Transcript Market Equilibrium

Principles of Economics-DBM1313
Chapter 4:
Market Equilibrium
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Definition of Market Equilibrium :
•Market equilibrium is the condition when demand equals to supply
(D=S).
•Equilibrium also referred to as market clearing. It occurs at any
price and quantity where the quantity demanded is equal to the
quantity supplied. The price at which the quantity demanded equal to
quantity supplied is known as equilibrium price.
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Table 1 Demand and Supply
Schedule for Shoes
Price per pair of
shoes (P)
Quantity demand
of shoes (Qd)
Quantity Supplied
of shoes (Qs)
Market
Outcome
40
40
20
50
35
25
Qd.>Qs
disequilibrium
(Excess demand)
60
30
30
70
25
35
80
20
40
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Qd.=Qs
Equilibrium
Qs.>Qd
disequilibrium
(Excess supply)
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Based on table 1, the equilibrium price is $60 and equilibrium
quantity is 30 units. This is because at this price level, quantity
demanded is equal to the quantity supplied. If the market is in
equilibrium, there is no tendency for the price to change as it is the
price that clears the market. In other words, there is no shortage or
surplus.
The equilibrium price can also be determined graphically. It is
determined by the intersection between the market demand and the
market supply curves. Refer to figure 1, the intersection of the
demand curve and the supply curve occurs at point E (equilibrium
point). This indicates that the equilibrium price is $60 and the
equilibrium quantity is 30 pair of shoes.
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Figure 1 The Determination of Market
Equilibrium Price and Quantity
Price per unit
90
S
80
70
E
60
50
40
30
D
20
10
0
10
20
30
40
50
Qty
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Figure 2 The effects of shifts in demand
on Market Equilibrium
Price per unit
E1
P1
P0
P2
E0
E2
D1
D0
D2
Q2 Q0 Q1
Qty
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Effects of a change in demand, assuming
supply is constant
(refer to Figure 2)
Originally, equilibrium point is E0 where demand equals to supply.
The equilibrium price and quantity are P0 and Q0 respectively. Now
assume that there is a change in demand as a result of increase in
consumers’ income. The demand curve will shift to the right from D0
to D1. The new equilibrium point is E1 will be achieved at the
intersection point of a new demand curve (D1) and the supply curve
(S0). Therefore, the new equilibrium price is P1 and the new
equilibrium quantity is Q1
Similarly, a fall in demand will cause a leftward shift in the demand
curve from D0 to D2. As a result, both equilibrium price and quantity
will fall to P2 and Q2 respectively.
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Note:
1. An increase in demand causes a rise in equilibrium price and
quantity
2. A decrease in demand causes a fall in equilibrium price and
quantity
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Figure 3 The effects of shifts in supply on
market equilibrium
Price per unit
S2
E2
P2
P0
P1
S0
S1
E0
E1
D0
Q2 Q0 Q1
Qty
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Effects of a change in supply, assuming demand
is constant
(refer to figure 3)
Originally, the equilibrium point is E0 where demand equal to
supply. The equilibrium price and quantity are P0 and Q0
respectively. Now assume that there is a change in supply due to a
change in firm’s cost. Suppose there is an increase in the cost as
workers ask for higher wages. This will result in a decrease in
supply, thus shifting supply curve to the left from S0 to S2, The new
equilibrium price will be P2 and Q2 will be the new equilibrium
quantity.
If there is an increase in supply, then the supply curve will shift to
the right from S0 to S1. The new equilibrium point will move from
E0 to E1. The price has decreased from P0 to P1 and the quantity has
increased from Q0 to Q1
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Note:
1. An increase in supply will cause a fall in equilibrium price
and a rise in quantity
2. A decrease in supply will cause a rise in equilibrium price
and a fall in quantity
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Figure 4(a) A simultaneous Change in Demand
and Supply
Price per unit
S0
S1
P1
P0
E1
E0
D1
D0
Q0
Q1
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Qty
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Simultaneous Change in Demand and
Supply (refer to figure 4a)
If demand and supply change at the same time, whether
equilibrium price will increase, decrease or remain the same will
depend on the relative increase (decrease) in demand and supply.
