NCERT Textbook: Market Equilibrium | Indian Economy for UPSC CSE PDF Download

 Page 1


Chapter 5
Price
O
Quantity
SS
DD
p*
p
f
q'
1 q* q
2
p
1
q
1
q'
1
Mark Mark Mark Mark Market Equilibrium et Equilibrium et Equilibrium et Equilibrium et Equilibrium
This chapter will be built on the foundation laid down in Chapters
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.
5.1 EQUILIBRIUM, EXCESS DEMAND, EXCESS SUPPLY
A perfectly competitive market consists of buyers and sellers who
are driven by their self-interested objectives. Recall from Chapters
2 and 4 that objectives of the consumers are to maximise their
respective preference and that of the firms are to maximise their
respective profits. Both the consumers’ and firms’ objectives are
compatible in the equilibrium.
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
q
D
(p
*
) = q
S
(p
*
)
Reprint 2024-25
Page 2


Chapter 5
Price
O
Quantity
SS
DD
p*
p
f
q'
1 q* q
2
p
1
q
1
q'
1
Mark Mark Mark Mark Market Equilibrium et Equilibrium et Equilibrium et Equilibrium et Equilibrium
This chapter will be built on the foundation laid down in Chapters
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.
5.1 EQUILIBRIUM, EXCESS DEMAND, EXCESS SUPPLY
A perfectly competitive market consists of buyers and sellers who
are driven by their self-interested objectives. Recall from Chapters
2 and 4 that objectives of the consumers are to maximise their
respective preference and that of the firms are to maximise their
respective profits. Both the consumers’ and firms’ objectives are
compatible in the equilibrium.
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
q
D
(p
*
) = q
S
(p
*
)
Reprint 2024-25
72
Introductory Microeconomics
where p
*
 denotes the equilibrium price and q
D
(p
*
) and q
S
(p
*
) denote the market
demand and market supply of the commodity respectively at price 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. In the next
two sections, we will try to understand what drives this change.
Out-of-equilibrium Behaviour
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. This assumption will be taken to hold in all
that we discuss in the text.
5.1.1 Market Equilibrium: Fixed Number of Firms
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.
Figure 5.1 illustrates equilibrium
for a perfectly competitive market
with a fixed number of firms. Here
SS denotes the market supply
curve and DD denotes the market
demand curve for a commodity.
The market supply curve SS
shows how much of the
commodity, firms would wish to
supply at different prices, and the
demand curve DD tells us how
much of the commodity, the
consumers would be willing to
purchase at different prices.
Graphically, an equilibrium is a
point where the market supply
curve intersects the market
demand curve because this is
where the market demand equals
market supply. At any other point,
either there is excess supply or
Market Equilibrium with Fixed Number of
Firms. Equilibrium occurs at the intersection of the
market demand curve DD and market supply curve
SS. The equilibrium quantity is q* and the equilibrium
price is p*. At a price greater than p*, there will be
excess supply, and at a price below p*, there will be
excess demand.
Fig. 5.1
Price
O
Quantity
SS
DD
p*
p
2
q'
2 q* q
2
p
1
q
1
q'
1
Reprint 2024-25
Page 3


Chapter 5
Price
O
Quantity
SS
DD
p*
p
f
q'
1 q* q
2
p
1
q
1
q'
1
Mark Mark Mark Mark Market Equilibrium et Equilibrium et Equilibrium et Equilibrium et Equilibrium
This chapter will be built on the foundation laid down in Chapters
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.
5.1 EQUILIBRIUM, EXCESS DEMAND, EXCESS SUPPLY
A perfectly competitive market consists of buyers and sellers who
are driven by their self-interested objectives. Recall from Chapters
2 and 4 that objectives of the consumers are to maximise their
respective preference and that of the firms are to maximise their
respective profits. Both the consumers’ and firms’ objectives are
compatible in the equilibrium.
