ECO2201 – Microeconomics

Chapter 4 :The Market Forces

of Supply and Demand

The Market Equilibrium

Lesson 3.2
Road Map
1. Introduction
2. Market Equilibrium Glossary
3. The Mechanics of Market Forces
4. Market Adjustment
5. Table and Equation Analyses
• Review

2
1. Market Equilibrium Glossary
• Equilibrium Price (or Market-clearing Price), Peq (or PE)
– The price that clears the market.
– i.e. no shortages nor surpluses.
• Equilibrium Quantity, Qeq (or QE)
– The quantities bought and sold at the equilibrium price.

3
1. Market Equilibrium Glossary
P
• Surplus (Excess Supply) Surplus S
P1
– When quantity supplied is more than
quantity demanded (QS > QD)
D
0 Q
QD QS
P S
• Shortage (Excess Demand)
– When quantity demanded is more than
P2
quantity supplied (QD > QS)
Shortage D
0 QS Q
QD

4
 1. Market Equilibrium Glossary
Market Equilibrium
• It is the equilibrium where price (Peq) has
P
reached the level at which quantity
S
supplied equals quantity demanded →
Peq the market is cleared
o That is, in equilibrium, there are no

D shortages or surpluses.

QD = QS = Qeq
0 QD = QS = Qeq Q

5
 Example 1: Market Equilibrium
• Equilibrium price: price where Q supplied = Q demanded
• Equilibrium quantity: Q supplied and Q demanded at the
equilibrium price P Q QS
D
P
D
$6.00 S $0 24 0
$5.00 1 21 5
$4.00 2 18 10
$3.00 3 15 15
$2.00
4 12 20
$1.00
5 9 25
$0.00
0 5 10 15 20 25 30 35
Q 6 6 30

6
Example 2: Market Equilibrium in Labor Market

• Market equilibrium can be applied in labor market where price

becomes the wage rate and quantity is the level of employment.
• What is the equilibrium wage rate and level of employment in this
labor market?

Wage Rate Quantity Demanded Quantity Supplied

$8 6,000 16,000
$7 9,000 14,000
$6 12,000 12,000
$5 15,000 10,000
$4 18,000 8,000

7
2. The Mechanics of Market Forces
• When the current market price (P) is different from the
equilibrium price (Peq), market will have a temporary shortage
or surplus.
• The price will adjust to close the shortage or surplus until it
reaches the equilibrium price, and market will no longer have
the shortage or surplus.

7
3. Market Adjustment

How will market adjust if the market has a

surplus/shortage of goods?

8
 3. Market Adjustment
Markets Not in Equilibrium
P D S Surplus
$6.00 Surplus
• Excess supply: quantity supplied is
$5.00
greater than quantity demanded
$4.00
• if P = $5,
$3.00
then QD = 9 lattes and
$2.00
QS = 25 lattes
$1.00 • A surplus of 16 lattes
$0.00
Q
0 5 10 15 20 25 30 35

9
 3. Market Adjustment
P D S Markets Not in Equilibrium
$6.00 Surplus
Surplus
$5.00 • Facing a surplus, sellers try to

$4.00 increase sales by cutting price.

• This causes QD to rise
$3.00
• and QS to fall…
$2.00
• …which reduces the surplus.
$1.00
$0.00
Q
0 5 10 15 20 25 30 35

10
 3. Market Adjustment
P Markets Not in Equilibrium
D S
$6.00 Surplus Surplus
$5.00 • Facing a surplus,

$4.00 sellers try to increase sales by

cutting price.
$3.00
• This causes QD to rise
$2.00 • and QS to fall…
$1.00 • Prices continue to fall until

$0.00 market reaches equilibrium.

Q
0 5 10 15 20 25 30 35

11
 3. Market Adjustment
P D S Markets Not in Equilibrium
$6.00
Shortage
$5.00 • Excess demand: quantity demanded
$4.00 is greater than quantity supplied
• Example: if P = $1,
$3.00
then QD = 21 lattes and
$2.00 QS = 5 lattes
$1.00 • resulting in a shortage of 16 lattes
Shortage
$0.00
Q
0 5 10 15 20 25 30 35

12
 3. Market Adjustment
P D S Markets Not in Equilibrium
$6.00
Shortage
$5.00 • Facing a shortage, sellers raise the
$4.00 price,
• causing QD to fall
$3.00
• and QS to rise,
$2.00
• …which reduces the shortage
$1.00 Shortage
$0.00
Q
0 5 10 15 20 25 30 35

13
 3. Market Adjustment
P
D S Markets Not in Equilibrium
$6.00
Shortage
$5.00 • Facing a shortage, sellers raise the
$4.00 price,

$3.00 • causing QD to fall

• and QS to rise,
$2.00
• Prices continue to rise until
$1.00 market reaches equilibrium
Shortage
$0.00 Q
0 5 10 15 20 25 30 35

14
3. Market Adjustment

P > Peq P < Peq

• The price is too high.
• Surplus of goods (or excess
supply)
• Price falls till we reach Peq, and
no more surplus.
• The price is too low.
• Shortage of goods (or excess
demand)
• Price rises till we reach Peq,
and no more shortage.

• Usually, it takes some time for the market to adjust its price to reflect
the equilibrium price.
• We call this event “market adjustment process.”

15
4. How Prices Allocate Resources
• Markets are usually a good way to organize economic activity
• As the price act as “an invisible hand”
– to balance supply and demand and lead market to equilibrium
• the price adjustment keeps on going till there is no surplus
or shortage. Then, there is no reason for the price to
change further.
– the equilibrium prices are the signals that guide economic
decisions and thereby allocate scarce resources

16
5. Table and Equation Analyses
• Instead of a graph analysis, we can use a table to visualize the
concept of price, equilibrium and adjustment.

