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.

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Table 3.1: Profit maximizing price and output

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

Produc Produc Market

P P P
f
er P f er Q f Supply

x Pf  x Qf
Fo 0
0 x Pf 0 x Qf
Fo Fo
od od od

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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

S
Pf

Pf*

x* 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

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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

S1 S
Pf
P1
P

D1 D
F1 F 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.

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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.

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Government Interventions to Market Prices: Are they always effective?
Economists would always recommend that in most cases there be as little interventions as
possible. Markets that function well, lead us to a set of prices and demand from households, and
supply by producers at which households maximize utility subject to their budget constraint;
producers maximize profits and demand is equal to supply in all markets. If market prices are
tampered with, it leads to overuse of resources which are scarce and underuse of resources which
are abundant.

There are many instances when free market prices are tampered with. The rupee was overvalued
vis a vis the dollar, so that importers had to pay less to import machinery to help in the country’s
industrialization. However, we ended up choosing capital intensive techniques of production
instead of labor intensive ones, and so ended up with a lot of unemployment. A lot of water and
electricity subsidies to farmers result in them choosing crops which require lots of water, and not
suited to the climatic condition of that place. Example: sugarcane in Maharashtra and rice in
Punjab. Taxes also distort the relative prices between different goods consumed. For example
taxes distort the relative choice between consumption and leisure. Let there be an electrician and
a carpenter, the electrician does his own job in 12 hours and a carpenters job in 20 hours. A
carpenter does his own job in 12 hours and a electrician’s job in 20 hours. The wage rate for both
is 10 units an hour. If both need each other, then they would work for 12 hours to pay for the
others services. If however a 50% income tax were imposed, the carpenter would prefer to the
electrician’s job himself, rather than hire a plumber since that would mean working for 24
instead of 20 hours and vice versa.

Price Floor and Price Ceiling

Price floor and price ceilings are, in general, government impositions to market free prices which
have an effect on the prices and the outcome produced. Laws enacted by the government to
regulate prices are called price controls. Price controls come in two flavors. A price
ceiling keeps a price from rising above a certain level—the “ceiling”. A price floor keeps a price
from falling below a certain level—the “floor”.

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A price ceiling is generally imposed to restrict any upward movement of prices. In order for a
price ceiling to be effective, it is important to set the ceiling below the market equilibrium. A
good example of a price ceiling is ‘rent control’ in a certain township. If due to certain reasons
such as increase in incomes, or an increase in demand for staying in a certain township due to
external factors push up rent prices, the governing body can control the rent prices by marking it
at or below the equilibrium price. In a similar way, for a price floor to be effective, it should be
set above the market equilibrium. A good example of a price floor is the minimum wages set by
the government for the informal labor economy. Figure 3.4 depict a case of both price ceiling
and price floor in a market economy.

Figure 3.4: An example of a price floor and price ceiling

P P

Pf

¿
P

Pc

Q¿ Q Q¿ Q

(a) Price floor (b) Price ceiling

Price ceilings prevent a price from rising above a certain level. When a price ceiling is set below
the equilibrium price, quantity demanded will exceed quantity supplied, and excess demand or
shortages will result. Price floors prevent a price from falling below a certain level. When a price
floor is set above the equilibrium price, quantity supplied will exceed quantity demanded, and
excess supply or surpluses will result. Another good example of price floors in the Indian
perspective is the application of minimum support prices by the Government on agricultural
crops. This exercise is primarily performed for the benefits of the farmers. A good insight of the

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economics of foodgrain in India was written up by Kaushik Basu when he was the Chief
Economic Advisor to the Indian Government.