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
q
D
(p
*
) = q
S
(p
*
)
Reprint 2024-25
72
Introductory Microeconomics
where p
*
 denotes the equilibrium price and q
D
(p
*
) and q
S
(p
*
) denote the market
demand and market supply of the commodity respectively at price 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. In the next
two sections, we will try to understand what drives this change.
Out-of-equilibrium Behaviour
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. This assumption will be taken to hold in all
that we discuss in the text.
5.1.1 Market Equilibrium: Fixed Number of Firms
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.
Figure 5.1 illustrates equilibrium
for a perfectly competitive market
with a fixed number of firms. Here
SS denotes the market supply
curve and DD denotes the market
demand curve for a commodity.
The market supply curve SS
shows how much of the
commodity, firms would wish to
supply at different prices, and the
demand curve DD tells us how
much of the commodity, the
consumers would be willing to
purchase at different prices.
Graphically, an equilibrium is a
point where the market supply
curve intersects the market
demand curve because this is
where the market demand equals
market supply. At any other point,
either there is excess supply or
Market Equilibrium with Fixed Number of
Firms. Equilibrium occurs at the intersection of the
market demand curve DD and market supply curve
SS. The equilibrium quantity is q* and the equilibrium
price is p*. At a price greater than p*, there will be
excess supply, and at a price below p*, there will be
excess demand.
Fig. 5.1
Price
O
Quantity
SS
DD
p*
p
2
q'
2 q* q
2
p
1
q
1
q'
1
Reprint 2024-25
73
Market Equilibrium
there is excess demand. To see what happens when market demand does not
equal market supply, let us look in figure 5.1 again.
In Figure 5.1, if the prevailing price is p
1
, the market demand is q
1
 whereas
the market supply is 
1
q' . Therefore, there is excess demand in the market equal
to 
1
q' q
1
. Some consumers who are either unable to obtain the commodity at all
or obtain it in insufficient quantity will be willing to pay more than p
1
. The market
price would tend to increase. All other things remaining the same as price rises,
quantity demanded falls and quantity supplied increases. The market moves
towards the point where the quantity that the firms want to sell is equal to the
quantity that the consumers want to buy. This happens when price is p
* 
, the
supply decisions of the firms only match with the demand decisions of the
consumers.
Similarly, if the prevailing price is p
2
, the market supply (q
2
) will exceed the
market demand (
2
q ' ) at that price giving rise to excess supply equal to 
2
q ' q
2
.
Some firms will not be then able to sell  quantity they want to sell; so, they will
lower their price. All other things remaining the same as price falls, quantity
demanded rises, quantity supplied falls, and at p
*
,
 
the firms are able to sell
their desired output since market demand equals market supply at that price.
Therefore, p
*
 is the equilibrium price and the corresponding quantity q
*
 is the
equilibrium quantity.
To understand the equilibrium price and quantity determination more
clearly, let us explain it through an example.
EXAMPLE  5.1
Let us consider the example of a market consisting of identical
1
 farms producing
same quality of wheat. Suppose the market demand curve and the market supply
curve for wheat are given by:
q
D
= 200 – p for 0 = p = 200
= 0 for p > 200
q
S
= 120 + p for p = 10
= 0 for 0 = p < 10
where q
D 
and q
S 
denote the demand for and supply of wheat (in kg) respectively
and p denotes the price of wheat per kg in rupees.
Since at equilibrium price market clears, we find the equilibrium price
(denoted by p
*
) by equating market demand and supply and solve for p
*
.
q
D
(p
*
) = q
S
(p
*
)
 200 – p
*
 = 120 + p
*
Rearranging terms,
2p
*
 = 80
  p
*
 = 40
Therefore, the equilibrium price of wheat is Rs 40 per kg. The equilibrium
quantity (denoted by q
*
) is obtained by substituting the equilibrium price into
either the demand or the supply curve’s equation since in equilibrium quantity
demanded and supplied are equal.
1
Here, by identical we mean that all farms have same cost structure.
