Market Equilibrium

This is Chapter 5, the last chapter of Introductory Microeconomics: 17 pages (71–87) in two sections — 5.1 equilibrium, excess demand and excess supply (5.1.1 with a fixed number of firms, including a box on wage determination in the labour market and the effects of shifts; 5.1.2 with free entry and exit) and 5.2 applications (price ceiling and price floor) — with eight numbered figures, an unnumbered labour-market figure, one table, two worked examples, two cartoons and 25 exercise questions, three of them numerical. Every number is recomputed and every graph drawn from computed points; where NCERT's labels or wording slip, we say so with a safe exam line.

• Builds on the whole book: Chapter 1 (leec201 — what, how and for whom; the market as a co-ordinating device), Chapter 2 (leec202 — market demand, normal and inferior goods, substitutes and complements), Chapter 3 (leec203 — marginal product and costs) and Chapter 4 (leec204 — the firm's supply, shut-down point, min AC and market supply). Here demand finally meets supply.
• Pairs with Introductory Macroeconomics (leec101–106): leec101 (classical faith in self-adjusting markets vs Keynes), leec104 (equilibrium of aggregate demand and output — the same ‘plans match’ idea for the whole economy) and leec105 (subsidies and taxes in the budget); and Indian Economic Development (keec1): keec102 and keec105 (MSP, procurement, buffer stocks, PDS) and keec104 (minimum wages and the labour market).
• UPSC, honestly: pure micro theory is light in UPSC. But the applications here — price ceilings and rationing (PDS), price floors (MSP), buffer stocks and minimum wages — recur in Prelims and GS3, and ‘excess demand/supply’ is the vocabulary for any question on why a price rose or fell. We link four past questions (1979, 2018, 2020 ×2).

• Equilibrium: qD(p*) = qS(p*) — plans of buyers and sellers match; the market clears. Graphically, where DD cuts SS.
• Excess demand (qD > qS) below p* → price rises; excess supply (qS > qD) above p* → price falls (the invisible hand). Example 5.1: ₹40, 160 kg; ED(p) = 80 − 2p.
• Labour market: hire till w = MRPL = MR × MPL (= VMPL for a price taker) → labour demand slopes down; individual supply can bend back, market supply slopes up.
• Fixed firms: demand shift → p and q same direction; supply shift → p and q opposite. Both shift together: same direction → q certain, p ambiguous; opposite → p certain, q ambiguous (Table 5.1).
• Free entry and exit (identical firms): p = min AC; q from demand; n₀ = q₀ / q₀f (Example 5.2: ₹20, 180 kg, 30 each → 6 firms). Demand shift changes q and n, not p.
• Price ceiling below p* → shortage → rationing, fair price shops, queues, black market. Price floor above p* → surplus → government buys (farm price support); minimum wage is a floor too.

In a perfectly competitive market, consumers maximise their satisfaction and firms their profit (Chapters 2 and 4); both take the price as given. An equilibrium is a situation in which the plans of all consumers and firms match and the market clears: the total that firms wish to sell equals the total that consumers wish to buy. The price at which this happens is the equilibrium price p*, and the amount bought and sold the equilibrium quantity q*: (p*, q*) is an equilibrium if qD(p*) = qS(p*). At any other price there is either excess supply (supply > demand) or excess demand (demand > supply), so equilibrium can also be described as zero excess demand and zero excess supply.

Out of equilibrium. Since Adam Smith (1723–1790), economists have held that an ‘invisible hand’ moves the price whenever the market is out of balance — up under excess demand, down under excess supply. NCERT assumes throughout that this process works and always reaches equilibrium. With a fixed number of firms, equilibrium is where the market supply curve SS cuts the market demand curve DD (Fig. 5.1). Below p*, some buyers get nothing or too little and offer more; as price rises, quantity demanded falls and quantity supplied rises until they meet at p*. Above p*, some firms cannot sell all they want and cut their price; quantity demanded rises and quantity supplied falls until, again, they meet at p*.

Example 5.1 (wheat, identical farms): qD = 200 − p for 0 ≤ p ≤ 200 (0 above); qS = 120 + p for p ≥ 10 (0 below), in kg and ₹ per kg. Setting 200 − p* = 120 + p* gives 2p* = 80, so p* = ₹40 and q* = 160 kg (check: 200 − 40 = 120 + 40 = 160). At ₹25, qD = 175 and qS = 145: excess demand 30. At ₹45, qD = 155 and qS = 165: excess supply 10. In general ED(p) = qD − qS = 80 − 2p, positive for every price below ₹40; ES(p) = 2p − 80, positive above ₹40. We recomputed every line.

