Introduction to Microeconomics

Lecturer:
Eric Tama, MPH
Lecturer, Strathmore University Business School
Email: etama@Strathmore.edu

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 Session 5 – Price determination or market
equilibrium
Session Objectives
1. Understand how market forces of demand and supply interact in the market
to set a market price
2. Understand the concept of market equilibrium and the factors that affect it

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 Market equilibrium

• We have so far separately looked at the important concepts of demand and

supply
• Remember the definition of demand?
• Remember the definition of supply?
• We also talked about suppliers and consumers interacting to supply and
demand goods and services - market
• We will now look at demand and supply together and how they interact to set
market prices

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 Market equilibrium
• Definition:
• Equilibrium– a state of rest in which
no economic forces are being
generated to change the situation
• Equilibrium market price – the price
at which the quantity demanded is
equal to the quantity supplied. It is
also known as the market clearing
price

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 Market equilibrium
Types of equilibria
Equilibrium is described as being stable or unstable

• Stable equilibrium – one where any divergence from

the equilibrium sets up forces which restore the
equilibrium
• Unstable equilibrium – one where any divergence from
the equilibrium sets up forces which push the price
further from the equilibrium price. This is also called a
knife-edge equilibrium

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 Market equilibrium
Stable vs unstable equilibrium
• The equilibrium price Pe is stable Stable
because the establishment of any
disequilibrium price like 0P1 or 0P2
sets up economic forces that push the
prices back to Pe
• What happens at price 0P2?
• What happens at price 0P1?

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 Market equilibrium
Stable vs unstable equilibrium
What is unusual about this graph?
Unstable
What type of good is Y?
• The demand curve for Y is upward
sloping – Giffen or Veblen good
• Pe and Qe are the equilibrium price
and quantity respectively
• This equilibrium is an unstable one
• At P2 there is excess supply which
would push prices lower and further
from Pe
• At P1 there is excess demand which
would push prices higher and away
from Pe
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 Market equilibrium
Equilibrium analysis
• What happens to the equilibrium when there are changes in supply and
demand?
• Effects of an outward shift in demand
What would cause the demand curve to shift
outwards?
• Assume there is an increase in consumers’
incomes causing the demand curve to shift
outwards
• The increased demand will cause prices to
increase from P to P1 and a new equilibrium is
achieved at P1,Q1
• Increased prices will eventually lead to a fall in
demand and prices will fall from P 1 to P
• Equilibrium is now restored back to P,Q

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 Market equilibrium
Equilibrium analysis
• Effects of an inward shift in demand
What would cause the demand curve to shift
inwards?

• Assume there is a fall in demand for long-haul

aircrafts causing the demand for aluminium to shift
inwards to D2
• The reduced demand will cause prices to fall from
P1 to P2 and a new equilibrium is achieved at P 2,Q2
• Reduced prices will eventually lead to an increase
in demand and prices will rise from P2 to P1
• Equilibrium is now restored back to P 1,Q1

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 Market equilibrium
Equilibrium analysis
• Effects of an outward shift in supply
What would cause the supply curve to shift
outwards?

• Assume there is a fall in the price of a substitute in

production (Y) causing the supply curve for X to
shift outwards to S1
• The increase in supply will cause prices to fall from
P to P1 and a new equilibrium is achieved at P1, Q1
• Reduced prices will eventually lead to an increase
in demand and prices will rise from P1 to P
• Equilibrium is now restored back to P, Q

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 Market equilibrium
Equilibrium analysis
• Effects of an inward shift in supply
What would cause the supply curve to shift
inwards?

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 Market equilibrium
Price controls
• Price ceilings and Price floors

Used to regulate prices so they don’t rise

or fall below a certain level

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 Market equilibrium
Price controls
• Price ceilings
 When equilibrium price is too high
 Price ceiling set below equilibrium price
 It creates excess demand or a shortage

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 Market equilibrium
Price controls
• Price floors
 When equilibrium price is too low
 Price floor set above equilibrium price
 It creates excess supply or a glut

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Demand analysis

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