Market Equilibrium

MARKET EQUILIBRIUM Question 1: Explain market equilibrium. Question 2: When do we say that there is an excess demand for a commodity in the market? Question 3: When do we say that there is an excess supply for a commodity in the market? Question 4: What will happen if the price prevailing in the market is (i) above the equilibrium price? (ii) below the equilibrium price? Question 5: Explain how price is determined in a perfectly competitive market with fixed number of firms. Question 6: Suppose the price at which the equilibrium is attained in exercise 5 is above the minimum average cost of the firms constituting the market. Now if we allow for free entry and exit of firms, how will the market price adjust to it? Question 7: At what level of price do the firms in a perfectly competitive market supply when free entry and exit is allowed in the market? How is the equilibrium quantity determined in such a market? Question 8: How is the equilibrium number of firms determined in a market where entry and exist is permitted? Question 9: How are equilibrium price and quantity affected when income of the consumers (a) increase (b) decrease Question 10: Using supply and demand curves, show how an increase in the price of shoes affects the price of a pair of socks and the number of pairs of socks bought and sold. Question 11: How will a change in price of coffee affect the equilibrium price of tea? Explain the effect on equilibrium quantity also through a diagram. ANSWERS Answer 1: Market equilibrium is defined as the state of rest that is determined by the rational objectives of the consumers and the producers (i.e. maximisation of satisfaction and profit respectively). It is a state where the aggregate quantity that all the firms want to sell is purchased by consumers, i.e. market supply equals market demand. At this situation, there is no incentive or tendency for any change in quantity demanded, quantity supplied and price. That is: yd = ys. Answers 2: When the market demand exceeds the market supply at a particular price, then the situation that arises is excess demand. In other words, if at any price, the producers are willing to supply comparatively less than what is demanded by all the consumers in the market, then we face the situation of excess demand. Answers 3: Excess supply is a situation when the supply of a commodity in the market exceeds its demand at a particular price. In other words, if at any price level, all the consumers demand comparatively less quantity than what is being supplied by all the suppliers, then we face the situation of excess supply. Answers 4: i) If the market price is above the equilibrium price, there occurs the situation of excess supply. In the given figure, the equilibrium price and quantity is demoted by Pe and qe. Let us assume that the market price (P1) is above the equilibrium price Pe. Now, according to the demand curve, the quantity demanded is qd. Whereas, according to the supply curve, the quantity supplied is qs. Thus, there exists a situation of excess supply equivalent to (qs − qd). (ii) If the market price is below the equilibrium price, there occurs the situation of excess demand. Let us assume that the market price P2 is below the equilibrium price Pe. According to the demand curve, quantity demanded is q′d. Whereas, according to the supply curve, the quantity supplied is q′s. So, it can be seen that there emerges the situation of excess supply equivalent to (q′d − q′s). Answers 5: When the number of firms in a perfectly competitive market is fixed, the firms are operating in the short-run. The equilibrium price is determined by the intersection of market demand curve and supply curve. It is the price at which the market demand equals market supply. In the given figure, if at any price above Pe, let us say Rs 12, there will be an excess supply, which will increase the competition among the sellers and they will reduce the price in order to sell more output. This causes a fall in the price, finally to Rs 8 (Pe), where the demand equals supply. If at any price lower than Pe , let us say Rs 2, there will be an excess demand that will raise the competition among the buyers or consumers and they will be ready to pay higher price for the given output. This will increase the price to Rs 8 (equilibrium price), where the market will reach the equilibrium. Thus, the invisible hands of market operate automatically whenever there exist excess demand and excess supply; ensuring equilibrium in the market. Answer 6: If the equilibrium price (Rs 8) in the above figure (of Q-5) is above the minimum of average cost, then it implies that the firm is earning supernormal profits. This situation will attract new firms in the market. As the new firms enter, the industry supply of output will also increase. New firms will continue to enter the industry that will lead the price to fall until it becomes equal to the minimum of the average cost. Thus, the supernormal profits are wiped out and all the firms earn normal profits. When the free entry and exit of firms is allowed, the equilibrium is