CHAPTER 3 MARKET EQUILIBRIUM

DEFINITION OF MARKET EQUILIBRIUM A market equilibrium is a situation when quantity demanded and quantity supplied are equal and there is no tendency for price or quantity to change. QDD = QSS

EQUILIBRIUM PRICE AND OUTPUT SURPLUS (QSS > QDD) 1 2 3 4 5 6 E P*= SS SHORTAGE (QDD > QSS) DD Quantity 2 4 Q*= 6 8 10

EQUILIBRIUM PRICE AND OUTPUT Quantity Demanded Quantity Supplied Market Condition Market Prices 5 2 10 SURPLUS Falls 4 8 3 6 EQUILIBRIUM Equilibrium SHORTAGE Rises 1

CHANGES IN DEMAND Assume supply is constant Increase in Demand DD curve shifts to the right Equilibrium price and quantity increase Price (RM) SS P2 P* DD1 P1 Decrease in Demand DD curve shifts to the left Equilibrium price and quantity decrease DD DD2 Q1 Q* Q2 Quantity

CHANGES IN SUPPLY Assume demand is constant Price (RM) SS2 SS P2 SS1 Increase in Supply SS curve shifts to the right Equilibrium price decreases and quantity increases Price (RM) SS2 SS P2 SS1 P* P1 DD Decrease in Supply SS curve shifts to the left Equilibrium price increases and quantity decreases Q1 Q* Q2 Quantity

CHANGES IN BOTH DEMAND AND SUPPLY SUPPLY AND DEMAND BOTH INCREASE Case 1: Same magnitude Equilibrium price is constant and quantity increases Price (RM) DD1 SS SS1 P* DD Q* Q1 Quantity

CHANGES IN BOTH DEMAND AND SUPPLY (cont.) SUPPLY AND DEMAND BOTH INCREASE Case 2: Different Magnitude Equilibrium price increases and quantity increases Price (RM) DD1 SS SS1 P1 P* DD Q* Q1 Quantity

CHANGES IN BOTH DEMAND AND SUPPLY (cont.) SUPPLY AND DEMAND BOTH INCREASE Case 3: Different Magnitude Equilibrium price decreases and quantity increases Price (RM) DD1 SS SS1 P* Both DD and SS increase Equilibrium quantity increase Equilibrium price is uncertain P1 DD Q* Q1 Quantity

CONSUMER SURPLUS CONSUMER SURPLUS Price of concert ticket A C B DD Difference between what a consumer is willing to pay and what is actually paid. A 80 CONSUMER SURPLUS The area of the triangle ABC which is the area under the demand curve and above the equilibrium price of RM40 is the CONSUMER SUPRLUS. 60 C 40 Consumer Surplus = ½ * (80-40)*2=RM40 B 20 DD 1 2 3 4 Quantity of concert ticket

PRODUCER SURPLUS Price of concert ticket SS E F D Difference between what a producer is paid and what he/she is willing to sell. SS 80 The area of the triangle DEF which is the area above the supply curve and below the equilibrium price of RM40 is the PRODUCER SUPRLUS. 60 E F 40 Producer Surplus = ½ * (40)*2=RM40 PRODUCER SURPLUS 20 D 1 2 3 4 Quantity of concert ticket

MARKET EFFICIENCY Price of concert ticket SS ECONOMIC EFFICIENCY The allocation of resources maximizes total surplus (consumer surplus plus producer surplus) which received by the society. SS 80 CONSUMER SURPLUS Consumer Surplus (CS) = area above equilibrium price and below demand curve Producer Surplus (PS) = area below equilibrium price and above supply curve Total Surplus (TS) = CS + PS 60 40 PRODUCER SURPLUS 20 1 2 3 4 Quantity of concert ticket

GOVERNMENT INTERVENTION IN THE MARKET MAXIMUM PRICE MINIMUM PRICE GOVERNMENT INTERVENTION IN THE MARKET TAXES SUBSIDIES

GOVERNMENT INTERVENTION IN MARKETS MAXIMUM PRICE/CEILING PRICE Government-imposed regulations that prevent prices from rising above a maximum level Price Advantage: Consumers purchase at lower price S Suppliers reduce the amount offered to Q1 but demand would rise to Q2 creating a shortage The equilibrium price is P* and the quantity is Q* P* The government imposes a maximum price of P1 P1 Price ceiling Disadvantages: Emergence of black market Reduction in quantity produced Producers tend to receive illegal payments from consumers Shortages occur D Q1 Q* Q2 Quantity

GOVERNMENT INTERVENTION IN MARKETS (cont.) MINIMUM PRICE/FLOOR PRICE Government-imposed regulations that prevent prices from falling below a minimum level Price S Surplus occurs Advantages: Protects the producer’s income Higher wage rate P1 Floor Price P* Disadvantages: Consumers pay more Waste of resources of production Creates unemployment Suppliers increase the amount offered to Q2 but demand drop to Q1 creating a surplus The equilibrium price is P* and the quantity is Q*. The government imposes a minimum price of P1 D Q1 Q* Q2 Quantity

EFFECT OF TAXATION S1 Price S D Quantity INDIRECT TAX Tax that is imposed by the government on producers or sellers but paid by or passed on to end-users Price Tax = RM4 S The equilibrium price is RM12 and the quantity is 400 14 CONSUMER’S SHARE The government imposes a sales tax of RM4 per carton 12 PRODUCER’S SHARE SS curve shift to left from S to S1 and new equilibrium is RM14 and 200 units 10 The tax amount of RM4 is shared equally between buyer and seller D 200 400 Quantity

Perfectly inelastic demand + tax O 12 16 400 D CONSUMERS ’ SHARE P Q Perfectly inelastic demand S + tax O 9 12 13 400 D P Q PRODUCERS ’ SHARE Demand is more elastic than supply CONSUMERS' SHARE S + tax PRODUCERS ’ SHARE P Q O 18 12 1 400 D Incidence of tax: elastic supply

EFFECT OF SUBSIDIES S Price S1 D Quantity SUBSIDY An incentive from the government to encourage producers to produce more Price Subsidy = RM10 S1 The equilibrium price is RM50 and the quantity is 10 50 CONSUMER’S SHARE The government provides a subsidy of RM10 per unit 45 PRODUCER’S SHARE SS curve shifts to the right from S to S1 and new equilibrium is RM45 and 20 units 40 The subsidy amount of RM10 is shared equally between buyer and seller D 10 20 Quantity

EFFECT OF PRICE ELASTICITY ON SUBSIDIES Demand is more elastic than supply S + tax (RM4) 43 50 10 D CONSUMERS ’ SHARE 40 PRODUCERS P Q Demand less elastic than supply S + tax O 40 47 50 10 D P Q CONSUMERS'S SHARE PRODUCERS ’ SHARE

MARKET FAILURE Market failure exists when a free market is unable to deliver an efficient allocation of resources which leads to a loss of economic efficiency. Causes of market failure Externalities Existence of monopoly power Public goods Incomplete information