Chapter 5 — Market Equilibrium

Equilibrium is a situation where the plans of all consumers and firms in the market match and the market clears — that is, market supply equals market demand. The price at which this occurs is the equilibrium price (p*) and the quantity bought and sold is the equilibrium quantity (q*). Formally, qD(p*) = qS(p*).

Excess demand exists when market demand exceeds market supply at a given price. Algebraically, ED(p) = qD − qS. It occurs when the prevailing price is below the equilibrium price (p*). In the wheat example from the chapter, at p1 = 25, qD = 175 and qS = 145, so excess demand equals 30 kg.

Excess supply exists when market supply exceeds market demand at a given price. Algebraically, ES(p) = qS − qD. It occurs when the prevailing price is above the equilibrium price (p*). In the wheat example, at p2 = 45, qS = 165 and qD = 155, so excess supply equals 10 kg.

From the time of Adam Smith (1723–1790), it has been maintained that in a perfectly competitive market an 'Invisible Hand' changes price whenever there is imbalance. It raises prices in the case of excess demand and lowers prices in the case of excess supply, guiding the market towards equilibrium.

With a fixed number of firms, equilibrium is found at the intersection of the market demand curve (DD) and the market supply curve (SS). Algebraically, you equate qD(p*) = qS(p*) and solve for p*. The equilibrium quantity is then obtained by substituting p* into either the demand or supply equation. For example, with qD = 200 − p and qS = 120 + p, solving gives p* = 40 and q* = 160 kg.

When the demand curve shifts rightward with the supply curve unchanged, at the original price p0 there will be excess demand. Price rises until a new equilibrium is reached at a higher price and higher quantity. Both equilibrium price and quantity increase — the direction of change in price and quantity is the same whenever the demand curve shifts.

When the supply curve shifts leftward with the demand curve unchanged, at the original price there is excess demand. Price rises until a new equilibrium is reached at a higher price and lower quantity. Equilibrium price increases and equilibrium quantity decreases — price and quantity change in opposite directions whenever the supply curve shifts.

The chapter identifies four possible cases. When both shift in the same direction, the effect on equilibrium quantity is unambiguous (both rightward → quantity increases; both leftward → quantity decreases) but the effect on price depends on the magnitude of the shifts. When they shift in opposite directions, the effect on equilibrium price is unambiguous (supply left + demand right → price increases; supply right + demand left → price decreases) but the effect on quantity depends on the magnitude of the shifts.

With free entry and exit of identical firms, the equilibrium price is always equal to the minimum average cost of the firms (p = min AC). If the price is above min AC, supernormal profits attract new entrants, pushing price down. If price is below min AC, firms incur losses and exit, pushing price up. Only at p = min AC do firms earn normal profit with no incentive to enter or exit.

With free entry and exit, a rightward demand shift increases equilibrium quantity and number of firms but leaves equilibrium price unchanged at min AC. A leftward shift decreases equilibrium quantity and number of firms but price again remains unchanged at min AC. This is in contrast to the fixed-firm case, where demand shifts also change the equilibrium price.

The equilibrium number of firms (n0) equals the total equilibrium quantity (q0) divided by the output each firm supplies at the equilibrium price (q0f): n0 = q0 / q0f. In the chapter's example, with q0 = 180 kg and each firm supplying q0f = 30 kg, n0 = 6 firms.

A profit-maximising firm employs labour up to the point where the wage rate (w) equals the Marginal Revenue Product of Labour (MRPL = MR × MPL). For a perfectly competitive firm, MR equals the output price, so the condition becomes w = VMPL (Value of Marginal Product of Labour = Price × MPL). As long as VMPL > w, hiring an additional unit of labour adds more to revenue than to cost.

A rise in the wage rate has two opposing effects. The substitution effect makes leisure costlier, so the individual works more. The income effect raises purchasing power, so the individual wants more leisure and works less. At low wage rates the substitution effect dominates and labour supply rises with wage. At high wage rates the income effect dominates and labour supply falls with wage, producing a backward bending individual supply curve. However, the market supply curve of labour is upward sloping because higher wages attract more individuals into the labour market.

Price ceiling is the government-imposed upper limit on the price of a good or service, set below the market-determined equilibrium price. It is generally imposed on necessary items like wheat, rice, kerosene, and sugar so that lower-income consumers can afford them. Because the ceiling is below equilibrium, it creates excess demand (shortage). Consequences include rationing through ration coupons and fair price shops, long queues, and the possible creation of a black market.

Price floor is the government-imposed lower limit on the price of a good or service, set above the market-determined equilibrium price. Common examples are agricultural price support programmes and minimum wage legislation. Because the floor is above equilibrium, it creates excess supply. In the case of agricultural support, the government needs to buy the surplus at the predetermined price to prevent prices from falling.

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