Reprint 2024-25
Page 4


Chapter 5
Price
O
Quantity
SS
DD
p*
p
f
q'
1 q* q
2
p
1
q
1
q'
1
Mark Mark Mark Mark Market Equilibrium et Equilibrium et Equilibrium et Equilibrium et Equilibrium
This chapter will be built on the foundation laid down in Chapters
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.
5.1 EQUILIBRIUM, EXCESS DEMAND, EXCESS SUPPLY
A perfectly competitive market consists of buyers and sellers who
are driven by their self-interested objectives. Recall from Chapters
2 and 4 that objectives of the consumers are to maximise their
respective preference and that of the firms are to maximise their
respective profits. Both the consumers’ and firms’ objectives are
compatible in the equilibrium.
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
q
D
(p
*
) = q
S
(p
*
)
Reprint 2024-25
72
Introductory Microeconomics
where p
*
 denotes the equilibrium price and q
D
(p
*
) and q
S
(p
*
) denote the market
demand and market supply of the commodity respectively at price 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. In the next
two sections, we will try to understand what drives this change.
Out-of-equilibrium Behaviour
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. This assumption will be taken to hold in all
that we discuss in the text.
5.1.1 Market Equilibrium: Fixed Number of Firms
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.
Figure 5.1 illustrates equilibrium
for a perfectly competitive market
with a fixed number of firms. Here
SS denotes the market supply
curve and DD denotes the market
demand curve for a commodity.
The market supply curve SS
shows how much of the
commodity, firms would wish to
supply at different prices, and the
demand curve DD tells us how
much of the commodity, the
consumers would be willing to
purchase at different prices.
Graphically, an equilibrium is a
point where the market supply
curve intersects the market
demand curve because this is
where the market demand equals
market supply. At any other point,
either there is excess supply or
Market Equilibrium with Fixed Number of
Firms. Equilibrium occurs at the intersection of the
market demand curve DD and market supply curve
SS. The equilibrium quantity is q* and the equilibrium
price is p*. At a price greater than p*, there will be
excess supply, and at a price below p*, there will be
excess demand.
Fig. 5.1
Price
O
Quantity
SS
DD
p*
p
2
q'
2 q* q
2
p
1
q
1
q'
1
Reprint 2024-25
73
Market Equilibrium
there is excess demand. To see what happens when market demand does not
equal market supply, let us look in figure 5.1 again.
In Figure 5.1, if the prevailing price is p
1
, the market demand is q
1
 whereas
the market supply is 
1
q' . Therefore, there is excess demand in the market equal
to 
1
q' q
1
. Some consumers who are either unable to obtain the commodity at all
or obtain it in insufficient quantity will be willing to pay more than p
1
. The market
price would tend to increase. All other things remaining the same as price rises,
quantity demanded falls and quantity supplied increases. The market moves
towards the point where the quantity that the firms want to sell is equal to the
quantity that the consumers want to buy. This happens when price is p
* 
, the
supply decisions of the firms only match with the demand decisions of the
consumers.
Similarly, if the prevailing price is p
2
, the market supply (q
2
) will exceed the
market demand (
2
q ' ) at that price giving rise to excess supply equal to 
2
q ' q
2
.
Some firms will not be then able to sell  quantity they want to sell; so, they will
lower their price. All other things remaining the same as price falls, quantity
demanded rises, quantity supplied falls, and at p
*
,
 
the firms are able to sell
their desired output since market demand equals market supply at that price.
Therefore, p
*
 is the equilibrium price and the corresponding quantity q
*
 is the
equilibrium quantity.
To understand the equilibrium price and quantity determination more
clearly, let us explain it through an example.
EXAMPLE  5.1
Let us consider the example of a market consisting of identical
1
 farms producing
same quality of wheat. Suppose the market demand curve and the market supply
curve for wheat are given by:
q
D
= 200 – p for 0 = p = 200
= 0 for p > 200
q
S
= 120 + p for p = 10
= 0 for 0 = p < 10
where q
D 
and q
S 
denote the demand for and supply of wheat (in kg) respectively
and p denotes the price of wheat per kg in rupees.