• Let’s examine a demand-supply table.

18
Example 3: Shortage & Surplus
• Does this table conform to the law of demand and the law of supply?

P QD QS • Demand
$0 24 0 • QD increases as P decreases.
1 21 5 • Yes, it conforms the law of
2 18 10 demand.
3 15 15 • Supply
4 12 20
• QS increases as P increases.
5 9 25
• It conforms the law of supply.
6 6 30

19
Example 3: Shortage & Surplus

• Calculating shortages and surpluses.

P QD QS
$0 24 0 QD > QS – Shortage of 24
1 21 5 QD > QS – Shortage of 16
2 18 10 QD > QS – Shortage of 8
3 15 15 QD = QS – Equilibrium
4 12 20 QD < QS – Surplus of 8 units
5 9 25 QD < QS – Surplus of 16 units
6 6 30 QD < QS – Surplus of 24 units

20
 Example 3: Shortage & Surplus
P QD QS • P < Peq
– Too low price
$0 24 0 QD > QS – Shortage of 24 – QD > QS
– Shortage
1 21 5 QD > QS – Shortage of 16
– P rises and
2 18 10 QD > QS – Shortage of 8 shortage shrinks
• P > Peq
3 15 15 QD = QS – Equilibrium
– Too high price
4 12 20 QD < QS – Surplus of 8 units – QS > QD
– Surplus
5 9 25 QD < QS – Surplus of 16 units
– P falls and surplus
6 6 30 QD < QS – Surplus of 24 units shrinks

21
Example 3: Shortage & Surplus
P QD QS
• Equilibrium
$0 24 0 QD > QS – Shortage of 24
o QD = QS = Qeq

1 21 5 QD > QS – Shortage of 16 o No shortage or surplus

o Peq = $3; Qeq = 15 lattes

2 18 10 QD > QS – Shortage of 8
o Price will not change
3 15 15 QD = QS – Equilibrium
further.
4 12 20 QD < QS – Surplus of 8 units

5 9 25 QD < QS – Surplus of 16 units

6 6 30 QD < QS – Surplus of 24 units

22
5. Table and Equation Analyses
• Similarly, we can use mathematical equations to visualize the
concept of price, equilibrium and adjustment.
• We will have a system of two equations.
– The first describes a relationship between price (P) and quantity
demanded (QD) – the demand curve with negative slope.
• e.g. QD = 24 – 3P.
– The second describes a relationship between price (P) and quantity
supplied (QS) – the supply curve with positive slope.
• e.g. QS = 5P.

23
5. Table and Equation Analyses
• We can find the Peq and Qeq by setting
QD = QS = Qeq
and solving the equations mathematically.
• The amount of shortage or surplus can be found from plugging
the price into the demand and supply equations.

24
Example 4: Demand & Supply Equations
• Same demand and supply functions as prior table.
– Demand function: QD = 24 – 3P
– Supply function: QS = 5P
– Quantities in unit of latte and price in US$.
• What are Peq and Qeq?
– Recall that at equilibrium, QD = QS = Qeq.
– So, we have
24 – 3P = 5P giving Peq = $3
Qeq = 5 x 3 = 15 Lattes or Qeq = 24 – (3 x 3)= 15 Lattes

25
Example 4: Demand & Supply Equations

• Note that to get Qeq, we can plug Peq into either the
demand or the supply equation.
– Read the units from the given information and put them after
price and quantity that we have solved from the equations.

26
Example 4: Demand & Supply Equations
• Recap:
– Demand function: QD = 24 – 3P
– Supply function: QS = 5P
– Quantities in unit of latte and price in US$.
• What if P = $5?
– So, we have
QD = 24 – (3 x 5) = 9 Lattes
QS = 5 x 5 = 25 Lattes
QS > QD gives surplus of 25 – 9 = 16 Lattes

27
Example 4: Demand & Supply Equations
• Recap:
– Demand function: QD = 24 – 3P
– Supply function: QS = 5P
– Quantities in unit of latte and price in US$.
• What if P = $1?
– So, we have
QD = 24 – (3 x 1) = 21 Lattes
QS = 5 x 1 = 5 Lattes
QD > QS gives shortage of 21 – 5 = 16 Lattes

28
Example 4: Demand & Supply Equations
• Note that sometimes the relationships between price and
quantity are expressed as follows.
1
– (Inverse) demand function: P = 8 – QD
3

– (Inverse) supply function: P = 0.2 QS

• If this is the case, still equate the two equations but solve for Qeq
first.
• Then, obtain Peq by plugging the Qeq into either the inverse
demand or inverse supply function.

29
Review
 Market Equilibrium
Market Equilibrium • It is where price (Peq) has reached the
level where quantity supplied equals
P
quantity demanded
S
o That is, in equilibrium, there are no
Peq shortages or surpluses.

QD = QS = Qeq
• It is where the demand curve intersects
D
the supply curve.
0 QD = QS = Qeq Q

31
 Market Adjustment
P > Peq P < Peq
• The price is too high. • The price is too low.
• Surplus of goods (or excess • Shortage of goods (or
supply) excess demand)
• Price falls till we reach Peq, • Price rises till we reach Peq,
and no more surplus. and no more shortage.

• Usually, it takes some time for the market to adjust its price to
reflect the equilibrium price.
• We call this event “market adjustment process.”

15
 Next Week Schedule
• Lecture session covers
– 3.3 Changes in Market Equilibrium
– 3.4 Government Intervention Policies
• Discussion session covers
– 3.5* Discussion and Exercise of Topics 3.1 and 3.2