The labour market reverses the roles: households supply labour and firms demand it. Labour means hours of work, not the number of workers. NCERT assumes labour is the only variable factor, both the labour market and the goods market are perfectly competitive (the firm takes the wage and the output price as given), and the law of diminishing marginal product holds. Demand: a profit-maximising firm hires labour up to the point where the extra cost of the last unit — the wage w — equals the extra revenue it brings — the marginal revenue product of labour, MRPL = MR × MPL. For a price taker MR = p, so MRPL equals the value of the marginal product, VMPL = p × MPL. While VMPL > w, one more hour adds to profit; if VMPL < w, one hour less does. If the wage rises, VMPL must rise to match; with the output price fixed, MPL must rise, which with diminishing MPL means fewer hours. So each firm's labour demand slopes down, and so does the market demand (the horizontal sum).

Supply: each person chooses between income and leisure. A higher wage has two effects: (1) leisure becomes costlier — its opportunity cost is the wage forgone — so she works more (substitution effect); (2) she is richer and wants to ‘buy’ more leisure, so she works less (income effect). At low wages the first dominates, at high wages the second, giving a backward-bending individual labour supply curve. The market supply still slopes up: even if some people work less at higher wages, many more are drawn in. The equilibrium wage w* and hours l* are where market demand and supply cross.

Equilibrium was found holding constant tastes, the prices of related goods, consumers' incomes, technology, the size of the market and input prices. When any of these change, a curve shifts. Demand shift (Fig. 5.2): if demand moves right with supply unchanged, at the old price p₀ there is excess demand, price rises, and the new equilibrium has higher price and higher quantity; a leftward shift creates excess supply and gives lower price and lower quantity. So a demand shift moves price and quantity in the same direction. NCERT's examples: a rise in consumers' incomes raises demand for a normal good such as clothes (for an inferior good demand would fall); an increase in the number of consumers also shifts demand right. Neither affects supply, which depends on technology, costs and the number of firms.

Supply shift (Fig. 5.3): if supply moves left with demand unchanged, excess demand at p₀ raises price — higher price, lower quantity; a rightward shift — lower price, higher quantity. A supply shift moves price and quantity in opposite directions. NCERT's examples: a rise in an input price raises firms' marginal cost and shifts supply left (price up, quantity down); an increase in the number of firms shifts supply right (price down, quantity up). Neither affects demand.

Two curves can shift together in four ways: both right, both left, demand left and supply right, demand right and supply left. Table 5.1 sums up the results. When both shift in the same direction, the effect on quantity is certain (both push it the same way) but price may rise, fall or stay unchanged, depending on the sizes of the shifts. When they shift in opposite directions, the effect on price is certain but quantity may go either way. NCERT draws two cases (Fig. 5.4): both curves right with price unchanged and quantity higher; demand left and supply right with quantity unchanged and price lower.

The second table is NCERT's ‘check this yourself’ done with numbers: in all three, quantity rises (190, 200, 220), but price can rise, stay or fall. A quick rule for straight lines like these: with demand qD = a − p and supply qS = c + p, equilibrium is p* = (a − c)/2 and q* = (a + c)/2 — a demand shift (a) and a supply shift (c) move q* the same way when both are rightward, but move p* in opposite directions.

Now let identical firms enter and exit freely. Then no firm can earn supernormal profit or make a loss for long. If the price is above minimum average cost, firms earn supernormal profit, new firms enter, market supply shifts right and the price falls until profits are normal. If the price is below minimum AC, firms make losses, some exit, supply shifts left and the price rises back. So the equilibrium price is p = min AC. At that price the market demand decides the quantity q₀, each firm produces the same q₀f, and the equilibrium number of firms is n₀ = q₀ / q₀f (Fig. 5.5).

Example 5.2: wheat demand qD = 200 − p; each identical firm supplies q_f = 10 + p for p ≥ 20 (0 below), so minimum AC is ₹20 — the lowest price at which a firm will produce in the long run. Then p₀ = ₹20, q₀ = 200 − 20 = 180 kg, each firm supplies 10 + 20 = 30 kg, and n₀ = 180 ÷ 30 = 6 firms. All recomputed. Demand shifts (Fig. 5.6): if demand moves right, the price rises briefly, supernormal profit attracts entrants, and the price returns to p₀ = min AC with a larger quantity and more firms; a leftward shift leads to exit, a smaller quantity and fewer firms, and again the same price. Compared with a fixed number of firms, a demand shift has a larger effect on quantity and no effect on price.

Our illustration † makes Exercise 21's claim concrete. Start at Example 5.2's equilibrium: 6 firms, each supplying 10 + p, give a market supply of 6(10 + p) = 60 + 6p for p ≥ 20, which meets 200 − p exactly at ₹20 and 180 kg. Shift demand to 260 − p. Fixed at 6 firms: 260 − p = 60 + 6p → p = 200/7 ≈ ₹28.57, q ≈ 231.4. Free entry: p stays ₹20, q = 240, firms = 240 ÷ 30 = 8. Quantity rises more (240 > 231.4) and price not at all.

