Market equilibrium

Market Equilibrium is determined when the quantity demanded of a commodity becomes equal
to the quantity supplied
Price Market Market Shortage Remarks
demand supply / supply
2 100 20 -80 Excess
4 80 40 -40 demand
6 60 60 0 Equilibrium level
8 40 80 40 Excess supply
10 20 100 80

With increase in price from 2 to 4, market demand falls from 100 to 80 chocolates and market
supply rises from 20 to 40 chocolates. Market demand curve DD and market supply curve SS
intersect each other at point E, which is the market equilibrium. At this point, 6 is determined as
the Equilibrium Price and 60 chocolates as the Equilibrium Quantity. This equilibrium price and
quantity.

Any price above 6 is not the equilibrium price as the resulting surplus, ie excess supply would
cause competition among sellers. In order to sell the excess stock, price would come down to
the equilibrium price of 6.

Any price below 6 is also not the equilibrium price as due to excess demand, buyers would be
ready to pay higher price to meet their demand. As a result, price would rise upto the
equilibrium price of 6.

Important Points about Market Equilibrium under Perfect Competition

 Each firm is a price-taker and industry is the price-maker.

 Each firm earns only normal profits in the long run
 Decisions of consumers and producers in the market are coordinated through free flow of prices
known as price mechanism. It is assumed that both law of demand and law of supply operate.
 Equilibrium Price is the price at which quantity demanded of a commodity is equal to the quantity
supplied.
 At equilibrium price, there is neither shortage nor excess of demand and supply.
 Equilibrium Quantity is the quantity demanded and supplied at the equilibrium price.
 Excess demand
Excess demand refers to a situation, when quantity demanded is more than quantity supplied at the
prevailing market price. Under this situation, market price is less than the equilibrium price. In Table
excess demand occurs at price of 2 and 4, when market demand is more than market supply. Let us
understand the concept of excess demand through Fig

In Fig, market equilibrium is determined at point E at which OQ is the equilibrium quantity and OP is the
equilibrium price. However, if market price is OP, then market demand of OQ, is more than market supply
of OQ2. This situation is termed as excess demand

 The excess demand of Q1Q2, will lead to competition amongst the buyers as each buyer wants to
have the commodity.
 Buyers would be ready to pay higher price to meet their demand, which will lead to rise in price:
 With increase in price, market demand will fall due to law of demand and market supply will rise
due to law of supply.
 The price will continue to rise till excess demand is wiped out. This is shown by arrows in the
diagram. Eventually, price will increase to a level where market demand becomes equal to market
supply at OQ and equilibrium price of OP is attained.

Excess supply

Excess supply refers to a situation, when the quantity supplied is more than the quantity demanded at the
prevailing market price. Under this situation, market price is more than equilibrium price. In Table , excess
supply occurs at price of 8 and 10, when market supply is more than market demand. In Fig. , if market
price is OP1 (more than equilibrium price of OP), then market supply of OQ1 is more than market demand
of OQ2 This situation is termed as excess supply.

• Excess supply of Q1Q2 will lead to competition amongst sellers as each seller wants to sell his
product
 Sellers would be ready to charge lower price to sell the excess stock , which will lead to fall in price.
 With decrease in price, market supply will fall due to law of supply and market demand will rise due
to law of demand.
 The price will continue to fall till excess supply is wiped out. This is shown by arrows in the diagram.
Eventually, price will decrease to a level where market demand becomes equal to market supply at
OQ and equilibrium price of OP is attained

A Demand Curve shifts due to following reasons

1. Change in the price of complementary goods
2. Change in the price of substitute goods
3. Change in the income (normal and inferior goods)
4. Change in taste and preference
5. Expectation of change in the price in future
6. Change in population

A supply curve shifts due to the following reasons

1. Change in the price of factors of production
2. Change in the prices of other goods
3. Change in the state of technology
4. Change in taxation policy
5. Expectation of change in price in future
6. Change in the goals of firm
7. Change in the number of firms

CHANGE IN DEMAND
(I) Increase in demand :- an increase in demand (assuming no change in supply) leads to a
rightward shift in demand curve from D1D1 TO D2D2

When demand increases to D2D2 it creates an excess demand at the

old equilibrium price of OP.

This leads to competition among buyers, which raises the price

Increase in price leads to rise in supply and fall in demand.

These changes continue till the new equilibrium is established at

point E1 As there is an increase in demand only, equilibrium price
rises from OP1 to OP2, and equilibrium quantity rises from OQ1 to
OQ2
 (II) DECREASE IN DEMAND :- In case of decrease in demand (supply remaining unchanged) ,
demand curve shifts from left from DD
In case of decrease in demand (supply remain unchanged)
demand curve shifts to left from DD to D1D1

When demand decreases to D1D1, it leads to excess supply at the

old equilibrium of OP

This lead to competition among sellers, which reduces the price

Decrease in price leads to rise in demand and fall in supply

The changes continue till new equilibrium is achieved at point E2

Change in supply

Change in supply or shift in the supply curve occurs due to change in any of the factors that were assumed
constant under the law of supply. The change may be either an 'Increase in Supply' or 'Decrease in Supply
Original Equilibrium is determined at point E. when demand curve DD and the original supply curve SS
intersect each other. OQ is the equilibrium quantity and OP is the equilibrium price