Since at equilibrium price market clears, we find the equilibrium price
(denoted by p
*
) by equating market demand and supply and solve for p
*
.
q
D
(p
*
) = q
S
(p
*
)
 200 – p
*
 = 120 + p
*
Rearranging terms,
2p
*
 = 80
  p
*
 = 40
Therefore, the equilibrium price of wheat is Rs 40 per kg. The equilibrium
quantity (denoted by q
*
) is obtained by substituting the equilibrium price into
either the demand or the supply curve’s equation since in equilibrium quantity
demanded and supplied are equal.
1
Here, by identical we mean that all farms have same cost structure.
Reprint 2024-25
74
Introductory Microeconomics
q
D
 = q
*
 = 200 – 40 = 160
Alternatively,
q
S
 = q
*
 = 120 + 40 = 160
Thus, the equilibrium quantity is 160 kg.
At a price less than p
*
, say p
1
 = 25
q
D
 = 200 – 25 = 175
q
S
 = 120 + 25 = 145
Therefore, at p
1
 = 25, q
D 
> q
S
 which implies that there is excess demand at
this price.
Algebraically, excess demand (ED) can be expressed as
ED(p) = q
D
 – q
S
= 200 – p – (120 + p)
= 80 – 2p
Notice from the above expression that for any price less than p
*
(= 40), excess
demand will be positive.
Similarly, at a price greater than p
*
, say p
2 
= 45
q
D
 = 200 – 45 = 155
q
S
 = 120 + 45 = 165
Therefore, there is excess supply at this price since q
S
 > q
D
. Algebraically,
excess supply (ES) can be expressed as
ES(p) = q
S
 – q
D
= 120 + p – (200 – p)
= 2p – 80
Notice from the above expression that for any price greater than p
*
(= 40),
excess supply will be positive.
Therefore, at any price greater than p
*
, there will be excess supply, and at
any price lower than p
*
,there will be excess demand.
Wage Determination in Labour Market
Here we will briefly discuss the theory of wage determination under a
perfectly competitive market structure using the demand-supply analysis.
The basic difference between a labour market and a market for goods is
with respect to the source of supply and demand. In the labour market,
households are the suppliers of labour and the demand for labour comes
from firms whereas in the market for goods, it is the opposite. Here, it is
important to point out that by labour, we mean the hours of work provided
by labourers and not the number of labourers. The wage rate is determined
at the intersection of the demand and supply curves of labour where the
demand for and supply of labour balance. We shall now see what the demand
and supply curves of labour look like.
To examine the demand for labour by a single firm, we assume that the
labour is the only variable factor of production and the labour market is
perfectly competitive, which in turn, implies that each firm takes wage rate
as given. Also, the firm we are concerned with, is perfectly competitive in
Reprint 2024-25
Page 5


Chapter 5
Price
O
Quantity
SS
DD
p*
p
f
q'
1 q* q
2
p
1
q
1
q'
1
Mark Mark Mark Mark Market Equilibrium et Equilibrium et Equilibrium et Equilibrium et Equilibrium
This chapter will be built on the foundation laid down in Chapters
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.
5.1 EQUILIBRIUM, EXCESS DEMAND, EXCESS SUPPLY
A perfectly competitive market consists of buyers and sellers who
are driven by their self-interested objectives. Recall from Chapters
2 and 4 that objectives of the consumers are to maximise their
respective preference and that of the firms are to maximise their
respective profits. Both the consumers’ and firms’ objectives are
compatible in the equilibrium.
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
q
D
(p
*
) = q
S
(p
*
)
Reprint 2024-25
72
Introductory Microeconomics
where p
*
 denotes the equilibrium price and q
D
(p
*
) and q
S
(p
*
) denote the market
demand and market supply of the commodity respectively at price 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. In the next
two sections, we will try to understand what drives this change.
Out-of-equilibrium Behaviour
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. This assumption will be taken to hold in all
that we discuss in the text.
5.1.1 Market Equilibrium: Fixed Number of Firms
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.
