Market Equilibrium

Market Equilibrium: • Market equilibrium is the situation in which the quantity demanded by consumers equals the quantity supplied by producers at a particular price. • At equilibrium, the market 'clears' — there is no tendency for price to change. • Equilibrium price (P*): The price at which Qd = Qs. • Equilibrium quantity (Q*): The quantity bought and sold at the equilibrium price. • Graphically, equilibrium is at the intersection of the demand curve (D) and the supply curve (S). When there is Excess Demand (Shortage): • Situation: Qd > Qs at the prevailing price (price is below equilibrium). • Buyers want more than sellers are willing to supply. • Consequence: Competing buyers bid up the price. • Adjustment: As price rises, Qd falls and Qs rises until Qd = Qs — equilibrium is restored. When there is Excess Supply (Surplus): • Situation: Qs > Qd at the prevailing price (price is above equilibrium). • Sellers want to sell more than buyers want to buy. • Consequence: Competing sellers reduce prices to clear unsold stock. • Adjustment: As price falls, Qs decreases and Qd increases until Qd = Qs — equilibrium is restored. This self-correcting mechanism — prices adjusting to eliminate excess demand or supply — is the essence of how free markets work (the 'invisible hand').

Law of Supply: Other things remaining constant (ceteris paribus), as the price of a good increases, the quantity supplied of that good increases, and vice versa. Price and quantity supplied are directly (positively) related — the supply curve slopes upward. Why does the supply curve slope upward? • Higher prices make production more profitable, incentivising existing firms to produce more and new firms to enter the market. • At higher prices, firms are willing to expand output even if their marginal costs are rising. Determinants of Supply (factors causing a shift in the supply curve): 1. Input prices (cost of production): A rise in input prices (wages, raw material costs) increases production costs → supply decreases (leftward shift). A fall in input costs → supply increases (rightward shift). 2. Technology: An improvement in technology lowers production costs → supply increases. 3. Number of sellers: More sellers → market supply increases. 4. Government policies: A subsidy lowers production cost → supply increases. A tax increases cost → supply decreases. 5. Natural conditions and climate: Good weather increases agricultural supply. 6. Expectations of future price: If firms expect higher prices in the future, they may hold back current supply. 7. Prices of related goods (in production): If the price of an alternative crop rises, a farmer may shift production to that crop, reducing supply of the first. Price Elasticity of Supply (PES): • PES = (% change in quantity supplied) ÷ (% change in price) • Since supply is positively related to price, PES is always positive. • Elastic supply (PES > 1): Quantity supplied responds more than proportionately to price change — typical of goods with flexible production. • Inelastic supply (PES < 1): Quantity supplied responds less than proportionately — typical of goods that take time to produce (agricultural crops, specialised goods). • Perfectly inelastic (PES = 0): Supply cannot change regardless of price — e.g., unique paintings, fixed land supply. • Perfectly elastic (PES = ∞): Supply is infinite at a given price — horizontal supply curve. • Main determinants of PES: time period (longer run = more elastic), ease of factor mobility, availability of stocks, production flexibility.

Changes in demand or supply cause a shift in the respective curve, leading to a new equilibrium price and quantity. 1. Increase in Demand (rightward shift of D), Supply unchanged: • Excess demand at the original price → price is bid up. • New equilibrium: Higher price AND higher quantity. • Example: A cold winter increases demand for heaters → price and quantity of heaters both rise. 2. Decrease in Demand (leftward shift of D), Supply unchanged: • Excess supply at the original price → price falls. • New equilibrium: Lower price AND lower quantity. • Example: A health scare about red meat reduces demand → price and quantity of beef fall. 3. Increase in Supply (rightward shift of S), Demand unchanged: • Excess supply at the original price → price falls. • New equilibrium: Lower price BUT higher quantity. • Example: Good monsoon rains increase wheat production → wheat price falls, quantity rises. 4. Decrease in Supply (leftward shift of S), Demand unchanged: • Excess demand at the original price → price rises. • New equilibrium: Higher price BUT lower quantity. • Example: A drought reduces wheat production → wheat price rises, quantity falls. 5. Both Demand and Supply increase: • Effect on quantity: Definitely increases. • Effect on price: Ambiguous — depends on the relative magnitude of the shifts. If demand increases more, price rises; if supply increases more, price falls. 6. Both Demand and Supply decrease: • Effect on quantity: Definitely decreases. • Effect on price: Ambiguous — depends on relative magnitudes. Key principle: Demand shifts drive price and quantity in the same direction; supply shifts drive price and quantity in opposite directions.