1. Introduction

• This chapter studies how markets reach equilibrium, what happens when supply and demand do not match (excess demand or excess supply), and how market structure and entry/exit affect equilibrium outcomes.
• We analyse two broad cases: market with a fixed number of firms (short run / partial equilibrium) and market with free entry and exit (long-run competitive equilibrium).
• Applications include policy interventions such as price ceilings and price floors, and welfare implications (consumer and producer surplus).

2. Basic Definitions

• Demand (D): schedule or curve showing quantity buyers want at each price (ceteris paribus).
• Supply (S): schedule or curve showing quantity sellers supply at each price.
• Market equilibrium: a price–quantity pair (P*, Q*) where quantity demanded equals quantity supplied: D(P*) = S(P*).
• Excess demand (shortage): at price P < P*, Qd > Qs; buyers want more than sellers supply.
• Excess supply (surplus): at price P > P*, Qs > Qd; sellers supply more than buyers demand.
• Equilibrium price (market-clearing price): the price that clears the market — no built-up unmet demand or unsold surplus (ignoring frictions and dynamic adjustment).

3. Determination of Market Equilibrium — Intuition

• At high price, suppliers are willing to sell more; demanders buy less → excess supply → downward pressure on price.
• At low price, demanders want more; suppliers supply less → excess demand → upward pressure on price.
• Price adjusts (via transactions, bargaining, or auction) until supply equals demand.
• Graphically: intersection point of downward-sloping demand curve and upward-sloping supply curve gives equilibrium (P*, Q*).

4. Excess Demand and Excess Supply — Dynamics

• Excess demand (Qd − Qs > 0):
• Results in queues, rationing, non-price allocation (first-come-first-served), black markets if price controls exist.
• Competition among buyers tends to bid up price toward P* (if price flexibility exists).
• Excess supply (Qs − Qd > 0):
• Leads to unsold inventories, incentives to cut prices or increase marketing, or firms may reduce output.
• Price declines until market clears (if price flexibility allowed).
• Adjustment speed and mechanism depend on market institutions: e.g., auctions adjust instantly, retail markets may adjust slowly, labour markets may have nominal wage rigidity.

5. Market Equilibrium — Fixed Number of Firms (Short Run)

• Assume number of firms (n) is fixed in the short run; industry supply is the horizontal summation of individual firm supply curves.
• Given demand curve D(P), market equilibrium solves D(P) = S(P) = Σ q_i(P), where q_i(P) is firm i’s supply at price P.
• Short-run adjustments: firms change output in response to price changes; entry/exit do not occur.
• Two possible comparative statics:
• Demand shifter (e.g., income ↑): demand shifts right → new equilibrium with higher P and Q (given upward-sloping supply).
• Supply shifter (e.g., input cost ↓): supply shifts right → lower P and higher Q.
• In SR, firms may earn positive economic profits, zero profit, or losses depending on position of price relative to ATC.

6. Graphical Steps to Find Short-Run Equilibrium

1. Plot market demand curve (downward sloping) and market supply curve (upward sloping) — supply built from firm MC schedules.
2. Intersection gives (P*, Q*).
3. To find individual firm output: price is taken as given — firm supplies q_i such that P* = MC_i(q_i) (assuming P* ≥ min AVC).
4. Aggregate individual q_i across n firms to get Q*; consistency required (market identity).

7. Welfare at Market Equilibrium (Short Run)

• Define consumer surplus (CS) as area under demand above price up to Q* — measure of buyers’ net benefit.
• Define producer surplus (PS) as area above supply (MC) below price up to Q* — measure of sellers’ net benefit.
• Total surplus = CS + PS — a measure of market welfare (ignoring externalities and distributional issues).
• Competitive equilibrium with price flexibility is allocatively efficient when P* = MC for the marginal unit (P = MC condition), maximizing total surplus under standard assumptions.

8. Market Equilibrium with Free Entry and Exit (Long Run)

• Allowing free entry and exit, firms will enter if existing firms earn positive economic profit; they will exit if firms earn losses.
• In the long run, entry/exit continue until firms earn zero economic profit (normal profit) — markets move to point where P = min(LRAC).
• Long-run industry supply depends on how input prices respond to industry expansion:
• Constant-cost industry: LR supply horizontal at P = minimum LRAC (price unchanged with entry).
• Increasing-cost industry: LR supply slopes upward (input prices rise with industry expansion).
• Decreasing-cost industry: LR supply slopes downward (industry expansion lowers input costs).
• Long-run equilibrium satisfies three conditions simultaneously: (i) firms choose output to maximize profit: P = MC, (ii) P = min LRAC (zero profit), (iii) market clears: Qd(P) = Qs(P) via industry output and number of firms.

