Chapter 5: Market Equilibrium

5.1 Equilibrium, Excess Demand, Excess Supply

Market Equilibrium: A situation where market demand equals market supply

At equilibrium price p*: q^D(p*) = q^S(p*)

Excess Demand: When market demand > market supply at a given price

Excess Supply: When market supply > market demand at a given price

Market Equilibrium Graph

5.1.1 Market Equilibrium: Fixed Number of Firms

Equilibrium is the price–quantity pair at which planned purchases equal planned sales. With a fixed number of firms, a price above equilibrium creates unsold output (excess supply), putting downward pressure on price; a price below equilibrium creates excess demand, putting upward pressure on price, assuming prices can adjust and other conditions remain unchanged.

To solve a linear model, set quantity demanded equal to quantity supplied, solve for price, then substitute that price into either equation to find quantity. Check that both sides give the same quantity.

Example 5.1: Wheat Market

Demand: q^D = 200 - p

Supply: q^S = 120 + p

Equilibrium: 200 - p* = 120 + p* → p* = 40

Equilibrium quantity: q* = 160 kg

Wage Determination in Labour Market

Equilibrium wage rate determined where labour demand equals labour supply

Labour Demand: Firms hire labor until w = MRP_L = MR × MP_L

For competitive firms: MRP_L = VMP_L = p × MP_L

Labour Market Equilibrium

Shifts in Demand and Supply

Demand Shift

Rightward shift → Higher equilibrium price and quantity
Leftward shift → Lower equilibrium price and quantity

Demand Shift Graph

Supply Shift

Rightward shift → Lower equilibrium price, higher quantity
Leftward shift → Higher equilibrium price, lower quantity

Supply Shift Graph

Simultaneous Shifts

Demand Shift	Supply Shift	Quantity	Price
Leftward	Leftward	Decreases	May change either way
Rightward	Rightward	Increases	May change either way
Leftward	Rightward	May change either way	Decreases
Rightward	Leftward	May change either way	Increases

5.1.2 Market Equilibrium: Free Entry and Exit

In the long-run competitive model used here, firms can enter when economic profit is positive and leave when it is negative. Entry expands industry supply and pushes price down; exit contracts supply and pushes price up. Under the model assumptions—homogeneous output, free entry and exit, and firms producing at the minimum of long-run average cost—the long-run equilibrium price equals minimum average cost and economic profit is zero. This is a long-run result; short-run equilibrium need not satisfy it.

p = min AC

Example 5.2: Wheat Market with Free Entry

Demand: q^D = 200 - p

Firm supply: q_f^S = 10 + p for p ≥ 20

Equilibrium price: p* = 20 (min AC)

Market quantity: q* = 180 kg

Number of firms: n* = 6

Demand Shifts with Free Entry/Exit

Price remains at min AC
Rightward demand shift → More firms enter, quantity increases
Leftward demand shift → Firms exit, quantity decreases

Free Entry Equilibrium

5.2 Applications

5.2.1 Price Ceiling

Price Ceiling: A legal maximum price. It is binding only when set below the market-equilibrium price; a non-binding ceiling does not change the market outcome.

Effects:

Creates excess demand
May lead to rationing and black markets

Price Ceiling Graph

5.2.2 Price Floor

Price Floor: A legal minimum price. It is binding only when set above the market-equilibrium price; a non-binding floor does not change the market outcome.

Effects:

Creates excess supply
Government may need to buy surplus (agricultural support)

Price Floor Graph

Worked application: a binding price ceiling

Suppose demand is Q^D = 100 − 2P and supply is Q^S = 20 + 2P. At equilibrium, 100 − 2P = 20 + 2P, so P = 20 and Q = 60. If a legal ceiling is set at P = 15, quantity demanded is 70 while quantity supplied is 50. The resulting shortage is 70 − 50 = 20 units. This calculation identifies excess demand; it does not by itself tell us how the scarce units are allocated.

Check your understanding

Demand is Q^D = 90 − P and supply is Q^S = 30 + 2P. Find equilibrium price and quantity.
Using the model above, calculate excess supply if the market price is 25.
Why can a simultaneous demand and supply shift leave the direction of price or quantity uncertain?

Answers: (1) 90 − P = 30 + 2P gives P = 20 and Q = 70. (2) At P = 25, Q^D = 65 and Q^S = 80, so excess supply is 15. (3) The final change depends on the relative size of the two shifts; one can offset or outweigh the other.

Chapter Summary

Market equilibrium occurs where quantity demanded equals quantity supplied
Excess demand leads to price increases; excess supply leads to price decreases
With fixed firms, demand shifts affect both price and quantity in same direction
Supply shifts affect price and quantity in opposite directions
With free entry/exit, price equals min AC; demand shifts only affect quantity
Price ceilings (max prices) create excess demand
Price floors (min prices) create excess supply
Labor market equilibrium occurs where labor demand (VMP_L) equals labor supply