(1) Increase in Supply: When there is an increase in supply, demand remaining

unchanged. the supply curve shifts towards right from S1S1 TO S2S2

When supply increase to S2S2, it creates an excess supply

at the old equilibrium price of OP

This leads to competition among the sellers, which

reduces the price

Decrease in the price leads to rise in demand and fall in

supply

These changes continue till the new equilibrium is

achieved.
 (2) Decrease in supply :- When the supply decreases, demand remaining unchanged, then
supply curve shifts to the left from SS to S1S1 as seen in Fig.
When supply decreases to S2S2 it creates an excess demand at the old equilibrium price
of OP. This leads to competition among buyers, which raises the price.
Increase in price leads to rise in supply and fall in demand.
These changes continue till the new equilibrium is established at point E2.
Equilibrium price rises from OP to OP1 and equilibrium quantity falls from OQ to OQ1

PRICE CEILING
Price ceiling refers to fixing the maximum price of a commodity at a level lower than the equilibrium price.
It is maximum price fixed by government.

Need for price ceiling :- when equilibrium price is too high for the common people to afford then
government fix the price below the equilibrium price

In the given diagram , OP1 is the price ceiling ,

while equilibrium price is OP

At this price producers are willing to supply only

PM and while consumer demand PN

The gap (MN) leads to black marketing

Implication
Black Market is any market in which the commodities are sold at a price higher than the
maximum price fixed by the government.
Black marketing may be termed as a direct consequence or implication of price ceiling as it
implies a situation where the commodity under the government's control policy is illegally
sold at a price higher than the one fixed by the government.
It may primarily arise due to the presence of consumers who may be willing to pay higher
price for the commodity than to go without it.

Rationing system
Rationing is a technique adopted by the government to sell a minimum quota of essential
commodities at a price less than equilibrium price to supply goods to the poor community at
a cheaper rate.

Price floor or minimum support price

It refers to the minimum price fixed by the government which the producers must be paid
for their produce.

Need for price floor

The need for price floor arises when government finds that the equilibrium price is too low
for the producers.

 Most well-known examples of imposition of Price Floor are agricultural price support
programmes and minimum wage legislation.

 Indian Government maintains a variety of price support programes for various

agricultural products like wheat, sugarcane etc. and the floor is normally set at a
level higher than the market determined price for these goods The effect of Price
Floor can be better understood with the help of Fig.

In the given diagram, OP, is the Price Floor, while equilibrium price is OP. At this price, the
producers are willing to supply P,B (or OQ), while consumers demand only P,A (or OQ).

This creates a situation of surplus in the market which is equivalent to AB in the diagram.
Implications of Price Floor or Minimum Price Ceiling
Price Floor is normally set at a level higher than the equilibrium price. This leads to excess
supply. Since producers are not able to sell all they want to sell, they illegally sell the good
or serve below the minimum price.

Buffer Stock acts as a Tool of Price Floor

Buffer Stock is an important tool in the hands of government to ensure price floor. When
market price is lower than what the government feels should be given to the
farmers/producers, it purchases the commodity at higher price from the farmers/producers
so as to maintain stock: of the commodity with itself, to be released in case of shortage of
the commodity in future.

Change in both demand and supply

Case 1 decrease in demand = decrease in supply
When decrease in demand is equal to decrease in supply, then leftward shift curve from S1S1
to S2S2. The new equilibrium is determined at E1. As demand and supply decrease in the
same proportion, equilibrium price remains same at OP, but equilibrium quantity falls from
OQ1 TO OQ2

Case 2 decrease in demand > decrease in supply

When decrease in demand is proportionately more than decrease in supply, then leftward
shift in demand curve from DD to D,D, is proportionately more than leftward shift in supply
curve from SS to S1S1. The new equilibrium is determined at E, equilibrium price falls from
OP to OP, and equilibrium quantity falls from OQ to OQ1

Case 3 decrease in demand < decrease in supply

When decrease in demand is proportionately less than decrease in supply, then leftward
shift in demand curve from DD to D,D, is proportionately less than leftward shift in supply
curve from SS to S1S1 The new equilibrium is determined at E1 equilibrium price rises from
OP to OP, whereas, equilibrium quantity falls from OQ to OQ₁-
 Both Demand and Supply Increase
Original Equilibrium is determined at point E when the original demand curve DD and the
original supply curve SS intersect each other. OQ is the equilibrium quantity and OP is the
equilibrium price. The effect of increase in both demand and supply on equilibrium price
and equilibrium quantity is discussed under three different cases:

Case 1: Increase in Demand = Increase in Supply

When increase in demand is proportionately equal to increase in supply, then rightward
shift in demand curve from DD to D1D1 is proportionately equal to rightward shift in supply
curve from SS to S1S1The new equilibrium is determined at E1 As both demand and supply
increase in the same proportion, equilibrium price remains the same at OP, but equilibrium
quantity rises from OQ to OQ1

Case 2 Increase is Demand Increase in Supply

When increase in demand is proportionately more than increase in supply, then rightward
shift in demand curve from DD to D,D, is proportionately more than rightward shift in supply
curve from SS to S1S1The new equilibrium is determined at E1 equilibrium price rises from
OP to OP1 and equilibrium quantity rises from OQ to OQ1

Case 3 Increase in Demand < Increase in Supply

When increase in demand is proportionately less than increase in supply, then rightward
shift in demand curve from DD to D,D, is proportionately less than rightward shift in supply
curve from SS TO S1S1The new equilibrium is determined at E1 equilibrium price falls from
OP to OP1 whereas, equilibrium quantity rises from OQ to OQ1