MICROECONOMICS

ECO162
 CHAPTER 4
MARKET EQUILIBRIUM
 LEARNING OUTCOMES
At the end of the chapter, you should be able to:

 Define market equilibrium price and quantity

 Explain market equilibrium and disequilibrium
 Explain the changes of market equilibrium price and quantity, due to
changes in demand and supply.
 Describe price control, i.e. maximum price and minimum price, and
discuss the effects of price control on market equilibrium.
 Discuss the effects of non-price control, i.e. indirect tax and subsidy,
on market equilibrium.
 Explain price control based on Islamic perspectives.
 DEFINITION OF MARKET EQUILIBRIUM

 Market - a place whereby both buyers and sellers interact to determine the
equilibrium price and quantity of goods and services exchanged.

 A market equilibrium is a situation when quantity demanded and quantity

supplied are equal and there is no tendency for price or quantity to change.

QDD = QSS

The price and quantity consumers willing to buy = The price and the quantity sellers willing to sell
 DETERMINATION OF EQUILIBRIUM PRICE & QUANTITY
HOW??

1) Real life – bargaining process.

 Buyers wish to purchase a commodity at the lowest possible price while the sellers wish to sell it at the highest
possible price.
 They will negotiate (bargain) until both of them agreed on one price level and the transaction take place. The agreed
price is the equilibrium price, and how many quantities purchased and sold at this price is the equilibrium quantity.

2) Theory – using demand & supply model.

a) Demand & Supple schedule:
 Market equilibrium is achieved at the price of a commodity where the quantity demanded is exactly equal to the
quantity supplied. Thus, this price level is called the, equilibrium price, and the quantity demanded or supplied at
the equilibrium price is called the equilibrium quantity.

b) Demand & Supply curves (graph):

 The point where the demand curve cuts (intersects) the supply curve cuts (intersect) is the equilibrium point. At this
point the amount of quantity demanded equals quantity supplied and is called equilibrium quantity. The price is the
equilibrium price.
DETERMINATION OF EQUILIBRIUM PRICE AND QUANTITY

Table 3.1
Analysis of market
equilibrium
 DETERMINATION OF EQUILIBRIUM PRICE AND
EQUILIBRIUM QUANTITY (cont.)

Surplus/Excess SS
 There would be a
downward
pressure for the
price to decrease
towards P*

Shortage/Excess DD
 There would be
upward pressure
for the price to
increase towards
Figure 3.1
P*
Market equilibrium
 DISEQUILIBRIUM & HOW IT IS CLEAR TO REACH EQUILIBRIUM

Shortage

 A situation when Qdd > Qss

 E.g.: At USD2, the buyers are willing to buy 8 units of pens but the sellers are
willing to sell only 4 units of pens.
 There is a shortage of 4 units (ie: 8 - 4) of pens.
 Therefore, there is a tendency for price to increase as demanders compete
against each other for the limited supply of pens.
DISEQUILIBRIUM & HOW IT IS CLEAR TO REACH EQUILIBRIUM (cont.)

There are two effects as price increases to USD3:

a) The Qdd falls because the buyers find substitutes of pen.

b) The Qss increases as sellers find it is profitable to increase supplies of pen.

The process will continue until the shortage eliminated.

When the Qdd and Qss are equal and there is no further increase in price, the
process has achieved an equilibrium level.
 DISEQUILIBRIUM & HOW IT IS CLEAR TO REACH EQUILIBRIUM
(summary)

• Market Shortage - occurs when there is excess demand

(i.e : Qty demanded > Qty supplied).

• In this situation, consumers won't be able to buy as much of a good as they

would like. In response to the demand of the consumers, producers will raise
both the price of their product and the quantity they are willing to supply.

