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CHAPTER 3 Market Equilibrium

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**DEFINITION OF MARKET EQUILIBRIUM**

Market equilibrium is a situation where quantity demanded and quantity supplied are equal and there is no price or quantity to change. QDD = QSS

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**EQUILIBRIUM PRICE AND OUTPUT**

Market equilibrium is determined by the intersection of the the demand curve and the supply curve. Equilibrium price and quantity refers to the price and quantity that consumers and suppliers are willing to buy and sell. Market equilibrium can be determined using a demand and supply model, graphical illustration and through mathematical equation.

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**GRAPHICAL ILLUSTRATION OF EQUILIBRIUM PRICE AND OUTPUT**

A Graphical illustration 1 2 3 4 5 6 Price Quantity 8 10 SURPLUS (QSS > QDD) E SS DD P* Q* SHORTAGE (QDD > QSS)

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**GRAPHICAL ILLUSTRATION OF EQUILIBRIUM PRICE AND OUTPUT(CON’T)**

(1) Price (RM) (2) Quantity Demanded (units) (3) Quantity Supplied (units) (4) Market Condition (5) Market Prices 9.00 2000 10000 SURPLUS Falls 8.50 4000 8000 8.00 6000 EQUILIBRIUM Equilibrium 7.50 SHORTAGE Rises 7.00

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**MATHEMATICAL EQUATION OF EQUILIBRIUM PRICE OUTPUT (CON’T)**

The market demand and supply functions are given below: Market demand, QDD = – 4000P (equation 1) Market supply, QSS = – P (equation 2) To find market equilibrium price and quantity, QDD = QSS QDD = QSS – 4000P = – P 8000P = P = RM8.00

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**MATHEMATICAL EQUATION OF EQUILIBRIUM PRICE OUTPUT (CON’T)**

Substitute P = 8 into equation 1 and 2 to obtain the quantity. QDD = – 4000(8) (equation 1) = 6000 units. QSS = – (8) (equation 2) So, the equilibrium quantity, Q = 6000 units.

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SHOCKS IN EQUILIBRIUM Once the market reaches equilibrium level, it remains there so long as no pressure is put on the prices. Market equilibrium will change when there is a shock that would shift the demand or supply curve. The shock that shifts the supply and demand curves are due to changes in non-price factors. MICROECONOMICS

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**EFFECT OF CHANGES ON DEMAND**

ASSUME THAT SUPPLY IS CONSTANT Increase in Demand DD curve shifts to the right Equilibrium price and quantity increases Price (RM) P1 P* P2 Q2 Q* Q1 SS DD1 DD DD2 Quantity Decrease in Demand DD curve shifts to the left Equilibrium price and quantity decreases

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**EFFECT OF CHANGES ON SUPPLY ASSUME THAT DEMAND IS CONSTANT**

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

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**EFFECT OF CHANGES ON DEMAND AND SUPPLY**

SUPPLY AND DEMAND INCREASE Quantity Price (RM) P* Q* Q1 SS SS1U DD DD1 Case 1: Increase at same magnitude Equilibrium price undetermined and quantity increases THIS CONCEPT CAN APPLY WHEN BOTH DEMAND AND SUPPLY BOTH DECREASE.

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**EFFECT OF CHANGES ON DEMAND AND SUPPLY (CON’T)**

SUPPLY AND DEMAND DECREASE Quantity Price (RM) P* Q1 Q* SS1 SS DD DD1 Case 2: Decrease at same magnitude Equilibrium price undetermined and quantity decreases THIS CONCEPT CAN APPLY WHEN BOTH DEMAND AND SUPPLY BOTH DECREASE.

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**EFFECT OF CHANGES ON DEMAND AND SUPPLY (CON’T)**

SUPPLY INCREASE AND DEMAND DECREASES Price (RM) P* Q* SS SS1 DD DD1 Quantity P1 Case 3: Changes in different magnitude Equilibrium price decreases and quantity undetermined THIS CONCEPT CAN APPLY WHEN BOTH DEMAND AND SUPPLY BOTH DECREASE.

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**EFFECT OF CHANGES ON DEMAND AND SUPPLY (CON’T)**

SUPPLY DECREASES AND DEMAND INCREASES Price (RM) Q* P* SS SS1 DD DD1 Quantity P1 Case 4: Changes in different magnitude Equilibrium price increases and quantity undetermined THIS CONCEPT CAN APPLY WHEN BOTH DEMAND AND SUPPLY BOTH DECREASE.

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**GOVERNMENT INTERVENTION GOVERNMENT INTERVENTION IN THE MARKET**

MAXIMUM PRICE MAXIMUM PRICE GOVERNMENT INTERVENTION IN THE MARKET TAXES SASUBSIDIES

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**GOVERNMENT INTERVENTION (CON’T) MAXIMUM PRICE/ CEILING PRICE**

Government-imposed regulations prevent prices from rising above the maximum level. Advantage Consumers purchase at lower price. Disadvantages Emergence of black market. Reduction in quantity produced. Producers tend to receive illegal payments from consumers. Price Quantity DD SS P* P1 The government imposes a maximum price of P1. Suppliers reduce the amount offered to Q1 but demand would rise to Q2 creating a shortage. Q* Q1 Q2 Shortage occurs The equilibrium price is P* and the quantity is Q*. Price ceiling

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**GOVERNMENT INTERVENTION (CON’T) MINIMUM PRICE/ FLOOR PRICE**

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

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**EFECT OF TAXATION Quantity SS SS1 Price DD 14 200 10 Tax = RM4 400 12**

The equilibrium price is RM12 and the quantity is 400 units 14 200 10 Tax = RM4 The government imposes a sales tax of RM4 per carton. 400 INDIRECT TAX Tax that is imposed by the government on producers or sellers but paid by or passed on to end-users. 12 CONSUMER’S SHARE PRODUCER’S SHARE SS curve shift to the left from SS to SS1 and new equilibrium is RM14 and 200 units. The tax amount of RM4 is shared equally between buyer and seller.

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**Perfectly inelastic demand Demand less elastic than supply**

+ tax O 12 16 400 D CONSUMERS’ SHARE P Q Perfectly inelastic demand S + tax (RM4) 12 15 400 D PRODUCERS’ SHARE P Q 11 CONSUMERS’ SHARE Demand less elastic than supply S + tax O 9 12 13 400 D P Q CONSUMERS’ SHARE Demand less elastic than supply PRODUCER’ SHARE S + tax P Q O 18 12 1 400 D Incidence of tax: elastic supply PRODUCERS’ SHARE

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**EFECT OF SUBSIDIES SUBSIDY D Price Quantity S S1 45 10 20 50 40**

Subsidy = RM10 SUBSIDY An incentive from the government to encourage producers to produce more. Price Quantity D S S1 45 10 The equilibrium price is RM50 and the quantity is 10. 20 50 40 CONSUMER’S SHARE PRODUCER’S SHARE The government provides a subsidy of RM10 per unit. SS curve shift right from SS to SS1 and new equilibrium is RM45 and 20 units. The subsidy amount of RM10 is shared equally between buyer and seller.

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**EFECT OF PRICE ELASTICITY ON SUBSIDIES**

+ tax O 40 47 50 1 D P Q CONSUMERS’ SHARE PRODUCERS’ SHARE Demand is more elastic than supply S + tax (RM4) 43 50 10 D CONSUMERS’ SHARE PRODUCERS’ SHARE P Q Demand less elastic than supply 40

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