LESSON 4

Market Equilibrium

Learning Objectives:
At the end of the lesson, students are able to:

1. Explain what market equilibrium in the product market is about;

2. Define equilibrium price and equilibrium quantity;
3. Determine the equilibrium price and equilibrium quantity by using
the demand and supply schedules, demand and supply functions;
4. Explain why and how a shortage and a surplus occur in the product
market and how prices adjust to clear the market of a shortage or a
surplus;
5. Discuss how changes in demand and supply affect equilibrium in
the product market
6. Apply demand and supply analysis in situations where the
government implements price controls , such as price ceilings and
price floors.

Market Equilibrium in the Product Market

In economics, Market Equilibrium is when the quantity demanded of a

good and its quantity supplied are balanced. The price that exists will no
longer go up or down; it is in state of rest.

In market economy where competition among buyers and sellers is

present, it is the forces of demand and supply that determine the prices of
goods and services.

The equilibrium price (Pe) is the price at which the quantity of a kind
of goods that buyers are able and willing to buy (quantity demanded) and the
quantity that sellers are able and willing to sell (quantity supplied) are equal.

Equilibrium quantity (Qe) is when quantity demanded and quantity

supplied are the same.
Example:

The equilibrium price of rice is 30 pesos and the equilibrium quantity is

40,000 kilos. At the price of 30 pesos , quantity demanded and quantity
supplied are both equal to 40,000 kilos.

The equilibrium price and equilibrium quantity can be determined

algebraically by using the demand and supply functions.

Market demand : Qd = 100 - 2P

Supply function : Qs = -20 + 2P

Where the constants a, b, c and d are in thousands

Therefore: Equating both formulas

Qd = Qs

100 - 2P = -20 + 2P

When P = 30 ; Pe = 30.00 pesos

Solving for Qe:

100 – 2( 30 ) = -20 + 2(30)

100 – 60 = -20 + 60

40 = 40

Qe = 40,000 kilos

If the price that exists in the market is not the equilibrium price, then,
the market is in disequilibrium. Either a surplus or a shortage appears in the
market so that the price automatically adjusts upward or downward to bring
the market to equilibrium. The market is said to be self- equilibrating.
Example:

Suppose the price of rice is 25 pesos per kilo; at this price, the quantity
demanded is 50,000 kilos; while quantity supplied is 30,000 kilos. The
quantity demanded exceeds quantity supplied by 20,000 kilos. So there is a
shortage of 20,000 kilos of rice. On the other hand, if the price of rice is 40
pesos per kilo, quantity supplied is 60,000 kilos, while quantity demanded is
20,000 kilos, a surplus of 40,000 kilos appears in the market since quantity
supplied exceeds the quantity demanded by 40,000 kilos.

Whenever the price is lower than what it should be (Pe) ,a shortage

results. Thus, price goes up and quantity demanded decreases while quantity
supplied increases. The price stops increasing until the shortage disappears;
that is, quantity demanded becomes equal to quantity supplied. The price that
eventually exists is the equilibrium price.

If the price is higher than its equilibrium level, a surplus results.

If the price goes down and continues to go down as it does, the

quantity supplied decreases while the quantity demanded increases until the
surplus disappears.

The price stops decreasing until the quantity demanded becomes

equal to the quantity supplied.

In equilibrium, the market is cleared of any surplus or any shortage.

Comparison of Market Equilibrium and Disequilibrium

Price per
kilo Quantity Demanded Quantity Supplied Shortage or Adjustment of
(pesos) (kilos) (kilos) Surplus Price
         
20 60,000 20,000 shortage upward
25 50,000 30,000 shortage upward
30 40,000 40,000 equilibrium none
35 30,000 50,000 surplus downward
40 20,000 60,000 surplus downward
Effects of Changes in Demand and Supply on Market Equilibrium

Changes in the demand and/or supply will bring about changes in

market conditions leading to a new equilibrium price and a new equilibrium
quantity, because the price has changed, consumers and sellers also alter
their choices.

Consumers change the quantity of the goods that they are able and
willing to buy, and sellers change the quantity that they are able and willing to
sell.

The following are the changes in demand or supply and the

corresponding changes in equilibrium price and equilibrium quantity.

1. Increase in demand , supply is constant

Result: Increase in Pe, increase in Qe
2. Decrease in demand, supply is constant
Result: Decrease in Pe, decrease in Qe
3. Increase in supply, demand is constant
Result: Decrease in Pe, increase in Qe
4. Decrease in supply, demand is constant
Result: Increase in Pe, decrease in Qe

Possible changes in the equilibrium price and the equilibrium quantity,

depending on which change is bigger – the change in demand or the change
in supply.