• The increase in price will be too much for some consumers and they will no
longer demand the product. Meanwhile the increased quantity of available
product will satisfy other consumers. Eventually equilibrium will be reached.
 DISEQUILIBRIUM & HOW IT IS CLEAR TO REACH EQUILIBRIUM

Surplus

A situation when Qss > Qdd

 E.g.: At USD4, the sellers are willing to sell 8 units of pens and the buyers are
willing to buy only 4 units of a pens.
 There is a surplus of 4 units (ie: 8- 4) of pens.
 DISEQUILIBRIUM & HOW IT IS CLEAR TO REACH EQUILIBRIUM

There are two effects as price decreases to USD3.

a) Sellers will supply less because now it is unprofitable to supply more due to
the price cut.
b) When price decreases, it may attract new buyers.

 The process will continue until the surplus is eliminated and the equilibrium
level is achieved.
DISEQUILIBRIUM & HOW IT IS CLEAR TO REACH EQUILIBRIUM
(summary)

 A Market Surplus - occurs when there is excess supply

(i.e: Qty supplied > Qty demanded).

 In this situation, some producers won't be able to sell all their goods. This will
induce them to lower their price to make their product more appealing. In order
to stay competitive many firms will lower their prices thus lowering the market
price for the product.

 In response to the lower price, consumers will increase their quantity

demanded, moving the market toward an equilibrium price and quantity.
Exercise 1
 CHANGES IN DEMAND & SUPPLY : THE EFFECTS ON MARKET
EQUILIBRIUM

 The market equilibrium will change when there is a shift in the demand or/and
supply curve.
 The shift in the demand and supply is due to determinants of demand and
supply that have been discussed in Chapter 2.
 There are four situations to be discussed:
(1) Demand changes, but supply remain unchanged.
(2) Supply changes but demand remains unchanged.
(3) Both the demand and supply changes simultaneously in the same
proportion.
(4) Both demand and supply changes simultaneously but in different
proportions.
 CHANGES IN DEMAND & SUPPLY : THE EFFECTS ON
MARKET EQUILIBRIUM
 Increase in demand only Steps to analyze:
 Decrease in demand only
1. Is the event affects DD and/SS?
 Increase in supply only
 Decrease in supply only 2. Does it shift the curve to the right or left?
 Decrease in supply only 3. Draw (sketch) a graph to determine the new
 Both demand & supply increase equilibrium price and quantity
 Both demand & supply decrease
 Demand increase, supply decrease
 Demand decrease, supply increase
 CHANGES IN DEMAND AND SUPPLY : THE EFFECTS ON MARKET
EQUILIBRIUM (cont.)
(a) Demand Increases and Supply is Held Constant

• The initial equilibrium level at E0 with P* = P0

and Q* = Q0.
• Suppose there is an increase in consumers’
income. Thus the demand for meal at KFC
restaurant will increase.
• The DD curve for meal at KFC restaurant will
shift to the right from D0 to D1.
• As a result:
a) P* increase from Po to P1
b) Q8 increases from Q0 to Q1.
c) E* is at E1
CHANGES IN DEMAND AND SUPPLY, AND THE EFFECTS ON MARKET
EQUILIBRIUM (cont.)

(b) Demand Decreases and Supply is Held Constant

• The initial equilibrium level at E0 with P* = P0

and Q* = Q0
• Suppose there is an increase in the price of
car, therefore the quantity demanded for
petrol will decrease (complement goods)
• The DD curve for petrol will shift to the left
from D0 to D1
• As a result:
a) P* decreases from P0 to P1
b) Q* decreases from Q0 to Q1
c) E* is at E1
 CHANGES IN DEMAND AND SUPPLY, AND THE EFFECTS ON MARKET
EQUILIBRIUM (cont.)
(c) Supply Increases and Demand is Held Constant

• The initial equilibrium level at E0 with P* = P0

and Q* = Q0
• Suppose the cost of production decreases
that causes supply of cloth to increase
• The SS curve for cloth will shift to the right
from S0 to S1
• As a result:
a) P* decreases from P0 to P1
b) Q* increases from Q0 to Q1
c) E* is at E1
 CHANGES IN DEMAND AND SUPPLY : THE EFFECTS ON MARKET
EQUILIBRIUM (cont.)

