Market and Market Equilibrium

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Market and Market Equilibrium

  1. 1. Unit 5 Market and Market Equilibrium Objectives: After going through this unit, you will be able to explain: Interaction of demand and supply curves. Concept of market and market equilibrium. What causes disequilibrium in the market? Various market adjustments. Concept of surplus and shortage in the market. What happens in the market when government intervenes? Structure: 1.1 Introduction 1.2 Market Equilibrium 1.3 Adjustments in the market 1.4 Government interference with market equilibrium 1.5 Summary 1.6 Key words 1.7 Self-assessment questions1.1 IntroductionMarket has assumed substantial in modern market and global economies. Understandingthe concept of market becomes absolutely imperative. Infact, understanding markets isthe first step in analyzing it. In economics, a market is primarily understood as amechanism which allows people to trade, normally governed by the theory of supply anddemand, allocating resources through a price mechanism and matching, so that thosewilling to pay a price for something meet those willing to sell for it. It is network which
  2. 2. because of advancements in modern technology can be real or virtual, by way of whichbuyers and sellers interact to exchange goods and services for money. Markets performthe vital economic function of bringing buyers and sellers together through the pricemechanism.1.2 Market EquilibriumEquilibrium is understood as a situation in which competing forces balance with eachother. In the market buyers and sellers may have competing objectives where buyers aimto maximize value for their money and sellers maximize profits. Economics helps usunderstand how they arrive at equilibrium. It defines market equilibrium as follows,The point at which the demand and the supply curve intersect and the buyers andsellers expectations match for trade to take place.Market equilibrium is, hence, state of equilibrium that exists when the disparate marketforces of demand and supply exactly counterbalance each other and there is no innatetendency for change. Consider the following figure,In a price or market system, supply and demand together will determine the prices atwhich transaction or exchanges will take place. Once achieved, market equilibriumpersists unless or until an outside force disrupts it. Market equilibrium is indicated by
  3. 3. equilibrium price and equilibrium quantity. When the equilibrium is disturbed there canbe two situations: a) Shortage - A situation where quantity demanded is in excess of quantity supplied. b) Surplus – A situation where quantity supplied is in excess of quantity demanded.The following figure shows surplus and shortage situations in the market. Quantit y Supply Demand Surplus Equilibrium Shortage Quantity 0The above figure shows, the surplus situation when supply exceeds demand, and shortagesituation when demand exceeds supply. Either of these situations is a movement awayfrom equilibrium and is called a disequilibrium situation in the market.1.3 Adjustments in the MarketWe have already analyzed in detail various factors that cause demand and supply tochange in the market. The economic analysis of the changes in market equilibrium iscaused by changes in the demand determinants and supply determinants.
  4. 4. The demand curve and the supply curve are the two curves that comprise the market,each of which can increase or decrease causing adjustments in the market. Theseadjustments come in eight varieties. Four involve a shift of either the demand curve or thesupply curve. The other four involve a shift of both the demand curve and the supplycurve. Consider the following table which show shifts in demand and supply andconsequent adjustments and impact on the market equilibrium.Diagram Change in Change in Impact on market equilibriumnumber Demand Supply 1 Increase No change Price increases; Quantity increases 2 Decrease No change Price decreases; Quantity decreases 3. No change Increase Price decreases; Quantity increases 4 No change Decrease Price increases; Quantity decreases 5 Increase Increase Price decreases; Quantity increases 6 Increase Decrease Price increases; Quantity increases 7 Decrease Increase Price decreases; Quantity decreases 8. Decrease Decrease Price increases; Quantity decreasesThis table is further exhibited through the following diagrams:
  5. 5. 1 2 43 5 6 7 8
  6. 6. 1.4 Government interference with market equilibriumGovernments the world over interfere with the market mechanism in some or the otherway. Such interference can be subtle or indirect on one hand, or outright or direct on theother hand. The underlying objectives could be socio-economic in nature, such as, a) To keep a low price in the market in favor of the consumer b) To maintain certain income levels for the sellers c) Price stabilitySome direct forms of interference which are discussed below may greatly affect theequilibrium price and quantity in the market. Consider some cases: a) Price ceilings: Government sometimes, imposes a price ceiling - a price is fixed at a level lower than the equilibrium price. The objective could be to enable product affordability to the masses. Sometimes prices of some products are kept artificially low through a ceiling because if the prices were allowed to rise it would lead to cascading effect in the economy. Price D S P e P1 Q1 Q Q2 Quantity In the above diagram, at equilibrium ‘e’, market price is P and quantity bought and sold is Q. A price ceiling at price P1 lower than the equilibrium price creates market demand Q2 in excess of market supply Q1.