The main problem that the government faces today is twofold: (1) keeping prices low, and hence
lowering food inflation, and (2) to keep an appropriate buffer stock so as to be able to provide
food grains to the vulnerable section of the population during bad time

It was seen that in 2009, food inflation increased by more than 20 percent. To add to this, studies
had pointed out almost 67 percent of the food grains intended to reach the poor always missed
the target. Any effective food grain policy in India should resort to three goals – (1) providing
farmers with a price which is above the market price, (2) providing individuals with as much or
more food that they would have got, if the market was free, (3) reduce fiscal burden. Kaushik
Basu in his paper argues that having all three in place is impossible to achieve.
In his article, he prescribes a few policies, and critically analyses the existing ones. A good
policy should have the following features – (1) Government should hold a buffer with the aim of
holding prices down during food shortages, (2) Government should make sure that the poor have
access to food at all times. He argues that there are a lot of factors, such as weather shocks that
have an impact of the production of food grains in India. Thus, the government should vary
procurement by taking in more when the weather is good, supply plentiful and prices low and
less (and may be nothing) when the weather is bad and prices high. However procurement of
food grains is just one side of the story. A small caveat in the procurement strategy is – How
much should the government hoad? Having a minimum reserve policy can actually be
meaningless. In fact their only effect is the price increase that will occur as a consequence of the
procurement of the reserves from the market.
The article goes on to suggest that a good strategy for the disbursement of food grains in equally
important. If the government’s aim (in times of drought) is to lower the price of foodgrains, it is
not enough to release a large quantity of foodgrains, X. In addition, this should be released in
small batches to many traders or directly to consumers. One way is to release food in bundles as
the FCI does but at a fixed price per unit, giving traders the right to buy exactly the amount they
want. In other words, we may consider releasing the food the same way that it is procured.
Last, with regard to the issue of the poor and the vulnerable, the article argues that rationing the
food through the ration shops is not a good idea, as this leads to resale by the shops for their own
benefit, leading to lesser supply for the households. A strategy to tackle this would be to give
food coupons/vouchers to the household, through which they can receive their supplies. This
voucher can then be encashed by the shops through the banks.

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Elasticity
In the ongoing discussion, it was seen that prices are generally market driven and not set by
either consumers or producers. The situation discussed was that of a perfect competitive market,
where there are large number of buyers and sellers, and hence, no one had any power in setting
prices. However, in case of a single seller (monopoly), he has the power to set prices, which he
generally sets to maximize profits. It is in this case where the concept of ‘elasticity’ becomes
important.

The cost to the producer generally consists of: fixed and variable cost. The fixed cost cannot be
controlled, and is irrespective of the output produced. For example, running a show in a movie
hall may be thought of having only fixed costs, the electricity and other costs are the same
irrespective of the number of people. In such a situation maximizing revenues which is price
times quantity (p*q), may be equivalent to maximizing profits. However as price increases,
demand declines, so we are not sure of whether the product demand will increase or decrease,
and that is where the concept of elasticity becomes important

Definition: Elasticity is defined as the percentage change in quantity which is demanded from a
percentage change in price. Mathematically, it is denoted as

Δq/q pΔq
ε= =
Δp/ p qΔp
Elasticity can be further categorized into various segments as follows:

(a) Relatively elastic: If the value of ε > 1

(b) Relatively inelastic: If the value of ε < 1
(c) Unitary elastic: If the value of ε = 1
(d) Perfectly elastic: ε =
(e) Perfectly inelastic: ε = 0

Let the total revenue be defined as TR = p*q (p=price, q = quantity)

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The firm wants to find the price to charge, so as to maximize total revenue. If we differentiate
Total revenue with price, we get

∆ TR ∂q
=p +q
∆p ∂p

To find the point of maximum total revenue, we set this equation to zero, and we get

∂q
p +q=0
∂p
∂q −q
=
∂p p
∂q
∂p
=1
q
p
ε d=1

Thus, at the point where elasticity is one, total revenue is maximized.

