Market Equilibrium with demand and supply

 

Market Equilibrium and Changes in Market Equilibrium

Market equilibrium is a situation where the supply of a particular commodity is equal to the demand of that commodity in the market. The equilibrium price is defined as the price at which the quantity supplied and quantity demanded are equal. Quantity demanded is an inverse function of price, while quantity supplied is a direct function of price.

Before Marshall, there were some disputes among economists. Few economists gave importance to the force of demand in determining the price while few emphasized the force of supply.

Marshall has given equal importance to both demand and supply in the determination of price. According to him, neither the upper-blade of scissors nor the lower-blade can separately cut the paper but both have their importance in the process of cutting.

Likewise, neither supply nor demand alone can determine the price of a commodity. Both are having equal importance but the relative importance of the two may vary depending upon the time under consideration. Thus, the demand of all the consumers and the supply of all the firms together determine the price of the particular good in the market.

Market Equilibrium

Market Equilibrium is obtained by the intersection of the demand and supply curve. Price is an independent variable while demand and supply are variables that depend on price.

The demand curve has a negative slope and the supply curve has a positive slope. At a point where these two curves intersect with each other, the equilibrium price is determined. At this price, the quantity demanded is equal to the quantity supplied.

Price	Demand	Supply	State of Market	Pressure on Price
10	500	100	D > S	P↓
20	400	200
30	300	300	D = S	Neutral
40	200	400	D < S	P↑
50	100	500

In the above diagram, DD is Demand Curve and SS is Supply Curve. At point E, Demand and Supply are in equilibrium where both curves intersect. Where the equilibrium price is OP and equilibrium output is OQ.

Suppose, the price (OP2) is higher than the equilibrium price because of the excess supply. Competition among the sellers will bring it down to the equilibrium price where the supply is equal to demand. On the other hand, if the price (OP1) is lower than the equilibrium price because of the excess demand. Excess demand pushes up the price, this process will go on until the equilibrium is reached where supply becomes equal to demand.

Changes in Market Equilibrium

It occurs when there will be a shift either in the demand curve or in the supply curve, or in both.

Effects of the shift in Demand Curve on Equilibrium

A shift in the demand curve will affect the equilibrium price and quantity while the supply curve remaining unchanged. When there is a change in the determinants of demand like income, taste & habits, price of substitutes and complementary goods, size of the population, etc., it will change the demand. If demand increases due to a change in any one of these conditions, the demand curve shifts to the right, and it shifts to the left in the case when demand decreases. Such rise and fall in demand, are referred to as increase and decrease in demand.

An increase in demand would result in an increase in the equilibrium price and quantity.

Conversely, a decrease in demand would result in a decrease in equilibrium price and quantity.

This diagram depicts the effects of the shift in demand on Equilibrium.  Demand and Supply are on OX and Price on OY. E is the initial equilibrium at the point where DD and SS curves are intersecting each other. At P price OQ quantity is determined. If the demand curve D1D1 shift to right because of an increase in demand and supply remained unchanged. Seller will increase the price because of the increase in demand and the new equilibrium point also changes from E to E1 where at high price P1, quantity rises to OQ1. Similarly, when the demand curve shifts downward to D2D2, price and quantity fall to OP2 and OQ2, respectively.  

Effects of the shift in Supply Curve on Equilibrium: A shift in the supply curve will affect the equilibrium price and quantity while the demand curve remaining unchanged.

An increase in supply would result in a fall in the equilibrium price and an increase in the equilibrium quantity.

A decrease in supply would result in a rise in the equilibrium price and a fall in the equilibrium quantity.

This diagram depicts the effects of the shift in supply on Equilibrium.  Demand and Supply are on OX and Price on OY. E is the initial equilibrium at the point where DD and SS curves are intersecting each other. At P price OQ quantity is determined. If the supply curve S1S1 shift to right because of an increase in supply and demand remained unchanged. The new equilibrium point also changes from E to E1 where price decreases to P1 and quantity increase from OQ to OQ1. Similarly, when the supply curve shifts to the left to S2S2, quantity falls from OQ to OQ2, and price increases from P to P2.

 Effect of changes in both demand and supply: The net result would depend upon the relative change in demand and supply.

If  the rate of change in demand and the rate of change in supply is matched, and both the demand and supply curves shift rightward, the quantity increases, but the equilibrium price remains the same.

In the above diagram, DD and SS are intersecting each other at the initial equilibrium point E, with equilibrium price P and equilibrium output Q. Suppose both demand and supply increase by the same proportion. Demand curve D1D1 and supply curve S1S1 shift to them rightwards. The new equilibrium point is E1 with higher equilibrium output Q1 but the same equilibrium price P.

When a decrease in demand is greater than the decrease in supply

In this situation, Equilibrium price and quantity both fall.

In this diagram, DD and SS are intersecting each other at the initial equilibrium point E, with equilibrium price P and equilibrium output Q.

Suppose demand decreases but greater than the decrease in supply, demand curve D1D1 and supply curve S1S1 shift respectively and intersect each other at new equilibrium point E1 where the price P1 and quantity Q1 both decrease.

When the decrease in supply is greater than the decrease in demand: In this situation, the equilibrium price will rise but equilibrium quantity will fall.

In this diagram, DD and SS are intersecting each other at the initial equilibrium point E, with equilibrium price P and equilibrium output Q.

Suppose supply decreases but greater than the decrease in demand, demand curve D1D1 and supply curve S1S1 shift respectively and intersect each other at new equilibrium point E1 where the price P1 rises and quantity Q1 decreases.

Thus, when a decrease in demand is greater than a decrease in supply, equilibrium price, and quantity both fall, but when a decrease in supply is greater than a decrease in demand, equilibrium price rises, and quantity falls.

Dr. Swati Gupta

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