 CALCULATION ON CONSUMER
SURPLUS AND PRODUCER SURPLUS
 CALCULATION ON CONSUMER
SURPLUS AND PRODUCER SURPLUS
 CALCULATION ON CONSUMER
SURPLUS AND PRODUCER SURPLUS
Refer to samples of Paper 3

Siti Norashikin Misman, Economics Unit, KMB

 EXERCISE 2

Siti Norashikin Misman, Economics Unit, KMB

 EXERCISE (PAPER 2)
OXFORD PAGE 105

Siti Norashikin Misman, Economics Unit, KMB

EXERCISE (PAPER 2)
OXFORD PAGE 105
 EXERCISE (PAPER 2)
OXFORD PAGE 105

Siti Norashikin Misman, Economics Unit, KMB

 END OF THE CHAPTER

Siti Norashikin Misman, Economics Unit,KMB