5 - Market Equilibrium

This chapter will be built on the foundation laid down in Chapters 1, 2 and 4 where we studied the consumer and firm behaviour when they are price takers. In Chapter 2, we have seen that an individual’s demand curve for a commodity tells us what quantity a consumer is willing to buy at different prices when he takes price as given. The market demand curve in turn tells us how much of the commodity all the consumers taken together are willing to purchase at different prices when everyone takes price as given. In Chapter 4, we have seen that an individual firm’s supply curve tells us the quantity of the commodity that a profit-maximising firm would wish to sell at different prices when it takes price as given and the market supply curve tells us how much of the commodity all the firms taken together would wish to supply at different prices when each firm takes price as given. In this chapter, we combine both consumers’ and firms’ behaviour to study market equilibrium through demand-supply analysis and determine at what price equilibrium will be attained. We also examine the effects of demand and supply shifts on equilibrium. At the end of the chapter, we will look at some of the applications of demand-supply analysis.

An equilibrium is defined as a situation where the plans of all consumers and firms in the market match and the market clears. In equilibrium, the aggregate quantity that all firms wish to sell equals the quantity that all the consumers in the market wish to buy; in other words, market supply equals market demand. The price at which equilibrium is reached is called equilibrium price and the quantity bought and sold at this price is called equilibrium quantity. Therefore, (p, q) is an equilibrium if qD(p∗) = qS(p∗).

If at a price, market supply is greater than market demand, we say that there is an excess supply in the market at that price and if market demand exceeds market supply at a price, it is said that excess demand exists in the 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 the market is not in equilibrium, there will be a tendency for the price to change.

From the 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 the market. Our intuition also tells us that this ‘Invisible Hand’ should raise the prices in case of ‘excess demand’ and lower the prices in case of ‘excess supply’. Throughout our analysis we shall maintain that the ‘Invisible Hand’ plays this very important role. Moreover, we shall take it that the ‘Invisible Hand’ by following this process is able to reach the equilibrium.

Recall that in Chapter 2 we have derived the market demand curve for price-taking consumers, and for price-taking firms the market supply curve was derived in Chapter 4 under the assumption of a fixed number of firms. In this section with the help of these two curves we will look at how supply and demand forces work together to determine where the market will be in equilibrium when the number of firms is fixed. We will also study how the equilibrium price and quantity change due to shifts in demand and supply curves.