determined by the intersection of demand curve and the ‘P = min AC’ line. Answer 7: In the long run, due to the free entry and exit of firms, all the firms earn zero economic profit or normal profit. They neither earn abnormal profits nor abnormal losses. Thus, the free entry and exit feature ensures that in the long run the equilibrium price will be equal to the minimum of average cost, irrespective of whether profits or losses are earned in the short run. The equilibrium is determined by the intersection of consumers’ demand curve and the ‘P = min AC’ line. At equilibrium point E, quantity supplied by each firm is qe at the price (P). Answer 8: The characteristic of free entry and exit of firms ensures that all the firms in a perfect competitive market earn normal profit, i.e. the market price is always equal to the minimum of LAC. No new firm will be attracted to enter the market or no existing firm will leave, if the price is equal to the minimum of LAC. Thus, the number of firms is determined by the equality of price and the minimum of LAC. The market equilibrium is determined by the intersection of market demand curve (D1D1) and the price line. The equilibrium price is P1 and the equilibrium output is q1. At this equilibrium price, each firm supplies the same output q1f , as it is assumed that all the firms are identical. Therefore, at the equilibrium, the number of firms in the market is equal to the number of firms required to supply output q1 at price P1, and each in turn supplying q1f amount at this price. That is n q1 q 1f Where, n = number of firms at market equilibrium q1 = the equilibrium quantity demanded q1f = the quantity of output supplied by each firm Answer: 9 (a) Increase in income of consumers If the number of firms is assumed to be fixed, then the increase in consumers’ income will lead the equilibrium price to rise. Let us understand how it happens: D1D1 and S1S1 represent the market demand and market supply respectively. The initial equilibrium occurs at E1, where the demand and the supply intersect each other. Due to the increase in consumers’ income, the demand curve will shift rightward parallelly while the supply curve will remain unchanged. Hence, there will be a situation of excess demand, equivalent to (qe − q1). Consequently, the price will rise due to excess demand. The price will continue to rise until it reaches E2 (new equilibrium), where D2D2 intersects the supply curve S1S1. The equilibrium price increases from Pe to P2 and the equilibrium output increases from qe to q2. (b) Decrease in the income of consumers The decrease in consumers’ income is depicted by leftward parallel shift of demand curve from D1D1 to D2 D2. Consequently, at the price Pe, there will be an execs supply (qe − q1), resulting the price to fall. At the new equilibrium (E2), where D2D2 intersect the supply curve, the equilibrium price falls from Pe to P2 and the equilibrium quantity falls from qe to q2. Answer 10: Shoes and socks both are complementary to each other and are used together. Therefore, the increase in shoe price will discourage the demand for socks. Therefore, due to the decrease in demand for socks, the demand curve for socks will shift leftwards parallelly from D1D1 to D2D2. The supply remaining unchanged, at the equilibrium price Pe, there exists excess supply of socks, which reduces the price of socks and the new equilibrium will be at E2, with equilibrium price P2 and equilibrium quantity q2. Answer 11: Coffee and tea are substitute goods, i.e. they are used in the place of each other. An increase or a decrease in the price of coffee will lead to an increase or a decrease in the demand for tea respectively. The figure depicts the equilibrium of the tea market. The initial demand and supply of tea is depicted by D1D1 and S1S1 respectively. The initial equilibrium is at E1, with the equilibrium price (Pe) and equilibrium quantity (qe). Now, if the price of coffee increases, which will lead to an increase in the demand for tea (being a substitute good), the demand curve of tea will shift rightward parallelly. At the equilibrium price (Pe), there will be an excess demand for tea; consequently, the price of tea will rise. This will form the new equilibrium at E2, with the new equilibrium price P2 and the new equilibrium output q2. Hence, an increase in the price of coffee, will lead the equilibrium price of tea to rise (due to excess demand). Further, the increase in the price of coffee will also lead to the increase in demand for tea as tea is the substitute good for coffee. Now, if the price of coffee decreases, there will be a decrease in the demand for tea. The demand curve for tea will shift leftward parallelly to D2D2. At the equilibrium price (Pe), there will be an excess supply. Consequently, the price of tea will fall, which will form the new equilibrium at E2, with the new equilibrium price P2 and the new equilibrium output q2. Hence, a decrease in the price of coffee will lead to a decrease in the price of tea and a decrease in the demand for tea, as people will switch over to consumption of coffee.