9. Comparative Statics in Long Run — Entry and Exit Effects

• When demand increases permanently:
• In SR: price rises and incumbent firms increase output (P ↑, Q ↑), earning positive profits.
• In LR: entry of new firms increases industry supply → price falls back (possibly to original if constant-cost industry). Final Q higher, firms earn zero economic profit again.
• When costs of production increase (e.g., wage rise tied to industry):
• SR: supply shifts left → price rises, output falls, firms may have lower profits or losses.
• LR: exit reduces industry supply further; price may settle at higher level with fewer firms earning zero profit.

10. Stability of Equilibrium

• An equilibrium is stable if small deviations cause forces (price adjustments, quantity adjustments) that restore equilibrium.
• Walrasian tâtonnement: prices adjust in response to excess demand; if price change proportional to excess demand and demand/supply slopes satisfy stability conditions, price converges to equilibrium.
• Non-tâtonnement dynamics: quantity adjustments or quantity rationing when prices are sticky can lead to different dynamics and multiple possible allocations.
• Real-world frictions (menu costs, contracts, inventories) affect speed and path of adjustment.

11. Market Equilibrium — Applications and Policy

• Policymakers intervene in markets for equity or efficiency reasons. Common interventions: price ceilings, price floors, taxes, subsidies, quotas, and rationing.
• We study two canonical interventions: price ceilings (maximum price) and price floors (minimum price).

12. Price Ceiling (Binding and Non-Binding)

• Price ceiling is a legally imposed maximum price P_max that sellers may charge.
• If P_max ≥ P* (market equilibrium price) → non-binding (no effect).
• If P_max < P* → binding → creates excess demand (shortage): Qd(P_max) > Qs(P_max).
• Consequences of a binding price ceiling:
• Shortages; long queues; non-price rationing; potential for black markets where good is sold at higher price.
• Reduction in producer surplus and potential loss of quality as suppliers cut costs; transfer of surplus to consumers but not necessarily to same set of consumers (rationing issues).
• Deadweight loss: total surplus falls relative to market equilibrium because mutually beneficial trades between Qs and Qd are prevented.
• If government supplies additional quantity (subsidized supply), welfare effects depend on cost of provision and distribution.
• Graphical depiction: horizontal line at P_max below equilibrium; vertical gap between demand and supply at that price is shortage.

13. Price Floor (Binding and Non-Binding)

• Price floor is a legally imposed minimum price P_min that buyers must pay.
• If P_min ≤ P* → non-binding (no effect). If P_min > P* → binding → creates excess supply (surplus): Qs(P_min) > Qd(P_min).
• Consequences of binding price floor:
• Unsold surplus; government may purchase excess (support price) — costly; storage and disposal issues.
• Transfer of surplus to producers but possibly welfare loss due to inefficiency and government expense; consumers pay higher price and consume less.
• Deadweight loss arises because trades between Qd and Qs prevented; potential for wasted resources.
• Minimum wage is a prominent example of price floor in labour markets — potential unemployment if binding and labour demand is elastic.

14. Rationing and Non-price Allocation

• When price controls bind, non-price rationing methods arise: queues, coupons, favoritism, seller discretion, or black markets.
• Non-price rationing often allocates goods inefficiently and may favor those with better access or time.
• Policy trade-offs: controlling prices may be politically appealing, but rationing and black markets are costly and inequitable.

15. Taxes, Subsidies and Incidence

• Imposition of a per-unit tax t shifts supply (or demand) depending on statutory incidence: a tax on sellers shifts supply up by t; a tax on buyers shifts demand down by t (per unit) — equilibrium quantity falls.
• Tax incidence (who bears burden) depends on relative elasticities: more inelastic side bears larger share of tax burden.
• Subsidies shift supply down or demand up; incidence and welfare effects are mirror images of taxes.
• Revenues and deadweight loss: tax raises government revenue but creates deadweight loss proportional to square of tax times elasticities (loss increases with higher elasticity and tax size).

