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Market Equilibrium

Introduction of concept of Market Equilibrium, Excess Demand and Excess Supply

Objectives

After going through this chapter you shall be able to understand the following concepts

  • Concept of Market Equilibrium
  • Concept of Excess Demand and Excess Supply

 

Introduction

Market Equilibrium is defined as a state of rest, which is determined by the rational objectives of the consumers and the producers. As learnt in the previous chapters, the rational objective of consumers is to maximise their satisfaction given their money income, while the rational objective of the producers is to maximise their profit given their cost structures. Both the consumers as well as the producers try to maximise their respective objectives. Market equilibrium is reached at that particular point, where both the consumers as well as the producers maximise their rational objectives. Thus, we can define market equilibrium as a state or position, where the aggregate quantity that all the firms want to sell is purchased by all the consumers, i.e. where market supply equals market demand. The price at which the market supply and market demand intersects with each other determines the equilibrium price and the corresponding quantity of output is called equilibrium output.

Important Note: An important point to note here is that equilibrium is defined as the state of rest where there is no further incentive to change and there exists a complete balance between the two opposite market forces, i.e. market demand and market supply.

Algebraically, Market Equilibrium is represented as:

QS (Pe) = QD (Pe)

where,

Qs represents Market Supply at the equilibrium price

QD represents Market Demand at the equilibrium price

Pe represents the Equilibrium Price

Graphically, market equilibrium is determined by the intersection of the market demand curve and the market supply curve. In the following figure, E represents the market equilibrium, with Pe as the equilibrium price and qe as equilibrium quantity.



Excess Demand and Excess Supply

Excess Demand- It is defined as a situation, where the market demand exceeds the market supply at a particular market price. In other words, if at any price level, the quantity of output supplied by the producers is lesser than what is demanded by all the consumers in the market, then we face the situation of excess demand. Symbolically, the situation of excess demand is represented as:

     QD (Pe) > QS (Pe)  

Excess Supply- It is defined as a situation, where the market demand falls short of the market supply at a particular price. In other words, if at any price level, the quantity of output supplied by the producers is more than what is demanded by all the consumers in the market, then we face the situation of excess supply. Symbolically, the situation of excess supply is represented as:

   QS (Pe) > QD (Pe)

Explanation of Excess Demand and Excess Supply- Diagrammatically

Let us understand the concept of excess demand and excess supply with the help of the following schedule and graph.

Schedule

Price

Quantity Demanded

Quantity Supplied

14

12

10

1

2

3

8

4

4

 = Market Equilibrium

6

4

2

5

6

7

From the graph, we can analyse that the market demand curve DD and the market supply curve SS intersects each other at the point ‘E’, which is known as market equilibrium. The corresponding price and quantity are regarded as equilibrium price and equilibrium quantity, OPe and Oqe. The equilibrium price is Rs 8 and the equilibrium quantity is 4 units.

Now, let us suppose that the price is Rs 12, then at this price as per the market demand curve DD, only 2 units of output is demanded, while as per the market supply curve SS, the producers are ready to sell 6 units of output. As the market supply is more than the market demand, so there is situation of excess supply by 4 units (i.e. 6 –2 = 4 units). This excess supply will increase competition among the sellers; consequently, they will reduce the price in order to sell more of their output. The fall in price will continue until price becomes Rs 8, where market demand equals market supply.

On the contrary, let us suppose that if the market price is Rs 2. At this price, as per the market demand curve DD, 7 units of output will be demanded; while as per the market supply curve SS, the producers are ready to sell only 1 unit of output. As the market demand is more than the market supply, so there is a situation of excess demand by 6 units (i.e. 7 – 1 = 6 units). This excess demand of 6 units will increase competition among the buyers; consequently, the buyers will tend to buy output at higher price (due to the competition), which as a result will increase the market price. The market price will continue to rise until it becomes Rs 8, where the equilibrium is restored.

Hence, no matter whatever is the initial price, the final price will always be the equilibrium price. That is, why the point of intersection is known as equilibrium. This implies that the market will at a state of rest with no further incentive to deviate from the equilibrium point.

Automatic Mechanisms- by Adam Smith     

We can observe that the situations of excess demand and excess supply are automatically corrected by the market forces i.e. by the demand and supply. The father of economics, Adam Smith regarded these forces as the invisible hands of the market. As these forces automatically restore the market back to the equilibrium, so these are also known as automatic mechanisms. He argued that in case of excess demand the invisible hands will push-up the price and will restore the equilibrium back, while in case of excess supply, the invisible hands will reduce the price and will restore the equilibrium back.

Objectives

After going through this chapter you shall be able to understand the following concepts

  • Short Run Concept of Market Equilibrium under fixed Number of Firms
  • Changes in Market Demand
  • Changes in Market Supply
  • Simultaneous Change in Market Demand and Market Supply

 Introduction

We know that the situatio...

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