Principles of Microeconomics

Lecture 4- Unit 2: Market Diagram and Market Equilibrium

Lecturer: Dr. O. Davis

 Learning Objectives
 At the end of this unit, students should be
able to:
Explain the law of demand.
Distinguish between a shift in the demand
curve from a movement along the demand
curve.
 Explain the law of supply.
Distinguish between a shift in the supply curve
from a movement along the supply curve.
Explain the importance of opportunity cost
and substitution to the laws of demand and
supply.
 Market Equilibrium
 Market Equilibrium: occurs when the
quantity demanded of a good equals
the quantity supplied of that good.

 Graphically, market equilibrium occurs

at the point at which the demand curve
intersects the supply curve.

 A market equilibrium consists of:

 An equilibrium price (P*)
 An equilibrium quantity (Q*)
Demand &Supply Together
 Equilibrium Price
the price that equates quantity supplied with
quantity demanded.

P QD QS
$0 24 0
1 21 5
2 18 10
3 15 15
4 12 20
5 9 25
6 6 30
 Equilibrium Quantity
the quantity supplied equals the quantity
demanded at the equilibrium price.
P QD QS
$0 24 0
1 21 5
2 18 10
3 15 15
4 12 20
5 9 25
6 6 30
Surplus (aka excess Supply)
when quantity supplied is greater than quantity
demanded. QS > QD
Surplus (aka excess Supply)
when quantity supplied is greater than quantity
demanded. QS > QD
Shortage (aka excess demand)
when quantity demanded is greater than quantity
supplied. QD > QS

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Shortage (aka excess demand)
when quantity demanded is greater than quantity
supplied. QD > QS

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Three Steps to Analyzing Changes in Equilibrium

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Example: The Market for Hybrid Cars

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Example: Shift in Demand

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Example 1: A Shift in Demand

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Example 2: A Shift in Supply

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Example 3: A Shift in Both Supply and
Demand

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Example 3: A Shift in Both Supply and
Demand

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Activity 1: Shifts in Demand & Supply
Use the three-step method to analyze the effects of each
event on the equilibrium price (P*) and quantity (Q*) of
music downloads.

Event A: A fall in the price of CDs.

Event B: Sellers of music downloads negotiate a

reduction in the royalties they must pay for each song
they sell.

Event C: Events A and B both occur.

Note: Royalties are a fixed amount that sellers must pay

the artistes & are part of sellers’ “costs of production.”
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A. Fall in the Price of CDs

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B. Fall in the cost of royalties

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 C. Fall in price of CDs and fall in cost of
royalties

STEPS
1. Both curves shift (see parts A & B).
2. D shifts left, S shifts right.
3. P* falls.
Effect on Q* is ambiguous:
the fall in demand reduces Q*,
the increase in supply increases Q*.
The final answer for Q* depends on which shift is bigger.

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Calculating Market Equilibrium
• So far we have focused on the graphical depiction of
market equilibrium.
•Now we will use functions (or equations) to represent
market demand and market supply.
•We will use these functional forms to calculate values
for the equilibrium price and the equilibrium quantity.
•Let’s consider the market for sweets at a primary
school:

QD=500 – 50P Demand Function

QS= 50 + 25P Supply Function

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Calculating Market Equilibrium Cont’d

Step 1: Equate the demand and supply functions:

QD = QS
500-50P = 50+25P
Step 2: Group like terms:
500-50 = 25P+50P
Step 3: Simplify the equation:
450 = 75P
75P=450
Step 4: Solve for the equilibrium price (P*):
P = 450/75
P* = $6
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Calculating Market Equilibrium Cont’d

Step 5: Insert P* into either the demand or the supply

function to solve for the equilibrium quantity (Q*):
QD = Q* = 500-50($6)
Q* = 500-300
Q* = 200 units
Step 6: Verification: In order to check that you did the
calculations correctly, also insert P* into the supply
function:
QS = Q* = 50+25($6)
Q* = 50+150
Q* = 200
Success! We now know that the equilibrium price is $6
and the equilibrium quantity is 200 units. 
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Calculating Market Equilibrium Activity 2
The demand and supply functions for a
market are given as:
QD=180-25P
P = QS/30 + 40/30

a. Calculate the equilibrium price and the equilibrium

quantity in this market.
b. Calculate the total revenue of sellers in equilibrium.
c. What would happen if the price is set at
$7?
d. At what price is there an excess demand of 40 units?
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 Activity 2 Part A: Market Equilibrium
Before we can proceed, we need to make sure that each function has
the quantity term (or Q) on the left hand side of the equation. So
adjusting the supply function to make QS the subject of the formula:
P = QS/30 + 40/30

Multiply both sides of the equation by 30:

