Principles of Microeconomics

ECA002/ECB037

Lecture 4
Market Equilibrium

Luke Garrod

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Aims of this lecture

In this lecture, we will learn about: MARKET EQUILIBRIUM

So far we have looked at the demand and supply side of the market separately
Now, we need to put them together

TODAY: Market price is determined by the “invisible hand of the market”

Generate predictions of how price changes with respect to other factors

In the process: we’ll gain a better understanding of the functions of markets

… convey information … provide incentives … allocate resources

Today we: analyse what determines the price in some markets and how the price
will change with other important factors

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Lecture outline

1. Equilibrium: the intersection of supply and demand

2. Predictions: changes in supply or demand

3. Predictions: changes in supply or demand of related markets

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Reading

Lipsey and Chrystal, ch.2, p.33-44

Mankiw and Taylor, ch.4, p.80-93

Sloman, Wride and Garratt, ch.2, p.42-51

Sloman News site: Have you got your Weetabix?

http://pearsonblog.campaignserver.co.uk/?p=8082

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 Excess demand and Excess supply

There is excess demand when quantity demanded exceeds quantity supplied

There is excess supply when quantity supplied exceeds quantity demanded
Price in £s

excess supply
supply (S)

P* The market clears when there is no

excess demand or excess supply

excess demand

demand (D)

Q*
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Quantity demanded and supplied
The law of price adjustment

There are two parts to this law:

When supply exceeds demand, the price will fall

When demand exceeds supply, the price will rise

● When there is excess supply, prices are too HIGH

sellers are frustrated as they cannot sell as much as they would like

INCENTIVE TO CUT PRICES

● When there is excess demand, prices are too LOW

buyers are frustrated as they cannot buy as much as they would like

INCENTIVE TO RAISE PRICES

Equilibrium: a point where there is no incentive to change behaviour

The market is in equilibrium when it clears
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 Market Equilibrium

VERTICAL INTERPRETATION: the demand curve shows what the maximum price
that a buyer is willing to pay for this unit of the product
Price in £s

supply (S)
The product is consumed by
the buyers who are willing
and able to pay the price

P*

The product is produced by

the sellers who are willing
and able to accept the price

demand (D)

Q*
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Quantity demanded and supplied
 PREDICTIONS: Increase in demand

Suppose there is an increase in demand – due to increase in income

At P*, there is now excess

Price in £s

demand. The price begins

supply (S) to rise to ration demand.

new P* A rising price signals a profitable

opportunity to firms, who
P* increase production or enter

new demand (D)

The market moves to

demand (D)
the new equilibrium

Q* new Q*
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Quantity demanded and supplied
 PREDICTIONS: Increase in supply

Suppose there is an increase in supply – due to an advancement in technology

At P*, there is now excess

Price in £s

supply. The price begins to

supply (S) fall to attract more buyers

new supply (S)

P* A falling price signals that too

much is being produced by firms,
who limit production
new P*

The market moves to

the new equilibrium
demand (D)

Q* new Q*
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Quantity demanded and supplied
 Quick Exercise
In 2012, the threat of a fuel strike cause panic buying of petrol. With
the person next to you, generate a prediction of how the price of
petrol and the quantity sold should change.
Price in £s
supply (S)

new P*

P*

new demand (D)

demand (D)

Q* new Q*
Quantity demanded and supplied 10
 Summary of predictions

Equilibrium price Equilibrium quantity

Increase in demand increase increase

Decrease in demand decrease decrease

Increase in supply decrease increase

Decrease in supply increase decrease

Exam prep: sketch the supply and demand diagram for each of these cases
check whether there’s excess demand or supply before price adjusts
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The roles of prices

Prices convey information

Prices are signals that convey all information needed for buyers and sellers

● If flour is even more scare:

no need for Government to advise less production and consumption of bread

By signalling what is relatively scare and what is abundant:

price channels production and consumption

Prices ration scare resources

Since resources are limited, need a mechanism to decide who gets what

● Those willing and able to pay get the good

Prices determine income

Income depends upon the supply & demand of the services you can sell
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 PREDICTIONS: related markets (substitutes)
Renault CEO warns of bigger price jump ahead as costs soar, Expansion reports
Suppose a substitute becomes cheaper to produce … people buy more of the
substitute and demand less
Lower costs shifts the supply of the product…
P curve of substitute to the right… P
supply (S)
supply (S)

new supply (S)

Px * P y*
new new
Px * P y*
demand (D)
demand (D)
new demand (D)

Qx* new Qx* new Qy* Qy*

Q Q
The equilibrium price of the substitute falls… … the equilibrium price falls
(a) substitute market (b) market
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 PREDICTIONS: related markets (complements)

Suppose a complement is more expensive to produce … people buy less of the

complement, so demand
Higher costs shifts the supply less of the product…
P curve of substitute to the left… P
supply (S)
new supply (S) supply (S)

demand (D)
demand (D)
new demand (D)

The equilibrium price of Q Q

the complement rises… … the equilibrium price falls
(a) complement market (b) market
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 Summary of predictions
Equilibrium price Equilibrium quantity

Shortage of substitute increase increase

Surplus of substitute decrease decrease

Shortage of
decrease decrease
complement

Surplus of complement increase increase

Shortage of input increase decrease

Surplus of input decrease increase

Exam prep: sketch the supply and demand diagrams for each of these cases
check whether there’s excess demand or supply before price adjusts
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Summary

There is excess demand if: quantity demanded greater than

quantity supplied

There is excess supply if: quantity demanded less than

quantity supplied

A market is in equilibrium when: supply and demand curves intersect

Shifts in demand & supply: changes equilibrium price & quantity

Prices in other markets: can cause a market’s demand & supply

curve to shift

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Summary

Following this lecture, you should be able to:

(1) explain how a market will converge on the equilibrium price

(2) illustrate changes in equilibrium prices and quantities using a supply and
demand diagram

(3) describe how changes in the supply and demand of related goods affect the
supply and demand of another good

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