  7. 7. b) Price Floors: Sometimes in order to protect the seller and assure him of some minimum income, government fixes a price floor, which is a price higher than the equilibrium price. The price in the market is not allowed to fall below the floor price. This strategy is popular particularly for agricultural prices which have a tendency to fall after a bumper harvest. The situation is explained through the following diagram: Price D SP1 P e Q1 Q Q2 Quantity In the above figure, at equilibrium ‘e’, market price is P and quantity bought and sold is Q. A price floor at price P1 higher than the equilibrium price creates market supply Q2 in excess of market demand Q1. c) Taxes and subsidies: Taxes and subsidies imposed by government also influence the equilibrium in the market. We have already discussed that taxes increase the cost of production and shift the supply curve leftwards while subsidies acting as a negative tax shift the supply curve leftwards. This is shown in the following set of diagrams. Consider first the effect of the tax:
  8. 8. Price S1 D SP1 e’ P e Q1 Q Quantity In the above figure, D is the demand curve and S is the supply curve which intersect at equilibrium ‘e’, market price is P and quantity bought and sold is Q. After the tax the supply curve shifts leftwards to S1. The new equilibrium point is e’, the equilibrium price is higher at P1 and quantity bought and sold is lesser at Q1. Consider the following diagram that shows the effect of subsidies:
  9. 9. Price S D S1 P e P1 e Q Q1 Quantity In the above figure, D is the demand curve and S is the supply curve which intersect at equilibrium ‘e’, market price is P and quantity bought and sold is Q. After the subsidy the supply curve shifts rightwards to S1. The new equilibrium point is e’, the equilibrium price is lower at P1 and quantity bought and sold is higher at Q1. d) Existence of Black Markets: Whenever there is government intervention to fix prices that are too high or too low, it means that there is another price at which the buyers and sellers are willing to trade. Such a situation has the tendency to create “black markets”, where people begin to make illegal arrangements to circumvent the fixed prices.1.5 SummaryIn this unit we have learnt that markets arrive at equilibrium as a result of the forces ofdemand and supply. Changes in demand and supply, forces adjustments in the market.The result could also be creation of shortages or surplus in the market. Governmentinterference with equilibrium prices is likely to influence the movements of the supplycurve and in some situations create a parallel market.
  10. 10. 1.6 Key words a) Equilibrium: A situation in which competing forces balance with each other. b) Market equilibrium: The point at which the demand and the supply curve intersect and the buyers and sellers expectations match for trade to take place. c) Shortage: A situation where quantity demanded is in excess of quantity supplied. d) Surplus : A situation where quantity supplied is in excess of quantity demanded. e) Price ceiling: A price is fixed at a level lower than the equilibrium price. f) Price floor: A price which is higher than the equilibrium price. g) Black market: A parallel, illegal market where buyers and sellers are willing to trade for a price which is higher or lower than the price fixed by the government.1.7 Self-assessment questions 1. Explain the term market equilibrium. 2. Show through neatly labeled, well indexed diagrams what happens in the market when: a) Supply increases b) Demand decreases c) Supply decreases d) Demand increases 3. Explain the following diagram and highlight the following: a) Equilibrium point b) Shortages and surplus
  11. 11. 4. Write a short note on government interference in the market.5. In economics, a market is primarily understood as a mechanism which allows people to a) Trade b) Talk c) Watch d) None of the above6. Markets perform the vital economic function of bringing buyers and sellers together through the, a) Price mechanism b) Quantity mechanism c) Share mechanism d) None of the above7. In economics, a market is primarily understood as a mechanism which allows people to trade a) True b) False c) Can’t say d) None of the above8. Governments the world over interfere with the market mechanism in some or the other way in order to a) Keep a low price in the market in favor of the consumer b) Maintain certain income levels for the sellers c) Maintain price stability d) None of the above9. Fill in the blanks: a) Markets perform the vital economic function of bringing ____________and____________ together.. b) Equilibrium is understood as a situation in which competing forces ____________with each other.
  12. 12. c) When the equilibrium is disturbed there can be two situations: ____________and ____________d) The ____________curve and the____________ curve are the two curves that comprise the market.e) Government sometimes, imposes a ____________- a price is fixed at a level lower than the equilibrium price.f) Sometimes in order to protect the seller and assure him of some minimum income, government fixes a____________, which is a price higher than the equilibrium price.g) Taxes increase the cost of production and shift the supply curve____________ while subsidies acting as a negative tax shift the supply curve ____________.h) In a “black markets”, people begin to make ____________arrangements to circumvent the fixed____________.

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