Chapter 3 – Market equilibrium, the price mechanism and market efficiency

9/10
Equilibrium –> “a state of rest, self-perpetuating in the absence of any outside influence”

The equilibrium is self-righting........examples:

Excess Demand
 • Producers lower price to P1
• Quantity Demanded rises to Q2 and Quantity Supplied falls to Q1
• We have excess demand of Q1-Q2
• More is demanded than being supplied
• To eliminate shortage, prices have to be raised.
• This lowers quantity demanded and raises quantity supplied ~> back to equilibrium

Excess Supply

• Producers raise price to P2

• Quantity Demanded falls to Q3 and Quantity Supplied rises to Q4
• We have excess supply of Q3-Q4
• More is supplied than being demanded
• To eliminate surplus, prices have to be lowered.
• This raises quantity demanded and lowers quantity supplied ~> back to equilibrium
Effect of change in demand and supply on equilibrium
• A shift in demand or supply will cause the equilibrium to shift.
EG:

• A reduction in income tax raises real income causing demand to shift to the right to
D1
• Quantity demanded increases to Q2 ~> Excess demand exists therefore price
needs to rise to eliminate the shortage
• Price rises to Pe1, new equilibrium price, and quantity demanded falls to Qe1, the
new equilibrium quantity.
• A shift in demand or supply in the market, if left alone, will cause the market to
adjust to a new equilibrium
Price mechanism
• A rise in price of a good signals firms to produce this good because it it more likely
to gain profit from this good.
• Higher prices ~> Higher demand for this good
• NO CENTRAL PLANNING AGENCY
• The forces of the market – change in price – allocates resources accordingly
~> the invisible hand
Market efficiency
➢ Consumer and producer surplus
Market for product X

Consumer surplus
➔ Consumer is willing and able to buy X at a price higher than Pe.
➔ But the consumers can buy product X at price Pe ~> the consumers have made a
gain because they have paid less money for X than they could have.
Producer surplus
➔ Producer is willing and able to sell X at a price lower than Pe
➔ But the producers can sell product X at the price Pe ~> the producers have made a
gain because they have sold X for a much larger amount of money they could have.
➢ Allocative efficiency
Market for product X

➔ Allocative efficiency ~> when the market is in equilibrium with no external

influences and no external effects
➔ This means that resources are allocated in the best possible way from society's
POV
➔ Consumer Surplus + Producer Surplus = Community Surplus ~> total benefit
to society
➔ @ the equilibrium ~> Community surplus is maximized(optimal allocation of
resources)
➔ Supply curve = Marginal Social Cost(MSC)........because......Cost of the industry =
Cost of the society
➔ Demand curve = Marginal Social Benefit(MSB).......because......Benefit in the
market = Benefit in the society
 Calculating and illustrating market equilibrium using linear demand and supply
functions
EG:
QD = 2000 – 200P
QS = – 400 + 400P

How to get the equilibrium:

2000 – 200P = – 400 + 400P QD = 2000 – 200P
2000 + 400 = 400P + 200P QD = 2000 – (200 x 4)
2400 = 600P QD = 2000 – 800
P = $4 QD = 1200 units
(Can also use Supply function to find out Quantity)
If Demand shifts?
QD1 = 1400 – 200P
QS = – 400 + 400P
1400 – 200P = – 400 + 400P QS = – 400 + 400P
1400 + 400 = 400P + 200P QS = – 400 + (400 x 3)
1800 = 600P QS = – 400 + 1200
P = $3 QS = 800
(Can also use Demand function to find out Quantity)
If Supply shifts?
QD = 2000 – 200P
QS1 = – 1000 + 400P
2000 – 200P = – 1000 + 400P QD = 2000 – 200P
2000 + 1000 = 400P + 200P QD = 2000 – (200 x 5)
3000 = 600P QD = 2000 – 1000
P = $5 QD = 1000
(Can also use Supply function to find out Quantity)

EASY WAY TO DRAW GRAPHS OF DEMAND AND SUPPLY

FIND
THE X(QUANTITY) AND Y(PRICE)
INTERCEPTS AND JOIN THE POINTS
Fred uses X- raYs to make Ice Jelly Pies
FXYIJP
Graphs
Chapter 3 05 September 2012

Consumer & Producer surplus

Consumer surplus ~> Satisfaction that consumers feel as they buy a product in a cheaper price than
they could have

Producer surplus ~> Satisfaction that producers feel as they sell a product in a higher price then
they could have

Allocative efficiency ~> When the market allocates resources in the best possible way in society’s
POV