16. Comparative Statics — Worked Examples

• Example 1 — Increase in demand (short run): Demand shifts right from D0 to D1. With fixed supply S0, price rises from P0 to P1 and Q increases from Q0 to Q1. If entry possible in long run, new firms enter shifting supply right until price returns to long-run level.
• Example 2 — Binding price ceiling: With demand D and supply S, a ceiling at Pc < Pe causes Qs(pc) < Qd(pc). Consumer surplus: some gains for those allocated units at Pc; producer surplus falls; deadweight loss equals transactions lost between Qs and Qe.
• Example 3 — Per-unit tax t on sellers: Supply shifts up by t. New equilibrium price paid by buyers increases, price received by sellers decreases; quantity traded falls. Tax revenue = t × Q_tax. Deadweight loss area equals triangles on sides of tax wedge.

17. Market Failures and Price Controls — Caveats

• Markets may fail to maximize welfare due to externalities (pollution), public goods, information asymmetries, or market power — in these cases policy intervention may increase welfare.
• However, price controls are blunt instruments — targeted interventions (taxes/subsidies, Pigouvian taxes, tradable permits, provison of public good) may be more efficient.

18. Dynamics with Sticky Prices and Quantity Adjustment

• When prices are sticky (do not adjust quickly), quantity adjustments occur: firms change output, inventories accumulate, rationing occurs.
• Example: labour markets often show wage rigidity leading to unemployment (excess supply of labour) rather than wage fall.
• Understanding real-world disequilibrium requires models beyond simple price adjustment (e.g., quantity adjustment models, menu cost models, staggered wages/prices).

19. Market Equilibrium with Heterogeneous Firms

• If firms differ in costs, the industry supply curve is built by aggregating individual supply curves — low-cost firms supply at lower prices and vice versa.
• Entry/exit in LR selects firms with lowest long-run costs — inefficient firms exit; industry evolves to efficient scale mix.
• Policy impacts differ across firms — subsidies might disproportionately favor large low-cost firms or incumbents depending on design.

20. Market Equilibrium under Uncertainty and Expectations

• Expectations about future prices alter current supply/demand (intertemporal substitution):
• If producers expect higher future prices, they may withhold supply → current supply falls, price rises.
• If consumers expect higher future prices, current demand rises (buy now) → price rises now.
• Speculative bubbles and self-fulfilling expectations can cause volatile deviations from fundamentals; policy may aim to stabilize expectations.

21. Welfare Analysis — Deadweight Loss and Redistribution

• At competitive equilibrium, total surplus is maximized given the constraints. Interventions that prevent mutually beneficial trades (price ceilings/floors/taxes) create deadweight loss.
• Deadweight loss measures lost gains from trade — graphically triangular areas between supply and demand curves where quantity falls short of efficient level.
• Redistribution can be achieved but often at cost of efficiency; policymakers need to weigh equity-efficiency trade-offs.

22. Policy Design — Minimizing Distortions

• When implementing price controls or taxes, design matters: e.g., targeted transfers to low-income consumers may be less distortionary than broad price ceilings.
• Supply-side interventions (subsidies for production, infrastructure to reduce costs) can increase supply without creating shortages.
• Careful use of price supports (e.g., buffer stock schemes in agriculture) can stabilize income while managing surplus/shortage via government purchase/sale strategies.

23. Useful Formulas & Quick Reference

24. Practice Problems (with hints)

1. Given linear demand Qd = 120 − 4P and supply Qs = 10 + 2P, find equilibrium P and Q. (Hint: set Qd = Qs)
2. If a binding price ceiling P_c = 10 is imposed and equilibrium price P* = 15, compute shortage and discuss rationing consequences. (Hint: compute Qd(10) and Qs(10))
3. Suppose a per-unit tax t = 2 is levied on sellers; with demand Qd = 100 − P and supply Qs = 20 + 2P, find new equilibrium and tax revenue. (Hint: supply shifts up by t)
4. Explain how free entry would change an initial short-run equilibrium where firms earn positive profit.

25. Summary — Key Takeaways

• Market equilibrium occurs when supply equals demand; deviations create excess demand or supply, which drive price adjustments under flexible prices.
• Short-run equilibrium with fixed number of firms allows profits/losses; long-run equilibrium with free entry leads to zero economic profit (P = min LRAC) for competitive firms.
• Price controls (ceilings/floors) cause shortages or surpluses and generate deadweight loss; non-price rationing and black markets emerge when prices are constrained.
• Policy interventions should consider both efficiency and equity; supply-side measures and targeted transfers often cause fewer distortions than blanket price controls.
• Understanding elasticity, incidence, and dynamic adjustment is crucial for predicting the effects of shocks and policy measures on markets.