2. CHAPTER 3
MARKET EQUILIBRIUM

3. 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

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

5. 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

6. 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 DD
Decrease in Demand
DD curve shifts to the left
Equilibrium price and quantity decrease
DD2 Q1 Q* Q2
Quantity

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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