NCERT Books Class 12 Microeconomics Chapter 5- Market Equilibrium

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This chapter will be built on the foundation laid down in Chapters 2 and 4 where we studied the consumer and firm behaviour when they are price takers. In Chapter 2, we have seen that an individual’s demand curve for a commodity tells us what quantity a consumer is willing to buy at different prices when he takes price as given. The market demand curve in turn tells us how much of the commodity all the consumers taken together are willing to purchase at different prices when everyone takes price as given.

In Chapter 4, we have seen that an individual firm’s supply curve tells us the quantity of the commodity that a profit-maximising firm would wish to sell at different prices when it takes price as given and the market supply curve tells us how much of the commodity all the firms taken together would wish to supply at different prices when each firm takes price as given.

In this chapter, we combine both consumers’ and firms’ behaviour to study market equilibrium through demand-supply analysis and determine at what price equilibrium will be attained. We also examine the effects of demand and supply shifts on equilibrium. At the end of the chapter, we will look at some of the applications of demand-supply analysis.

5.1 EQUILIBRIUM, EXCESS DEMAND, EXCESS SUPPLY

A perfectly competitive market consists of buyers and sellers who are driven by their self-interested objectives. Recall from Chapters 2 and 4 that objectives of the  consumers are to maximise their respective preference and that of the firms are to maximise their respective profits. Both the consumers’ and firms’ objectives are compatible in the equilibrium.

An equilibrium is defined as a situation where the plans of all consumers and firms in the market match and the market clears. In equilibrium, the aggregate quantity that all firms wish to sell equals the quantity that all the consumers in the market wish to buy; in other words, market supply equals market demand. The price at which equilibrium is reached is called equilibrium price and the quantity bought and sold at this price is called equilibrium quantity. Therefore, (p*, q*) is an equilibrium if qD(p) = qS(p). where p denotes the equilibrium price and qD(p) and qS(p) denote the market demand and market supply of the commodity respectively at price p.

If at a price, market supply is greater than market demand, we say that there is an excess supply in the market at that price and if market demand exceeds market supply at a price, it is said that excess demand exists in the market at that price. Therefore, equilibrium in a perfectly competitive market can be defined alternatively as zero excess demand-zero excess supply situation. Whenever market supply is not equal to market demand, and hence the market is not in equilibrium, there will be a tendency for the price to change. In the next two sections, we will try to understand what drives this change.

5.1.1 Market Equilibrium: Fixed Number of Firms

Recall that in Chapter 2 we have derived the market demand curve for pricetakingn consumers, and for price-taking firms the market supply curve was derived in Chapter 4 under the assumption of a fixed number of firms. In this section with the help of these two curves we will look at how supply and demand forces work together to determine where the market will be in equilibrium when the number of firms is fixed. We will also study how the equilibrium price and quantity change due to shifts in demand and supply curves.

Figure 5.1 illustrates equilibrium for a perfectly competitive market with a fixed number of firms. Here SS denotes the market supply curve and DD denotes the market demand curve for a commodity. The market supply curve SS shows how much of the commodity, firms would wish to supply at different prices, and the demand curve DD tells us how much of the commodity, the consumers would be willing to purchase at different prices. Graphically, an equilibrium is a point where the market supply curve intersects the market demand curve because this is where the market demand equals market supply. At any other point, either there is excess supply or there is excess demand. To see what happens when market demand does not equal market supply, let us look in figure 5.1 again.

In Figure 5.1, if the prevailing price is p1, the market demand is q1 whereas the market supply is 1 q' . Therefore, there is excess demand in the market equal to 1 q' q1. Some consumers who are either unable to obtain the commodity at all or obtain it in insufficient quantity will be willing to pay more than p1. The market price would tend to increase. All other things remaining the same as price rises, quantity demanded falls and quantity supplied increases. The market moves towards the point where the quantity that the firms want to sell is equal to the quantity that the consumers want to buy. This happens when price is p* , the supply decisions of the firms only match with the demand decisions of the consumers.

Similarly, if the prevailing price is p2, the market supply (q2) will exceed the market demand ( 2 q ' ) at that price giving rise to excess supply equal to 2 q ' q2. Some firms will not be then able to sell quantity they want to sell; so, they will lower their price. All other things remaining the same as price falls, quantity demanded rises, quantity supplied falls, and at p*, the firms are able to sell their desired output since market demand equals market supply at that price. Therefore, p* is the equilibrium price and the corresponding quantity q* is the equilibrium quantity.

To understand the equilibrium price and quantity determination more clearly, let us explain it through an example. 

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