MARKET EQUILIBRIUM

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MARKET EQUILIBRIUM

• PRINCIPLES OF MICROECONOMICS

Dr. Fidel Gonzalez Department of Economics and
Intl. Business Sam Houston State University
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OPPORTUNITY COST
MARGINAL ANALYSIS
Elasticity
Elasticity
SUPPLY
DEMAND
MARKET EQUILIBRIUM
CONSUMER SURPLUS, PRODUCER SURPLUS AND TOTAL
SURPLUS
MARKET EFFICIENCY
MARKET FAILURE
Pigouvian Taxes Quotas Coase Theorem Command and
control
EXTERNALITIES
TAXES
PUBLIC GOODS
COMMON GOODS
ARTIFICIALLY SCARCE GOODS
GAME THEORY
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Market Equilibrium
Now that we know market demand and supply, we can
analyze equilibrium.
Demand and supply TOGETHER determine the
equilibrium price and quantity in the market.
The price that you see in the market is the
equilibrium price. Total amount sold and bought
in the market at that price is the equilibrium
quantity.
We define equilibrium as the point where Quantity
Supplied is equal to the Quantity Demanded for a
given price
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In the following table you can see how the market
demand and market supply determine the
equilibrium price and quantity
We find the equilibrium point by finding the
price at which the quantity supplied is equal to
the quantity demanded.
When the price is 4 the quantity demanded (6
units) is equal to the quantity supplied (6
units).
Hence, the equilibrium price is 4 and the
equilibrium quantity is 6 units. The equilibrium
price is denoted by P and the equilibrium
quantity by Q.
P4 and Q6
Note that if the price is 2 then the quantity
demanded is 10 and the quantity supplied is 3.
Hence, the QD gt QS this is called a shortage. The
price is too low and consumers wants more of the
good than what producers are willing to supply.
In this case there is a shortage of 7 units.
Note that if the price is 6 then the quantity
demanded is 2 and the quantity supplied is 9.
Hence, the QD lt QS this is called a surplus. The
price is too high and producers produces more of
the good than what seller are willing to buy. In
this case, there is a surplus of 7 units.
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In general, when P lt P then QDgtQS and there is a
shortage.
In general, when P gt P then QDltQS and there is a
surplus.
Next, we graph the supply and demand curves.
P
S
7
Graphically the market equilibrium takes place
when the supply and demand curve cross each other.
P4
D
Q
14
Q6
The quantity supplied equal the quantity demanded
for a given price when the demand and supply
curve cross each other.
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Shortage Imagine that P lt P In particular
assume that P2 and P4. When P2 the QS10 and
the QD3, hence there is a shortage of 7 units.
P
S
7
P2
D
Shortage of 7 units
Q
14
10
3
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Shortage When P lt P we have a shortage. So, how
do we get to equilibrium. Note that when there
is a shortage people want the good but they can
not get it. Some people will be willing to pay
more in order to get the good. Also some
producers realized that the are selling all the
goods very fast and that people are willing to
buy the good for a higher price. Hence, the price
starts to increase, when the price goes up the QD
goes down and the QS goes up. This process
continues until we reach equilibrium
P
S
7
Price goes up and QD goes down until we reach
equilibrium
Price goes up and QS goes up until we reach
equilibrium
P2
D
Q
14
10
3
Once we reach equilibrium there is no reason to
move away from it. If the producer keep producing
it will create a surplus as we saw before.
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Surplus Imagine that P gt P In particular
assume that P6 and P4. When P6 the QS9 and
the QD2, hence there is a surplus of 7 units.
P
S
Surplus of 7 units
12
P6
D
Q
18
9
2
9
Surplus When P gt P we have a surplus. So, how
do we get to equilibrium. Note that when there
is a surplus firms have a lot of inventories
because they can not sell their products. Some
producer reduce prices. Hence, when the price
goes down QD goes up and the QS goes down. This
process continues until we reach equilibrium
P
S
Surplus of 7 units
12
P6
Price goes down and QS goes down until we reach
equilibrium
Price goes down and QD goes up until we reach
equilibrium
D
Q
18
9
2
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Equilibrium using the demand and supply equations
Now, we are going to use the demand and supply
equation to obtain the equilibrium price and
quantity. First, we need to obtain the demand
equation. From the graph in slide 4 we can see
that the inverse demand equation is P-0.5 QD
7 Hence, the inverse demand equation is QD -2
P 14 Second, we need to obtain the supply
equation. From the graph in slide 4 we can see
that the inverse supply equation P 2/3 QS The
supply equation is QS 1.5 P
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Equilibrium using the demand and supply equations
We have two equations QD -2 P 14 Demand
Equation QS 1.5 P Supply Equation So far
we have two equations and three variables (QS,QD
and P). We can not solve the problem. We need to
have the same number of equations as variables to
be able to solve the problem. We know that at
equilibrium the QS and QD. That is our next
equation, QSQD Equilibrium condition (note
that the equilibrium condition only takes place
at the optimal level). Now, we have three
equations and three unknowns and we can solve the
problem. To solve the problem start with the
equilibrium condition QSQD Q (when QSQD
then we call that quantity Q) Next, substitute
it into the demand and supply equation Q -2 P
14 Q 1.5 P
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Equilibrium using the demand and supply equations
Q -2 P 14 Q 1.5 P Make the two equations
equal -2P 14 1.5 P Solve the previous
equation for P, 14 3.5 P 4 P That is the
equilibrium price is 4 (P4), just as we found
using the tables. Next we need to obtain the
optimal quantity. To do this we substitute the
equilibrium value of P into either the demand or
the supply equation. I will do it using the
supply equation Q1.5 P 1.5(4) 6
Q6 The optimal quantity is six units just what
we obtained when we used the tables.
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Shortage and surplus using the demand and supply
equations
We can also analyze shortage and surplus using
the demand and supply equations. For example
imagine that P2 Lets obtain the QD and
QS. First, obtain QD QD -2 P 14 -2(2) 14
10 QD 10 Second, obtain QS QS 1.5 P
1.5 (2) 3 QS3 Finally compare QD and
QS QD10 gt 3QS then we have a shortage of 7
units.
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Shortage and surplus using the demand and supply
equations
We can do a similar analysis for a
surplus Imagine that P6 Obtain QD QD -2 P 14
-2(6) 14 2 QD 2 Obtain QS QS 1.5 P
1.5 (6) QS9 Compare QD and QS QD2 lt 9QS
then we have a surplus of 7 units.
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Changes in Demand or Supply and its effect in
equilibrium
We now are going to see what happens to the
equilibrium price and quantity when the demand
and/or supply shifts We first start with changes
in either only supply or only demand. For example
imagine that the price of Pepsi goes up and we
want to see what happens to the equilibrium price
and quantity in the coke market. Since Pepsi is a
substitute of coke the demand for coke increases
(shift to the right)
The new equilibrium the equilibrium price
increases from P1 to P2. The equilibrium quantity
increases from Q1 to Q2.
S
P2
In summary, an increase in the price of Pepsi
increases the equilibrium Price and Quantity of
Coke
P1
D1
D2
Q1
Q2
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Changes in Demand or Supply and its effect in
equilibrium

