Topic 3: Market Equilibrium

Introduction
We have till now only looked at aspects concerning the household, namely how they decide how
much to earn, how much to save, and that they decide to spend on. In all these decisions, price
was an important variable, but that was given from outside the system. We now concentrate on
how prices are determined within the system. That depends on not only the decisions of the
household, but also that of the firm, so we need to look into firm behavior. A firm’s objective is
to maximize profits, which constitute revenues less costs. We assume that firms are given input
as well as output prices, and it has to decide on how much of output to produce given input as
well as output prices. The other issue of interest is how a supplier would respond to a rise in
output prices.

To look further into this problem it will be helpful to define a few concepts, namely that of
marginal revenue and marginal costs. Marginal revenue refers to the increase in total revenue
when an extra unit of output is produced and sold. Marginal cost refers to the increase in total
costs when an extra unit of a good is produced. Therefore, an extra unit is produced if and only if
the marginal revenue exceeds or is equal to the marginal costs. If price is given from outside, the
extra revenue obtained from selling an extra unit is the price, and at the profit maximizing
output, price must equal marginal cost. To illustrate the same, let us look at Table 3.1. As we can
see costs are increasing at an increasing rate, when price is 4, the profit maximizing output is 2,
at which marginal revenue equals marginal cost. Therefore as output price increases to 5, the
profit maximizing output is 3. Therefore if there are 10 such identical suppliers, the market
supply will be 20 at an output price of 4 and 30 at an output price of 5.
Table 3.1: Profit maximizing price and output

Marginal Marginal
Output Price Revenue Costs Profit
Revenue Cost

0 4 2

1 4 4 2 2 4 3

2 4 8 5 3 4 4

3 4 12 9 3 4 5
4 4 16 14 2 4 6
5 4 20 20 0

Marginal Marginal
Output Price Revenue Costs Profit
Revenue Cost

0 5 2

1 5 5 2 3 5 3
2 5 10 5 5 5 4
3 5 15 9 6 5 5
4 5 20 14 6 5 6
5 5 25 20 5

Thus if producers P and Q are suppliers of food, the derivation of the market supplier curve will
be given as in Figure 3.1.

Figure 3.1: The Market supply curve for a two-producer economy

 f
P
0

er P
Produc
x Pf
od
Fo

f
P
0

er Q
Produc
x Qf
od
Fo 0

f
P
Supply
Market
x Pf  x Qf
od
Fo

It should be noted that if fertilizer prices were to fall, profit maximizing output would increase
the firm supply as well as the market supply would shift to the right. Now that we have got both
the market demand curve and the market supply curve, juxtaposing both in the same diagram
gives us the equilibrium price, the price at which both curves intersect, this is the price which
prevails in the market and the quantity that is traded in the market. The same is shown in Figure
3.2
Figure 3.2: Market equilibrium price and quantity

Pf*

Pf
x*

S
Food

We will therefore have such equilibrium prices in food, clothing and all other markets. Let us
assume a closed village economy which produces and consumes all its goods. If there happens to
be a drought in the village, the supply curve for food shifts to the left. Farmer’s incomes are
affected, not only that, they demand less of clothing, so the weaves incomes are also affected, for
which the demand for food will also fall. What is clear, however, is that the equilibrium quantity
of food traded in the market falls, food prices may rise or fall depending on the relative shift of
demand and supply curves as in Figure 3.3. With a change in food prices, demand for clothing
also gets affected, which also changes the equilibrium in the clothing market. What is seen is a
shock in one market spreads to other markets as well in a closed economy. If the weaver had
access to outside markets, he would not be that much affected by the shock. However,
completely specializing in export markets of one country also has its risks; ones income is
completely dependent on the economic conditions of that country. So it is best to diversify by
selling in different markets.

Figure 3.3 Demand-Supply dynamics under market shocks

Pf
P
P1
F1 F

S1S
D1
Food

One can use the simple economics of demand and supply to analyze many real life situations.
Siwan Anderson wrote a very interesting paper on the economics of dowry and the bride price.
According to her, bride price is more common in places with heavy involvement of women in
agriculture, whereas dowry is more common in places where women’s outside role is limited.
Bride price is usually dependent upon the expected number of children a woman would bear.
Dowry was seen as a means to attract a good groom; men who were more qualified would
command a high dowry. However, what is surprising that in South Asia, despite the skewed sex
ratio with many more men than women, there is more of evidence of dowry rather than the bride
price. This explanation given is that in South Asia there is usually a difference in age between
the bride and the groom, and if there is population growth, it might be the case that many more
women than men enter the marriage market and we may witness dowry. Dowry is also seen as an
inheritance payment, women receive dowry and men receive bequests. Another good application
of the economics of demand and supply in real life is on the economics of love written by
William Nicolson titled: The Romantic Economist: The story of love and market forces.
Throughout, Nicolson sprinkles his tale with game theory and principles of economics, such as
bargaining power and supply and demand. Some of these closely map with his experience

In the opening chapter of the book, Nicolson draws an analogy of a relationship between a boy
and a girl to that of the market of demand and supply. He terms this as the ‘market for
relationship’. Just like how in a goods market, as supply falls, price rises, he gives an example of
how ‘playing hard to get’ can increase your ‘price’, and make the other person put in more effort
and investment to know you. However, this analogy is explained using the concept of normal
vis-a vis luxury goods. Most individuals prefer basic services to be cheap and accessible,
however, the luxury goods are differentiated goods, thereby having a higher price attached to
them. In a similar vein, Nicolson in his book argues how individuals in the relationship market
need to first prove their source of differentiation among other players in the market (in this case
other individuals), and can then continue with the ‘playing hard to get game’ to derive maximum
value.

In the next few chapters, Nicolson relates the market of relationships to the efficient market
hypothesis. Like in all markets, given the information in the market, individuals decide what to
buy (who to go out with), and at what price (how much effort to put in). Using the theory of
efficient market hypothesis, Nicolson concludes that in the market for relationships if the market
is well informed and efficient, the amount of effort that people are willing to invest to get with
others is proportionate to how desirable that person is.

In a similar vein, the book relates topics in economics such as game theory to the purchase of
wine, and other theories such as investments, liquidity, risk appetite, and signaling preferences to
the market for relationships. This mapping of real life scenarios to concepts in economics is what
makes it a fascinating read.