Chapter 5. Market Equilibrium

Equilibrium, Excess Demand and Excess Supply
• Equilibrium price is price at which seller of a good is willing to sell same quantity which buyer of that is willing to buy.
• An equilibrium is defined as a situation where plans of all consumers and firms in market match and market clears. In equilibrium, aggregate quantity that all firms wish to sell equals quantity that all consumers in market wish to buy; in other words, market supply equals market demand.
• price at which equilibrium is reached is known as equilibrium price and quantity bought and sold at this price is known as equilibrium quantity.

Note: If at a price, market supply is greater than market demand, then there is an excess supply in market at that price and if market demand exceeds market supply at a price, it is said that excess demand exists in market at that price.
• Therefore, equilibrium in a perfectly competitive market can be defined alternatively as zero excess demand-zero excess supply situation.
• Whenever market supply is not equal to market demand, and hence market is not in equilibrium, there will be a tendency for price to change.

Out-of-equilibrium Behaviour
• From time of Adam Smith [1723-1790], it has been maintained that in a perfectly competitive market an ‘Invisible Hand’ is at play which changes price whenever there is imbalance in market.

Market Equilibrium: Fixed Number of Firms:
• In long – run, free entry and exit of firms takes place under perfect competition. Firms will earn only normal profit in long run. This is assumed that all firms in market are identical.
• An equilibrium is a point where market supply curve intersects market demand curve because this is where market demand equals market supply.
• At any other point, either there is excess supply or there is excess demand.

Wage Determination in Labour Market
• extra cost of hiring one more unit of labour is wage rate [w]. extra output produced by one more unit of labour is its marginal product [MPL] and by selling each extra unit of output, additional earning of firm is marginal revenue [MR] she gets from that unit.
• Therefore, for each extra unit of labour, she gets an additional benefit equal to marginal revenue times marginal product which is known as Marginal Revenue Product of Labour [MRPL]. Thus, while hiring labour, firm employs labour up to point where w = MRPL and MRPL = MR × MPL

Note: As long as Value of Marginal Product of Labour [VMPL] is greater than wage rate, firm will earn more profit by hiring one more unit of labour, and if at any level of labour employment VMPL is less than wage rate, firm can increase her profit by reducing a unit of labour employed.
• assumption of law of diminishing marginal product, fact that firm always produces at w = VMPL implies that demand curve for labour is downward sloping.
• price of commodity remaining constant b, this is possible only if MPL increases which in turn implies that less labour should be employed owing to diminishing marginal productivity of labour. Hence, at higher wage, less labour is demanded thereby leading to a downward sloping demand curve.
• To arrive at market demand curve from individual firms’ demand curve, we simply add up demand for labour by individual firms at different wages and
since each firm demands less labour as wage increases, market demand curve is downward sloping demand curve.

Effect of Increase in Wage Rate
• This increase in wage rate will have two effects:
(1) First, due to increase in wage rate, opportunity cost of leisure increases which makes leisure costlier.
(2) Second, because of increase in wage rate to w2, purchasing power of individual increases.
• With an upward sloping supply curve and a downward sloping demand curve, equilibrium wage rate is determined at point where these two curves intersect; In other words, where labour that households wish to supply is equal to labour that firms wish to hire.

Shift in Demand
• Due to a shift in demand rightward [leftward], equilibrium quantity and number of firms will increase [decrease] whereas equilibrium price will remain unchanged.
• Initially, market equilibrium is at E. Due to shift in demand to right, new equilibrium is at G as shown in panel [a] and due to leftward shift, new equilibrium is at F, as shown in panel [b]. With a rightward shift equilibrium quantity and price increase whereas with a leftward shift, equilibrium quantity decrease and price increases.

Shift in Supply
• A shift in supply curve caused by a change in supply generates a market imbalance that is addressed by altering pricing and demand. supply curve shifts to right as change in supply increases, whereas supply curve shifts to left as change in supply decreases.
• Initially, market equilibrium is at E. Due to shift in supply curve to left, new equilibrium point is G as shown in panel [a] and due to rightward shift, new equilibrium point is F, as shown in panel [b]. With rightward shift, equilibrium quantity increases and price decreases whereas with leftward shift, equilibrium quantity decreases and price increases.

Simultaneous Shifts of Demand and Supply
• Initially, equilibrium is at E where demand curve DD0 and supply curve SS0 intersect. In panel [a], both supply and demand curves shift rightward leaving prices unchanged but a higher equilibrium quantity. In panel [b], supply curve shifts rightward and demand curve shifts leftward leaving quantity unchanged but a lower equilibrium price.
• simultaneous shifts can happen in four possible ways:
(1) Both supply and demand curves shift rightward.
(2) Both supply and demand curves shift leftward.
(3) Supply curve shifts leftward and demand curve shifts rightward.
(4) Supply curve shifts rightward and demand curve shifts leftward.

Note: It can be seen that due to rightward shifts in both demand and supply curves, equilibrium quantity increases whereas equilibrium price remains unchanged.
• Equilibrium quantity remains same whereas price decreases due to a leftward shift in demand curve and a rightward shift in supply curve.

Shift in Demand Shift in Supply Quantity Price
Leftward Leftward Decreases May increase, decrease or remain unchanged
Rightward Rightward Increases May increase, decrease or remain unchanged
Leftward Rightward May increase, decrease or remain unchanged Decreases
Rightward Leftward May increase, decrease or remain unchanged Increases

Market Equilibrium: Free Entry and Exit
• possibility of earning a supernormal profit will attract some new firms. As new firms enters market supply curve shifts rightward. However, demand remains unchanged. This causes market price to fall. As prices fall, supernormal profits are eventually wiped out. At this point, with all firms in market earning normal profit, no more firms will have incentive to enter.
• equilibrium price will be equal to minimum average cost of firms. In equilibrium, quantity supplied will be determined by market demand at that price so they are equal.

• Price Ceiling: government-imposed upper limit on price of a good or service is known as price ceiling. A price ceiling is usually imposed on necessary items like wheat, rice, kerosene, & sugar and it is fixed below market-determined price since at market-determined price some section of population will not be able to afford these goods.
• Price Floor: government-imposed lower limit on price that may be charged for a particular good or service is known as price floor.
(1) most well-known examples of imposition of a price floor are agricultural price support programmes and minimum wage legislation.
(2) Through an agricultural price support programme, government imposes a lower limit on purchase price for some of agricultural goods and floor is normally set at a level higher than market-determined price for these goods.
(3) Similarly, through minimum wage legislation, government ensures that wage rate of labourers does not fall below a particular level and here again minimum wage rate is set above equilibrium wage rate.

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