Lerner’s Index and Monopoly Power

The Lerner Index describes a relationship between elasticity and profit maximization for a
monopolist. In essence, the Lerner’s Index measures a firm’s level of market power. Higher the
Lerner Index, higher will be the market power. When prices or the information on cost structure
is not known, Lerner Index uses the price elasticity to determine market power. The Lerner Index
is derived in the following manner.
The monopolist is interested in maximizing profits which is Total Revenue – Total Cost. At the
point of profit maximization, Marginal Revenue = Marginal Cost

Total Revenue = P*Q

Maximizing Revenue with respect to quantity, we get

∆ TR P∗∂(Q) Q∗∂(P)
Marginal Revenue = = +
∆Q ∂Q ∂Q
Q ∂( P)
MR=P(1+ )
P ∂Q

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 1
MR=P(1+ )
Ed

At the profit maximizing point, MR = MC, therefore,

1
MC=P(1+ )
Ed

P−MC −1
=
P Ed

The left hand side of the equation is the Lerner’s Index which is the difference between price and
marginal cost over price. Depending on the elasticity of the commodity, the monopolist always
maximizes his profit, at the profit maximizing quantity and price. For commodities that have a
high elasticity of demand (flatter demand curve), the difference between price and marginal cost
is higher than commodities have a lower elasticity of demand (steeper demand curve).

Alternate Methods of Calculating Elasticity

1. Mid-Point Method: The mid-point method states that the elasticity can be calculated
when there are two different price and quantities at two different time periods. The
formula for calculating the elasticity using the mid-point method is

Q 2 −Q1 P2 −P1
E p= ÷
(Q 1 +Q 2 )/2 ( P1 + P2 )/ 2

2. The Point Method: The elasticity using the point method is defined from the linear
demand curve as follows

Lower Segment of theline

Ep=
Upper segment of theline

Implication of Elasticity of different commodities

The government needs to raise taxes to generate revenues for the functioning of the economy.
But, how does the government decide on the choice of products to tax. If the tax rate for certain
commodities are high, but the quantities demanded are low, then the resultant tax revenue will be
low. In general, to increase tax revenues, the government should tax those products that are
highly demand inelastic. It is because these products would be indispensable to the consumer,
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and hence would be definitely purchased. For instance, salt, which is a basic commodity can be
taxed more so as to increase revenues.

The impact of elasticity is seen even in international trade in the export and import market. The
question that most policymakers and trade economist face is: Can currency depreciation lead to
improvement of trade balance. Trade balance is defined as the difference between Export and
Import bill. If a country imports more than it exports, it faces a balance of payment deficit.
Conversely, if exports rise more than imports, the country faces a balance of payment surplus.

When an economy experiences depreciation in their currency with respect to any foreign
currency of the trading partner, exports generally become cheaper, while imports become
expensive. This is because following currency depreciation, imports and exports are generally
inelastic, and hence, in the short run, this causes the trade balance to deteriorate. However, two
economist, Alfred Marshall, and Abba Lerner derived a condition wherein the balance of trade
for an economy can improve after it has undergone currency depreciation. This can only be
possible is the sum of the price elasticity of demand for exports and imports is greater than one.
The Marshall-Lerner Condition is shown below

PED X + PED M >1

PED X : Price Elasticity of demand for exports

PED M : Price elasticity of demand for imports

In the long run, however, as prices become more flexible, domestic consumers demand less of
foreign goods, and thus imports fall, while, foreign consumers demand more goods, hence,
export rises. This change in the quantity effect offsets the negative cost effect, and we see a
positive increase in the balance of trade.  If goods exported are elastic with respect to price, their
quantity demanded will increase proportionately more than the decrease in price, and total export
revenue will increase. Similarly, if goods imported are price elastic, total import expenditure will
decrease. Both will improve the trade balance. An application of the Marshall Lerner condition is
the J curve. The J curve plots the relation between current account deficit over time. It follows a
J shaped curve, as current account is initially in deficit (when home currency depreciates), but in
the long run, the current account balance is in surplus.

Labor Markets
Till this point, we have focused only on the goods market. The topics that were covered were
deriving profit maximizing prices and quantities for producers, and various demand and supply
dynamics that govern market shocks. We now look into the labor markers under a similar

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demand and supply framework. The labor market consists of employees that provide labor and
hence constitute the supply side. Similarly, there are firms that employ these employees that
consist of the demand side. The gap between the labor demand and labor supply is termed as
‘unemployment’. Figure 3.5 depicts the labor market equilibrium

Figure 3.5: Labor Market Equilibrium depicting labor demand, labor supply
and wage rate

w Labor Supply

Unemployment

w¿

Labor Demand

¿
L L

Decision Making within the Household

The primary determinant of the number of hours of work is the prevailing wage rate. Given the
wage rate, the household decides on the number of working hours so as to maximize the

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satisfaction from the consumption of goods and leisure. If the wage rate is very low, then most
individuals prefer not to work. As the wage rates increase, the opportunity cost of not working
increases and more people join the work force. This gives us the upward sloping labor supply
curve. Conversely, at very low wage rates, the demand for labor increases as firms have to spend
a lower amount to employ workers for production.