Figure 5.1 illustrates equilibrium
for a perfectly competitive market
with a fixed number of firms. Here
SS denotes the market supply
curve and DD denotes the market
demand curve for a commodity.
The market supply curve SS
shows how much of the
commodity, firms would wish to
supply at different prices, and the
demand curve DD tells us how
much of the commodity, the
consumers would be willing to
purchase at different prices.
Graphically, an equilibrium is a
point where the market supply
curve intersects the market
demand curve because this is
where the market demand equals
market supply. At any other point,
either there is excess supply or
Market Equilibrium with Fixed Number of
Firms. Equilibrium occurs at the intersection of the
market demand curve DD and market supply curve
SS. The equilibrium quantity is q* and the equilibrium
price is p*. At a price greater than p*, there will be
excess supply, and at a price below p*, there will be
excess demand.
Fig. 5.1
Price
O
Quantity
SS
DD
p*
p
2
q'
2 q* q
2
p
1
q
1
q'
1
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Market Equilibrium
there is excess demand. To see what happens when market demand does not
equal market supply, let us look in figure 5.1 again.
In Figure 5.1, if the prevailing price is p
1
, the market demand is q
1
 whereas
the market supply is 
1
q' . Therefore, there is excess demand in the market equal
to 
1
q' q
1
. Some consumers who are either unable to obtain the commodity at all
or obtain it in insufficient quantity will be willing to pay more than p
1
. The market
price would tend to increase. All other things remaining the same as price rises,
quantity demanded falls and quantity supplied increases. The market moves
towards the point where the quantity that the firms want to sell is equal to the
quantity that the consumers want to buy. This happens when price is p
* 
, the
supply decisions of the firms only match with the demand decisions of the
consumers.
Similarly, if the prevailing price is p
2
, the market supply (q
2
) will exceed the
market demand (
2
q ' ) at that price giving rise to excess supply equal to 
2
q ' q
2
.
Some firms will not be then able to sell  quantity they want to sell; so, they will
lower their price. All other things remaining the same as price falls, quantity
demanded rises, quantity supplied falls, and at p
*
,
 
the firms are able to sell
their desired output since market demand equals market supply at that price.
Therefore, p
*
 is the equilibrium price and the corresponding quantity q
*
 is the
equilibrium quantity.
To understand the equilibrium price and quantity determination more
clearly, let us explain it through an example.
EXAMPLE  5.1
Let us consider the example of a market consisting of identical
1
 farms producing
same quality of wheat. Suppose the market demand curve and the market supply
curve for wheat are given by:
q
D
= 200 – p for 0 = p = 200
= 0 for p > 200
q
S
= 120 + p for p = 10
= 0 for 0 = p < 10
where q
D 
and q
S 
denote the demand for and supply of wheat (in kg) respectively
and p denotes the price of wheat per kg in rupees.
Since at equilibrium price market clears, we find the equilibrium price
(denoted by p
*
) by equating market demand and supply and solve for p
*
.
q
D
(p
*
) = q
S
(p
*
)
 200 – p
*
 = 120 + p
*
Rearranging terms,
2p
*
 = 80
  p
*
 = 40
Therefore, the equilibrium price of wheat is Rs 40 per kg. The equilibrium
quantity (denoted by q
*
) is obtained by substituting the equilibrium price into
either the demand or the supply curve’s equation since in equilibrium quantity
demanded and supplied are equal.
1
Here, by identical we mean that all farms have same cost structure.
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Introductory Microeconomics
q
D
 = q
*
 = 200 – 40 = 160
Alternatively,
q
S
 = q
*
 = 120 + 40 = 160
Thus, the equilibrium quantity is 160 kg.
At a price less than p
*
, say p
1
 = 25
q
D
 = 200 – 25 = 175
q
S
 = 120 + 25 = 145
Therefore, at p
1
 = 25, q
D 
> q
S
 which implies that there is excess demand at
this price.
