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Market Equilibrium
- Bharathi
1
The Market Mechanism
 Market Mechanism Summary
1) Supply and demand interact to
determine the equilibrium price.
2) When not in equilibrium, the market
will adjust to a shortage or surplus and
return to the equilibrium.
3) Markets must be competitive for the
mechanism to be efficient.
2
MARKET DEMAND & SUPPLY
Price
Price
P
Rs.5
4
3
2
1
QD
10
20
35
55
80
MARKET
x
200 DEMAND
B 2,000
U
Y
E
R
S
4,000
7,000
11,000
16,000
MARKET
P QS
Rs.5
4
3
2
1
60
50
35
20
5
200 SUPPLY
S 12,000
x
E
L
L
E
10,000
7,000
4,000
1,000
R
S
EQUILIBRIUM
3
MARKET DEMAND & SUPPLY
Price
Price
P QD
4
Rs.5 2,000
Rs.4 4,000 Rs3
Rs.3 7,000
Rs.2 11,000 2
Rs.1 16,000
Supply
P Q
Rs.5 12,000
S
Rs.4 10,000
Rs.3 7,000
Rs.2 4,000
Rs.1 1,000
Market
Equilibrium
1
o
Price
S
Rs.5
Demand
D
2
4
6
78
10 12 14 16
Q
4
Quantity
The Market Mechanism
Y
S
Price
(Rs. per unit)
P
E
D
O
Q
Quantity
X
5
The Market Mechanism
Price
(Rs. per unit)
S
Surplus
P1
If price is above equilibrium
Point-Supply exceeds
Demand.
P
D
Q
Quantity
6
The Market Mechanism
Price
(Rs per unit)
S
Surplus
P1
Assume the price is P1 , then:
1) Quantity Supplied is >
Quantity Demanded
2) Producers lower price.
3) Quantity supplied decreases
4) Equilibrium is restored
P2
D
Q1
Q3
Q2 Quantity
7
The Market Mechanism
Price
(Rs. per unit)
S
E
P3
Assume the price is P2, then:
1) Quantity Demanded is greater
than quantity Supplied
2) Producers raise price.
3) Quantity supplied increases
4) Equilibrium is restored
P2
Shortage
Q1
Q3
D
Q2 Quantity
8
Change in Supply
P
D1
Price
S2
S1
P2
P1
o
Q2
Q1
Quantity
Q
Change in Demand
P D1
D2
S1
Price
P2
P1
o
Q1
Q2
Q
D
P
D1
Q
D1
D
A
D1
S
P2
P1
P1
Q
P
S
B
D2
P2
“Increase in Demand”
S
P
Q 2 Q1
Q 1 Q2
Q
Four Possibilities
S
D
D
C
S1
S1
P2
“Decrease in Demand”
Q
P
D
S2
S1
P2
P1
P1
“Increase in Supply”
Q1 Q 2
Q2 Q1
11
“Decrease in Suply”
Change in Supply = Change in Demand
D1
D2
S3
D3
S1
S2
P
Q
12
Effects of Government Intervention
Price Controls
 If the Government decides that the
equilibrium price is too high, they may
establish a maximum allowable ceiling
price.
13
TAX SHIFTING AND THE ELASTICITIES
OF DEMAND AND SUPPLY
 When a product is taxed, who ultimately
shoulders the tax burden depends upon the
elasticity of demand and supply of the
product taxed.
 Usually the tax burden is shared between
producers and consumers.
 Consumers pay more of the tax, if demand
is relatively less elastic than supply
 Producers pay more of the tax if demand is
relatively more elastic than supply.
14
Price Ceilings
and Price Floors
 Price Ceiling
 is a legally established maximum
price which a seller can charge or a
buyer must pay.
 Price Floor
 is a legally established minimum
price which a seller can charge or a
buyer must pay.
15
Price Ceilings
 When the Government imposes a
price ceiling (i.e., a legal
maximum price at which a good
can be sold) two outcomes are
possible:
 The price ceiling is not binding.
 The price ceiling is a binding
constraint on the market, creating
shortages.
16
A Binding Price Ceiling
Price
S
Price
Ceiling
PE
PC
Shortage
Q
S
QE
D
Q
D
Quantity/time
17
Market Impacts
of a Price Ceiling
 A Binding Price Ceiling creates. . .
 Shortages (QD > QS)
 Shortages create :




Queuing
Discrimination criteria set by sellers
Bundled pricing with other goods
Bribery/corruption
18
Price Floors
 When the Government imposes a
price floor (i.e., a legal minimum
price at which a good can be sold)
two outcomes are possible:
 The price floor is not binding.
 The price floor is a binding constraint
on the market, creating surpluses.
19
A Binding Price Floor
Price
S
Surplus
PF
Price Floor
PE
D
Q
D
QE
Q
S
Quantity/time
20
Market Impacts
of a Price Floor
 A Binding Price Floor creates. . .
 Surpluses (QS > QD)
 Surpluses create :
 Discrimination criteria set by buyers
 Examples:
 Agricultural Price Supports
21
22
The Circular Flow of Income
Rest of the
World
Financial System
3
2
4
Investors
Consumers
1
Government
5
6
Firms
(produce the
domestic product)
23
24