For example, demand for mandrin oranges increases during
Chinese New Year and in order to meet this, the government
increases the supply of oranges by importing oranges from China.
Therefore, both the demandand supply curves for mandrin
oranges will shift to the right. The equilibrium quantity will
definitely increase but whether price will increase or not depends
on the relative increase in demand and supply.
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As shown in the figure 4, the demand curve will shift to
the right from D0 to D1 and the supply curve will also
shift to the right from S0 to S1. Even though the
government will try to meet increase in demand, yet an
increase in demand is greater relative to increase in
supply. Consequently, price is still increase from P0 to P1
and quantity increase from Q0 to Q1
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Figure 4(b) A Simultaneous
Change in Demand and Supply
Price per unit
S0
S1
E0
P1
P0
E1
D1
D0
Q0
Q1
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Qty
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If increase in supply is greater relative to increase in
demand result in lower price; i.e. price falls from P0 to P1
but quantity still increase from Q0 to Q1 (Figure 4b)
Note:
1. If increase in demand is greater relative to increase in
supply, both price and quantity will increase
2. If increase in supply is greater relative to increase in
demand, price will fall and quantity will increase
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Government Intervention
Price Control Act 1946 was legislated to give power for
the government to control the price of goods and
services. There are two types of price control; namely
price ceiling and price floor.
Price Ceiling
Price ceiling also known as maximum price, that is set
by the government below the market price. Any sales
above this price is not allowed. The rationale for
imposing price ceiling is to help consumers when price
of goods and services are extremely high in the market.
Example of goods and services which prices are
controlled by the government are the fare for public
transport, chicken, low cost houses, rent control etc.
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Figure 5 Price Ceiling (PC)
Price per unit (‘000)
S
Ep=$45
PC=$30
D
Qs
Eq
Qd
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In the absence of price control, equilibrium price for low cost
houses would have been at the intersection of the demand and
supply curve, with price $45,000. When the ceiling price is imposed
by government, it held price down to $30,000 and make it illegal to
sell at any price above price ceiling ($30,000). At this low price,
demand for low for low cost houses is Qd, and supply is only Qs.
There is a shortage equal to horizontal distance between Qd – Qs.
This is because more of low cost houses will be demanded by
consumers but less will be supplied at lower price. Thus maximum
price can lead to excess demand of Qd – Qs..
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The imposition of maximum price will bring advantage to the
consumers as they can obtain goods at lower price. Nevertheless,
this price ceiling leads to the following problems:
1. Encourage the existence of black market – an illegal market in which
goods are bought and sold outside normal channels of distribution at
price above legal ceiling.
2. Discourage firms from investing in new productive facilities for
expanding output – price ceiling limits profits in the controlled
market.
3. Exploit consumers – consumers are asked to pay extra money (under
table money) in order to get the goods that are scarce.
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Price Floor
Price floor is also known as a minimum price, that is set by the
government above market price. The government often regulates
the price of agricultural commodities, such as paddy. The rationale
for imposing price floor is that freely operating market does not
ensure farmers a high enough price for their products. Thus, this
minimum price enables sellers/producers to earn higher earnings
and sustain a reasonable standard of living. The effect of this
minimum price is shown in the figure 6.
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Figure 6
Price Floor (PF)
Price per kg
S
Pf=$2.00
Ep=$1.50
D
Qs
Eq
Qd
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If we allow the price to be determined by the market forces, the equilibrium
price for paddy will be at $1.50 per kg.. Now we assume that the minimum
price of $2.00 per kg of paddy is established. At that price, market supply of
paddy is Qs but consumers demand only Qd. Thus price floor results in
surplus of (Qs-Qd) kg paddy. Unless the surplus is some how eliminated, it
will create downward pressure on the price of paddy. The disadvantages that
may arise from the minimum price are as follows:
1.
Exists surplus of goods (paddy)
2.
government has to buy and store the surplus to avoid from it pushing prices
down to the market clearing level. The government must store most of the
surplus as it cannot give away the entire surplus that would reduce private
demand and even bigger surplus. Therefore, storage and regulatory cost are
incurred.
3.
Unfair – consumers are forced to pay higher price.
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