(d) Supply Decreases and Demand is Held Constant

• The initial equilibrium level at E0 with P*

= P0 and Q* = Q0
• Suppose there is bad weather that
causes supply of vegetables to
decrease
• The SS curve for vegetables will shift to
the left from S0 to S1
• As a result:
a) P* increases from P0 to P1
b) Q* decreases from Q0 to Q1
c) E* is at E1
 CHANGES IN DEMAND AND SUPPLY : THE EFFECTS ON MARKET
EQUILIBRIUM (cont.)

EXAMPLE

Hike in chicken price due to higher feed costs, says minister

https://www.theborneopost.com/2021/04/19/hike-in-chicken-price-due-to-higher-
feed-costs-says-minister/
 Exercise 2

Show the effects of the following factors on the market for hand sanitizers
using separate diagram:

a) The rise in hospital-acquired infections (HAIs) and the outbreak of

pandemics such as COVID-19.

a) Essential materials needed to make hand sanitizer have become difficult

to get.
 GOVERNMENT INTERVENTION IN THE MARKET

 Government controls and fixes prices of certain goods and services

depending on certain circumstances.

 Government interventions are:

(a) Fixing a maximum price (Ceiling Price)
(b) Fixing a minimum price (Floor Price)
 GOVERNMENT INTERVENTION IN THE MARKET (cont.)

Price Control
 Price control is the process of fixing a price either maximum price or minimum
price.

 Maximum price or ceiling price is a legal price set by the government below the
equilibrium price. The price is set to prevent price increase that would harm
consumers.

 Minimum price or floor price is the price set by the government above the
equilibrium price. This price is fixed to avoid price fall in certain conditions.
 PRICE CONTROL : MAXIMUM PRICE (CEILING PRICE)

(a) Ceiling Price (Maximum Price)

 Government imposed regulation that prevents the prices from rising above a
maximum level as set by government.

 When government indicates that there is an increase in essential

commodities such as sugar and rice, government will impose a ceiling price
on these commodities.

 The price is set below the equilibrium price and sellers are not allowed to
increase the price.
PRICE CONTROL : MAXIMUM PRICE (CEILING PRICE)

Fixing the price below the

equilibrium creates shortage
(Qdd > Qss)

Figure 3.2
Maximum price or ceiling price
PRICE CONTROL : MAXIMUM PRICE (CEILING PRICE)
 PRICE CONTROL: MINIMUM PRICE (FLOOR PRICE)

(b) Floor Price (Minimum Price)

 A minimum price fixed by the government to prevent the prices from falling
below minimum level.
 The floor price is set especially for agriculture sectors in order to protect
farmers in the event the prices of commodities are too low in a free market.
 E.g.: The price of paddy is usually fixed at a price above the equilibrium
price so that the income of farmers are protected.
 The concept of minimum wage rate is also one of floor prices.
 Minimum wage is the minimum payment made by employers to workers to
protect employees from exploitation.
PRICE CONTROL : MINIMUM PRICE (FLOOR PRICE)

Fixing the price

above the equilibrium
creates surplus
(Qss > Qdd)

Figure 3.3
Minimum price or floor price
PRICE CONTROL : MINIMUM PRICE (FLOOR PRICE)
EXAMPLE

30-day Raya Festive Period Maximum Price Control Scheme to begin April 21,
says minister

https://www.theborneopost.com/2021/04/19/30-day-raya-festive-period-
maximum-price-control-scheme-to-begin-april-21-says-minister/
Exercise 3
 Effects of Indirect Taxes on Equilibrium Price & Quantity
Indirect tax
 Definition : is a type of tax that is imposed by the government on
producers or sellers but paid by or passed on to the end-users

 Example: eg. Import duties, excise duties, sales tax, service tax and
export duties.