Decision made by the firm

Similar to the households’ decision to work in the labor market, the firms make a decision to hire
workers based on the wage rate and the marginal productivity of labor. Demand for labor comes
from producers. If one more labor is hired, the increase in output (Y) that comes with this hiring
will be the marginal product (MPL) of this last laborer. The value of this increased output, will be
the prevailing output price times marginal productivity, which is referred as the value of
marginal product (VMPL) of labor. That is VMPL =Price * MPL .

Existing profits will increase only if the value of marginal product is greater than the wage rate
which is the addition to cost by the hiring of the new labor. The following can be explained by
Table 3.2

Table 3.2: Profit maximizing labor supply and wage rate by the monopolist
Labor Output MPL P Wage VMPL Revenue Wage Profit
Rate Bill

1 40 35 2 40 70 80 40 40

2 75 30 2 40 60 50 80 70

3 105 25 2 40 50 210 120 90

4 130 20 2 40 40 260 160 100

5 150 15 2 40 30 310 200 100

6 165 10 2 40 20 330 240 90

7 175 5 2 40 10 350 280 70

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Table 3.3: Change in labor market equilibrium due to change in output price
Labor Output MPL P Wage VMPL Revenu Wage Profit
Rate e Bill

1 40 35 4 40 140 160 40 120

2 75 30 4 40 120 300 80 220

3 105 25 4 40 100 420 120 300

4 130 20 4 40 80 520 160 360

5 150 15 4 40 60 600 200 400

6 165 10 4 40 40 660 240 420

7 175 5 4 40 20 700 280 420

From the Table 3.3, it is seen that as the price of the output increases from 2 to 4 units, given
wage rate at 40, the demand for labor increases from 4 to 6 laborers since at that level of output
profit is maximized. In a similar way, it can be seen that if the wages decrease from 40 to 30,
then the total labor increases from 4 to 5. Thus, increase in output price or decrease in wage rate
increases labor supply.

Another variant of the labor market is a monopsonistic labor market characterized by one buyer
and numerous sellers. Here, the buyer is characterized by a single firm who demands the labor
for the final product and the sellers are the individuals who are ready to supply labor at different
wage rates. If labor is scarce, employing an additional laborer can only be done by a wage
increase. The wage bill increases not only for the last person, but all persons previously
employed, so the increase in wage bill by employing one more laborer will be the marginal cost.
However, as compared to the competitive labor market, in a monopsony, lower numbers will be
employed and the wage rate is generally lower.

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Additional Questions
1. In a two-good world, X & Y, price elasticity of demand for X with respect to its own
price is greater than unity. There is still a possibility of a rise in the demand for Y with a
decrease in the price of X. True or False? Give explanations

2. The US Government administers two programs for the market of cigarettes: Media
campaigns and labeling requirements are aimed at making the public aware of the
dangers of cigarette smoking. At the same time the Department of Agriculture maintains
a price-support program for tobacco farmers which raise the price of tobacco above the
equilibrium price. What will be the combined effect of these two programs on cigarette
consumption and prices?

3. The output produced by laborers hired by a firm is given in the table below. There are six
such firms in the economy. The price at which the output can be sold in the market is 2.

Labor 1 2 3 4 5 6 7 8

Output 40 75 105 130 150 165 175 180

The market labor supply schedule for different wage rates is given in the table below

Wage 10 20 30 40 50 60 70

Supply 2 4 6 8 10 12 14

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Determine the equilibrium wage rate in such a market. If there is only one firm who acts as a
monopsonist in the market, determine the equilibrium wage rate.

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