• In general, to figure out what is the effect of
  the change in a variable you can follow the next
  three steps
• Determine whether demand or supply is affected by
  the change.
• Determine the direction of the shift (right or
  left)
• See how the equilibrium price changes

• Another example
• Imagine that the price of steel increases.
• Q What happens to the equilibrium price and
  quantity of cars?
• A
• Since steel is used in the production of cars,
  the cost of producing cars increases.
• Higher costs decrease supply. Hence, supply goes
  down shifting to the left.
• Now lets look at the graph in the next slide to
  see what happens at the equilibrium price and
  quantity

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Changes in Demand or Supply and its effect in
equilibrium
S2
The equilibrium price increase and the
equilibrium quantity decreases
S1
P2
P1
D
Q1
Q2
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Changes in Demand or Supply and its effect in
equilibrium
I do not like to give you tables to memorize but
I understand that most students use them. So the
following is a table that summarizes the changes
in the equilibrium price and quantity when ONLY
the supply OR the demand changes
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Changes in both Demand and Supply at the same
time and its effect in equilibrium.

• We will study now what happens when supply and
  demand change at the same time.
• Assume that income increases and that the price
  of oranges goes down.
• Q What happens to the equilibrium price and
  quantity of orange juice?
• A
• Higher income increases demand (shift right)
• Higher prices of oranges increases the cost of
  producing orange juice, supply goes down (shift
  to the left)

In this case the equilibrium price increases from
P1 to P2. The equilibrium quantity goes down by
a little bit from Q1 to Q2. However, note that
the change in the quantity depend on how much I
shift the supply . If I shift the supply little
bit to the left then I the equilibrium quantity
goes up (see the next slide).
S2
S1
P2
P1
D2
D1
Q2
Q1
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Changes in both Demand and Supply at the same
time and its effect in equilibrium.
Supply shifts to the left just by a little bit
and the quantity of equilibrium increases from Q1
to Q2. Note that the price still increases from
P1 to P2 The previous implies that when supply
goes down and demand goes up the equilibrium
price increases but we do not know what happens
to the equilibrium quantity. That is, the change
in the equilibrium quantity is ambiguous.
S2
S1
P2
P1
D2
D1
Q2
Q1
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Changes in both Demand and Supply at the same
time and its effect in equilibrium.
The following table provides a summary of the
effect if changes in the supply and demand at the
same time on the equilibrium price and quantity.