Governments sometimes regulate prices that are thought too high or too low. A price ceiling is a government-imposed upper limit on the price of a good or service. It is usually applied to necessities — NCERT names wheat, rice, kerosene and sugar — and fixed below the market price because at the market price some people cannot afford them. In Fig. 5.7, with a ceiling p_c below p*, consumers want q_c but firms supply only q′_c: excess demand, a shortage. Though meant to help consumers, the ceiling can leave them short of the good. The available quantity may be shared through rationing: ration coupons limit each person's purchase, sold through ration shops or fair price shops. NCERT lists two adverse consequences: (a) long queues at ration shops; (b) since not everyone is satisfied with the rationed amount, some will pay more — creating a black market.

With numbers (NCERT's own p₁ = ₹25 from Example 5.1, treated as a ceiling): firms supply 145 kg, buyers want 175 kg — a shortage of 30 kg. Only 145 kg exist; buyers would pay up to 200 − 145 = ₹55 for the last of them, which is the most a black-market seller could charge (our extension †). Output falls from 160 to 145 kg; the value lost on the 15 kg no longer produced — the triangle between demand and supply — is ½ × 15 × (55 − 25) = ₹225, the deadweight loss (Beyond NCERT †).

A price floor is a government-imposed lower limit on the price of a good or service, usually set above the market price because a fall below some level is thought undesirable. NCERT's two best-known examples are agricultural price support programmes — a minimum purchase price for some farm goods, normally above the market price — and minimum wage legislation — a wage floor, set above the equilibrium wage. In Fig. 5.8, with a floor p_f above p*, buyers want q_f but firms offer q′_f: excess supply. Under agricultural support, to stop the price falling the government must buy the surplus at the floor price. With NCERT's own p₂ = ₹45 from Example 5.1 as a floor: buyers take 155 kg, farms offer 165 kg, so the government buys 10 kg for 10 × 45 = ₹450.

The chapter has no numbered activities, but section 5.1.1 asks the reader to check Table 5.1 by varying the shifts and to draw the cases Fig. 5.4 leaves out. Worked with Example 5.1's market (D: 200 − p, S: 120 + p) and shifts of our choosing †.

Questions 1–21 and 25 are conceptual (draw the diagram where asked); 22–24 are numerical — every answer recomputed. Try first, then open.

Numbers

One-liners

• Equilibrium: what buyers want to buy equals what sellers want to sell.
• Below p*: excess demand, price rises. Above p*: excess supply, price falls.
• A firm hires labour until the wage equals the value of the marginal product.
• One worker's supply can bend back; the market's slopes up.
• Demand shift: price and quantity move together.
• Supply shift: price and quantity move apart.
• Two shifts: one result is sure, the other depends on sizes.
• Free entry fixes price at min AC; demand decides quantity; quantity ÷ firm output gives the number of firms.
• Ceiling below equilibrium → shortage → rationing, queues, black market.
• Floor above equilibrium → surplus → government buys (MSP) or unemployment (minimum wage, simple model).

Traps to avoid

• Excess demand is below equilibrium, excess supply above.
• MRPL = VMPL only when the firm is a price taker in its output market.
• Backward bending applies to an individual, not market labour supply.
• Same-direction shifts make quantity certain, not price.
• Fig. 5.4 shows the text's cases (i) and (iv), not ‘(ii) and (iii)’ — those numbers match Table 5.1's rows.
• Curve subscripts (DD₁, DD₂, SS₁, SS₂) change meaning between figures — read the arrows.
• With free entry, a demand shift changes quantity and firm numbers, not price (constant costs assumed).
• A price ceiling binds only below equilibrium; a floor only above it.
• MSP is a floor: the market price can be above it.
• Minimum wage is a price floor, not a ceiling.

Prelims — what UPSC asks

• Excess supply / excess demand: a ‘buyers' market’ is one where supply exceeds demand (1979).
• MSP as a floor: MSP is not a level ‘to which the market price will never rise’, and procurement is not unlimited for all crops (2020, neither statement correct). Government policies — MSP, government trading, stockpiling, consumer subsidies — all move the market price of rice (2020, all four).
• Expect statement questions on: ceiling vs floor and what each creates; rationing and black markets; free entry and p = min AC; the certain vs ambiguous effects of simultaneous shifts; MRPL and VMPL.

Mains — where it appears and how to answer

• GS3 (2018): ‘What is MSP and how can it rescue farmers from a low-income trap?’ — define MSP as a price floor, draw Fig. 5.8, show the surplus the government must buy, then weigh income security against costs, stocks and cropping distortions.
• Use the ceiling and floor diagrams for PDS, buffer stocks, rent control and minimum-wage questions; set economists' positions side by side — efficiency (Friedman–Stigler; Gulati; Shanta Kumar Committee) vs food security and farm-income support (Drèze–Sen; Swaminathan Commission) — without present-day political commentary.

Tap an option. NCERT's own exercise questions come first; the rest test the figures and common confusions.

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