30P = QS +40

Place QS on one side of the equation by itself :

30P-40 = QS
QS = 30P-40

Therefore our customary supply function is: QS = 30P-40

Now we proceed with our usual solution process to solve for market
equilibrium:
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Activity 2 Part A: Market Equilibrium Cont’d

Step 1: Equate the demand and supply functions:

QD = QS
180-25P = 30P-40
Step 2: Group like terms:
180+40 = 25P+30P
Step 3: Simplify the equation:
220= 55P
55P=220
Step 4: Solve for the equilibrium price (P*):
P = 220/55
P* = $4 27
Activity 2 Part A: Market Equilibrium Cont’d

Step 5: Insert P* into either the demand or the supply

function to solve for the equilibrium quantity (Q*):
QD = Q* = 180-25($4)
Q* = 180-100
Q* = 80 units
Step 6: Verification: In order to check that you did the
calculations correctly, also insert P* into the supply function:
QS = Q* = 30($4)-40
Q* = 120-40
Q* = 80

Therefore, the equilibrium price (P*) is $4 and the equil ibrium quantity is
80 units.
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 Activity 2 Parts B&C: Market Equilibrium
Cont’d
b. Calculate the total revenue of sellers in equilibrium.
P* = $4 and Q* = 80 units
Total Revenue at equilibrium (TR*) = P* X Q*
= ($4) X (80 units) = $320

c. What would happen if the price is set at $7?

At this price, we are not in market equilibrium, so the quantity
demanded will not equal the quantity supplied.
To answer this question we insert P = $7 into both functions:

QD = 180-25P = 180-25($7) = 180-175 = 5 units

QS = 30P-40 = 30($7) – 40 = 210-40 =170 units

At a price of $7, we would have an excess supply of 165 units (QS-

QD).
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Activity 2 Parts D: Market Equilibrium Cont’d
d. At what price is there an excess demand of 40 units?

We know that with excess demand it is QD > QS. Therefore:

QD-QS = 40 units
(180-25P) – (30P-40) = 40
Expand the brackets:
180- 25P - 30P + 40 = 40
Simplify the equation:
220 - 55P = 40
Solve for the price where there’s an excess demand of 40
units:
220-40=55P
180/55=P
P = $3.27 (gives an excess
demand of 40 units) 30
 Price Controls
 Price ceiling: a legal maximum limit on the
price of a good or service. Example: rent
control
 Price floor: a legal minimum limit on the price
of a good or service. Example: minimum wage

We will use the demand & supply model to see

how each policy affects the market outcome.

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Example 1: The Market for Apartments

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How Price Ceilings Affect Market Outcomes

A price ceiling
above the eq’m
price is not
binding—
has no effect
on the market
outcome.
The eq’m
remains:
P*=$800
Q*=300 33
How Price Ceilings Affect Market Outcomes

The eq’m price ($800)

is above the ceiling
and is therefore
illegal.
The ceiling is a
binding constraint
on the price, & it
causes a shortage.

Pc=$500
Qd=400
Qs=250
Shortage=150 (i.e. 400
- 250) 34
 Shortages and Rationing
 With a shortage, sellers must ration the goods among
buyers.
 Some rationing mechanisms:
 (1) Long lines,
 (2) Discrimination according to sellers’ biases.

 These mechanisms are often unfair and inefficient,

because the goods do not necessarily go to the
buyers who value them most highly.

 In contrast, when prices are not controlled, the

rationing mechanism is efficient (the goods go to the
buyers that value them most highly) and it is
impersonal (and thus fair).
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The Market for Unskilled Labour

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How Price Floors Affect Market Outcomes

A price floor
below the
eq’m price is
not binding –
has no effect
on the market
outcome.

The eq’m remains:

W*=$6
Q*=500
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How Price Floors Affect Market Outcomes

The eq’m wage ($6) is

below the floor and is
therefore illegal.
The price floor is a
binding constraint on the
wage, causes a surplus
(i.e., unemployment).

Wf=$7.25
Qs=550
Qd=400
Surplus/
unemployment=150 (i.e.
550-400)
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The Minimum Wage

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 Activity 3: Price Controls

Determine the
effects of:
A. $90 price
ceiling
B. $90 price
floor
C. $120 price
floor

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 A. $90 Price Ceiling

The price falls to

$90.
Buyers demand
120 rooms,
sellers supply 90
rooms, leaving a
shortage of 30
rooms.

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 B. $90 Price Floor

Eq’m price is above

the floor, so price
floor is not
binding.
P* = $100,
Q* = 100 rooms.

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 C. $120 Price Floor

The price
rises to $120.
Buyers
demand
60 rooms,
sellers supply 120
rooms, causing a
surplus of 60
rooms.

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End of Unit Two
Part 3

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