1. Increase in demand is equal to the increase in supply

Result: Pe will not change, Qe will increase
2. Increase in demand is bigger than the increase in supply
Result: Pe will increase; Qe will increase
3. Increase in demand is smaller than the increase in supply
Result: Pe will decrease ; Qe will increase
Application of Demand and Supply Analysis in the Product Market

Demand and supply analysis can be applied in the product market like
the market for agricultural products.

Prices of fruits change as season change; mangoes, for instance, are

cheaper during the summer months of March to May. It is during these
months that the supply of mangoes increases while the demand for it
also increases.

When the rainy season starts in June, the supply of mango decreases
and its price starts to rise even if the demand for it has not changed.
Consumers tend to buy less of mangoes and shift their purchases to
other fruits that are in season like pineapple, banana, and the like.

Introduction of a New Product

Technology is constantly changing in this day and age so that not only
methods of production are changing, but also the range of goods that are
made available to consumers.

When a firm introduces a new product in the market, the initial price is
usually relatively high to cover the cost of research and development that has
gone into the product.

As other companies imitate and improve a similar product, the supply

of the product in the market increases, making the competitive brands
relatively cheaper than the original product. The iPhone, for example, is
relatively more expensive than the other brands.

As more companies imitate and produce the product, the supply of the
product increases, leading to a fall in the price Pe. The new equilibrium
quantity also increases since more the goods are sold in the market and more
of them are also bought.
Price Ceilings and Price Floors; Shortages and Surpluses

What if a change in supply or demand results in a new equilibrium price

that is either too low for producers/sellers or too high for consumers/buyers?

Some of these individuals may find themselves not satisfied with the
market outcome. The government , in this case has to intervene in the price
system to protect the interest of these individuals. To protect the consumers
from unscrupulous sellers who may take advantage of the existing situation,
the government, through the Department of Trade and Industry (DTI), will
have to impose price control in the form of a price ceiling.

The price ceiling, which is lower than the equilibrium price, is the
highest price at which the goods can be sold. Sellers cannot sell the goods at
a higher price than that set by the government. Sellers who are found to be
selling above the price ceiling are penalized.

Since the price ceiling is lower than the equilibrium price, a shortage of
the goods occurs in the market. There may be buyers who are not satisfied
with what they are able to buy at the price ceiling, and they are willing to buy
more. This situation leads to the so called black market.

Black Market is illegal since sellers sell goods at a price higher than the
price ceiling.

If a shortage occurs in the market, the government employs other

means of distributing goods like queuing and the distribution of purchase
coupons with a limited amount.

Recap:

When the market is in equilibrium, the forces of demand and supply are
balanced so that the market price, the quantity demanded, and quantity
supplied do not change over a given period of time.
 The equilibrium price is the price at which quantity demanded is equal
to quantity supplied. This is the price at which the market is cleared to any
shortage or surplus.

When the price is not the equilibrium price, a shortage or a surplus

results. A shortage exists when the quantity demanded is greater than the
quantity supplied. A surplus results when the quantity supplied is greater than
the quantity demanded.

Since the equilibrium price is determined by the demand and supply

forces, the changes in these will lead to the changes in the equilibrium price
and equilibrium quantity.

A shortage puts an upward pressure on price while a surplus puts a

downward pressure on price.

Supply and demand analysis can be applied to a study of changes in

the prices of agriculture crops, of basic commodities, and of new products in
the market.

Setting a price ceiling creates a shortage in the market while a price

floor creates a surplus.

Exercises

A. Answer the Following questions:

1. When is the market in equilibrium? Briefly explains your answer.
2. Why is the market cleared of surpluses or shortages at the equilibrium
price?
3. How will the market price change if a shortage is present in the
market? Why?
4. How will the market price change if s surplus occurs in the market ?
Why?
5. Distinguish between Price Ceiling and Price Floor.
B. Suppose the demand and supply of a certain good is defined by
the following functions.
Qd = 1300 – 5P Qs = -500 + 4P

1. Solve for the equilibrium price and equilibrium quantity.

2. If the market price is 150, solve for the quantity demanded and
quantity supplied. Is there a shortage or a surplus? How much is
the shortage or surplus?
3. If the market price is 250, solve for the quantity demanded and
quantity supplied. How much is the shortage or surplus?
4. Suppose demand increases so that the new demand function
becomes Qd = 2200 – 5P while the supply function does not
change. It is still Qs = -500 + 4P. Compute for the new
equilibrium price and new equilibrium quantity.