 Effect :
 Supply decrease (tax increase cost of production; demand constant.
 Market price of the goods – increase.
 Quantity traded – decrease.
 Effects of Indirect Taxes on Equilibrium Price & Quantity
Tax Burden :
a) Consumer
 Tax Per unit : (P2 – P1)
 Total tax : (P2 – P1 ) x Q2
P2

b) Producer P1

P3
 Tax Per unit : (P1 – P3)
 Total tax: (P1 – P3) x Q2

Tax Revenue
Tax Per unit : (P2 – P3)
Q2 Q1
Total tax: (P2 – P3) X Q2
 Effects of Indirect Taxes on Equilibrium Price & Quantity
The Incidence of an Indirect Tax
 Tax incidence is the distribution of the burden of tax between firms and
consumers. It is the measure of how much of the tax the producer and
consumer are responsible for.

 In general, whether consumers or firms will pay a larger proportion of a

tax on a good depends on the price elasticity of demand relative to the
price elasticity of supply.

 The side of the market which is less responsive to a change in the price
will pay a larger proportion of the tax.
 Effects of Subsidy on Equilibrium Price & Quantity

Subsidy
Definition: A subsidy is an amount of money provided to firms to help reduce
production costs which can then be passed on as lower prices, and which can
encourage consumption.

Objective : is to encourage the consumption and production of certain goods.

Effect: (Subsidy works in the opposite way as taxes)

Subsidies on a good will reduce the production cost of the good. Thus, with the
same amount of inputs and cost of production, the producer would increase the
supply of the good in the market. Assuming demand remains unchanged, the price of
the good will decrease but the quantity will increase.
 Effects of Subsidy on Equilibrium Price & Quantity

 The effect of a specific per unit

subsidy is to shift the supply curve
vertically downwards by the
amount of the subsidy (S to
S+subsidy). In this case the new
supply curve will be parallel to the
original.
 Depending on elasticity of
demand, the effect is to reduce
price (P to P1) and increase
output (Q to Q1).
 Effects of Subsidy on Equilibrium Price & Quantity
 The economic incidence of a subsidy indicates who is made
better off by the subsidy. In the diagram on the right, the
subsidy per unit is (A – B), and the new quantity consumed is
Q1.
 Subsidy Gain

 Consumer
 Per unit : (P – P1)
 Total : area PFBP1.

 Producer
 Per unit : C – P
 Total :area CAFP.

 The overall cost of the subsidy to the government is

the area, CABP1
 PRICE CONTROL FROM AN ISLAMIC PERSPECTIVE
 Price controls are allowed under certain circumstances, but are
forbidden under normal circumstances.

 Islam recognizes the determination of price by market forces and the

price should not be fixed by anyone.

 In Hadith – it is mentioned that it is Allah who pushes prices up or

down. It explains that the determination of price should be made by the
market itself and it is not in the hands or power of anyone.

 However, if the social welfare is disrupted then it is necessary for the

government to set price of goods and services.
 PRICE CONTROL FROM AN ISLAMIC PERSPECTIVE
 Ibn Taymiyyah explained the concept of shortage and surplus in detail.
 If producers are selling their goods without any price manipulation on
their part and the price increases due to decrease in the supply of good or
due to increase in population, then this is due to Allah SWT.
 If the availability of good (supply) decreases but the desire of good
(demand) increases, then the price will increase.

 If the availability of good (supply) increases but the desire of good

(demand) decreases, then the price will decrease.

 Therefore, the scarcity or abundance may not be due to any injustice.

 PRICE CONTROL FROM AN ISLAMIC PERSPECTIVE
Islam forbids price controls because they are unfair to both producers and
consumers.
 Maximum price for example, is unfair to the consumers whereas minimum
price is unfair to the producers.
 There are also many disadvantages of both maximum and minimum prices.

However, Islam allows the government to control prices if it is proven that the
increase and the decrease in prices are due to injustice or manipulation of the
market.
 Eg: if the exorbitant high prices is due to a planned decrease in supply by the
monopolist or hoarding by producers, it is therefore, the responsibility of the
government to interfere in order to protect the welfare of the people. The
intervention is most called for if the good is a Dharuriyyah good.