Algebraically, excess demand (ED) can be expressed as
ED(p) = q
D
 – q
S
= 200 – p – (120 + p)
= 80 – 2p
Notice from the above expression that for any price less than p
*
(= 40), excess
demand will be positive.
Similarly, at a price greater than p
*
, say p
2 
= 45
q
D
 = 200 – 45 = 155
q
S
 = 120 + 45 = 165
Therefore, there is excess supply at this price since q
S
 > q
D
. Algebraically,
excess supply (ES) can be expressed as
ES(p) = q
S
 – q
D
= 120 + p – (200 – p)
= 2p – 80
Notice from the above expression that for any price greater than p
*
(= 40),
excess supply will be positive.
Therefore, at any price greater than p
*
, there will be excess supply, and at
any price lower than p
*
,there will be excess demand.
Wage Determination in Labour Market
Here we will briefly discuss the theory of wage determination under a
perfectly competitive market structure using the demand-supply analysis.
The basic difference between a labour market and a market for goods is
with respect to the source of supply and demand. In the labour market,
households are the suppliers of labour and the demand for labour comes
from firms whereas in the market for goods, it is the opposite. Here, it is
important to point out that by labour, we mean the hours of work provided
by labourers and not the number of labourers. The wage rate is determined
at the intersection of the demand and supply curves of labour where the
demand for and supply of labour balance. We shall now see what the demand
and supply curves of labour look like.
To examine the demand for labour by a single firm, we assume that the
labour is the only variable factor of production and the labour market is
perfectly competitive, which in turn, implies that each firm takes wage rate
as given. Also, the firm we are concerned with, is perfectly competitive in
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Market Equilibrium
nature and carries out production with the goal of profit maximisation. We
also assume that given the technology of the firm, the law of diminishing
marginal product holds.
The firm being a profit maximiser will always employ labour upto
the point where the extra cost she incurs for employing the last unit of
labour is equal to the additional benefit she earns from that unit. The
extra cost of hiring one more unit of labour is the wage rate (w). The
extra output produced by one more unit of labour is its marginal product
(MP
L
) and by selling each extra unit of output, the additional earning of
the firm is the marginal revenue (MR) she gets from that unit. Therefore,
for each extra unit of labour, she gets an additional benefit equal to
marginal revenue times marginal product which is called Marginal
Revenue Product of Labour (MRP
L
). Thus, while hiring labour, the firm
employs labour up to the point where
      w = MRP
L
and MRP
L
 = MR × MP
L
Since we are dealing with a perfectly competitive firm, marginal
revenue is equal to the price of the commodity
a
 and hence marginal
revenue product of labour in this case is equal to the value of marginal
product of labour (VMP
L
).
As long as the VMP
L
 is greater than the wage rate, the firm will earn
more profit by hiring one more unit of labour, and if at any level of labour
employment VMP
L
 is less than the wage rate, the firm can increase her
profit by reducing a unit of labour employed.
Given the assumption of the law of diminishing marginal product,
the fact that the firm always produces at w = VMP
L
 implies that the
demand curve for labour is downward sloping. To explain why it is so,
let us assume at some wage rate w
1
, demand for labour is l
1
. Now, suppose
the wage rate increases to w
2
. To maintain the wage-VMP
L
 equality, VMP
L
should also increase. The price of the commodity remaining
constant
b
, this is possible
only if MP
L
 increases which in
turn implies that less labour
should be employed owing to
the diminishing marginal
productivity of labour.
Hence, at higher wage, less
labour is demanded thereby
leading to a downward
sloping demand, curve. To
arrive at the market demand
curve from individual firms’
demand curve, we simply
add up the demand for
labour by individual firms at
different wages and since
each firm demands less
labour as wage increases, the
market demand curve is also downward sloping.
Wage
O
Labour(in hrs)
S
L
D
L
w*
l*
Wage is determined at the point where the labour
demand and supply curves intersect.
a
Recall from Chapter 4 that for a perfectly competitive firm, marginal revenue equals price.
b
Since the firm under consideration is perfectly competitive, it believes it cannot influence
the price of the commodity.
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