Diploma in Management Studies

Microeconomics ECO001
Lecture 3- Market Equilibrium and Efficiency
Topics to be discussed:
Market Equilibrium
Shift of Demand and Supply Curve
Demand, Marginal benefit and Consumer
Surplus
Supply, Marginal Cost and Producer Surplus
Market and Efficiency
Ref: Parkin, Chapters 3 and 5

Learning Outcomes
After this lecture, students should be able to:
Explain how demand and supply determine prices
and quantities bought and sold
Use demand and supply to make predictions about
changes in prices and quantities
Explain the connection between demand and
marginal benefit and define consumer surplus
Explain the connection between supply and
marginal cost and define producer surplus
Explain the conditions under which markets move
resources to their highest-value uses
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Market Equilibrium
Equilibrium is a situation in which opposing
forces balance each other. Equilibrium in a
market occurs when the price balances the
plans of buyers and sellers.
The equilibrium price is the price at which
the quantity demanded equals the quantity
supplied.
The equilibrium quantity is the quantity
bought and sold at the equilibrium price.
Price regulates buying and selling plans.
Price adjusts when plans dont match.
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Price as a regulator: Surplus

Price as a Regulator
The figure illustrates
the equilibrium price
and equilibrium
quantity.
If the price is $2.00 a
bar, the quantity
supplied exceeds the
quantity demanded.
There is a surplus of 6
million energy bars.
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Price as a Regulator: Shortage

If the price is $1.00 a
bar, the quantity
demanded exceeds the
quantity supplied.
There is a shortage of
9 million energy bars.

If the price is $1.50 a

bar, the quantity
demanded equals the
quantity supplied.
There is neither a
shortage nor a surplus of
energy bars.

Market Equilibrium
At prices above the
equilibrium price, a
surplus forces the price
down. At prices below
the equilibrium price, a
shortage forces the
price up.
At the equilibrium price,
buyers plans and
sellers plans agree
and the price doesnt
change until some
event changes either
demand or supply.

Effects of Increase in Demand

The figure shows that
when demand increases
the demand curve shifts
rightward.
At the original price,
there is now a shortage.

The price rises, and

the quantity supplied
increases along the
supply curve.

Effects of Increase in Supply

The figure shows that
when supply increases
the supply curve shifts
rightward.
At the original price,
there is now a surplus.
The price falls, and the
quantity demanded
increases along the
demand curve.
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Changes in Demand and Supply

A change demand or
supply or both
demand and supply
changes the
equilibrium price and
the equilibrium
quantity.

Effects of Demand Increases

Change in Demand with
No Change in Supply
When demand increases,
equilibrium price rises and
the equilibrium quantity
increases.

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Effects of Demand Decreases

Change in Demand with No

Change in Supply
When demand decreases, the
equilibrium price falls and the
equilibrium quantity decreases.

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Effects of Supply Increases

Change in Supply with No
Change in Demand
When supply increases,
the equilibrium price falls
and the equilibrium
quantity increases.

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Effects of Supply Decreases

Change in Supply with No
Change in Demand
When supply decreases,
the equilibrium price rises
and the equilibrium
quantity decreases.

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Effects of Both Demand and

Supply Increases
Increase in Both Demand
and Supply
An increase in demand and
an increase in supply
increase the equilibrium
quantity.
The change in equilibrium
price is uncertain because
the increase in demand
raises the equilibrium price
and the increase in supply
lowers it.

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Effects of Both Demand and

Supply Decreases
Decrease in Both Demand
and Supply
A decrease in both demand
and supply decreases the
equilibrium quantity.
The change in equilibrium
price is uncertain because
the decrease in demand
lowers the equilibrium price
and the decrease in supply
raises it.
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Effects of Demand Decreases and

Supply Increases
Decrease in Demand and
Increase in Supply
A decrease in demand and
an increase in supply lowers
the equilibrium price.
The change in equilibrium
quantity is uncertain because
the decrease in demand
decreases the equilibrium
quantity and the increase in
supply increases it.
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Effects of Demand Increases and

Supply Decreases
Increase in Demand and
Decrease in Supply
An increase in demand and a
decrease in supply raises the
equilibrium price.
The change in equilibrium
quantity is uncertain because
the increase in demand
increases the equilibrium
quantity and the decrease in
supply decreases it.
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Demand and Marginal Benefit

Value is what we get, price is what we pay.
The value of one more unit of a good or
service is its marginal benefit.
We measure value as the maximum price
that a person is willing to pay.
But willingness to pay determines demand.
A demand curve is a marginal benefit curve.

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Individual and Market Demand

The relationship between the price of a
good and the quantity demanded by one
person is called individual demand.
The relationship between the price of a
good and the quantity demanded by all
buyers in the market is called market
demand.

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Individual and Market Demand

Lisa and Nick are the only buyers in the market for pizza.
At $1 a slice, the quantity demanded by Lisa is 30
slices and by Nick is 10 slices.

The quantity demanded by all buyers in the market is 40

slices.

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Individual and Market Demand

The market demand curve is the
horizontal sum of the individual demand
curves.

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Consumer Surplus
Consumer surplus is the value of a good
minus the price paid for it, summed over
the quantity bought.
It is measured by the area under the demand
curve and above the price paid, up to the
quantity bought.
The figure on the next slide shows the
consumer surplus from pizza when the market
price is $1 a slice.
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Consumer Surplus
At $1 a slice, Lisa spends $30, Nick spends
$10, and together they spend $40 on pizza.
The consumer surplus is the value from pizza
in excess of the expenditure on it.

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Supply and Marginal Cost

Supply, Cost, and Minimum Supply-Price
Cost is what the producer gives up, price
is what the producer receives.
The cost of one more unit of a good or
service is its marginal cost.
Marginal cost is the minimum price that a
firm is willing to accept.
But the minimum supply-price determines
supply.
A supply curve is a marginal cost curve. 24

Individual and Market Supply

Individual Supply and Market Supply
The relationship between the price of a
good and the quantity supplied by one
producer is called individual supply.
The relationship between the price of a
good and the quantity supplied by all
producers in the market is called market
supply.
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Individual and Market Supply

Max and Mario are the only producers of pizza.
At $15 a pizza, the quantity supplied by Max is 100
pizzas and by Mario is 50 pizzas.
The quantity supplied by all producers is 150 pizzas.

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Individual and Market Supply

The market supply curve is the horizontal sum of
the individual supply curves.

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Producer Surplus
Producer surplus is the price received for
a good minus the minimum-supply price
(marginal cost), summed over the quantity
sold.
It is measured by the area below the market
price and above the supply curve, summed
over the quantity sold.
The figure on the next slide shows the
producer surplus from pizza when the market
price is $15 a pizza.
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Producer Surplus
The red areas show the cost of producing the
pizzas sold.
The producer surplus is the value of the pizza
sold in excess of the cost of producing it.

29

Competitive Market and Efficiency

The figure shows
that a competitive
market creates an
efficient allocation
of resources at
equilibrium.
In equilibrium, the
quantity demanded
equals the quantity
supplied.
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Competitive Market and Efficiency

At the equilibrium
quantity, marginal
benefit equals
marginal cost, so
the quantity is the
efficient quantity.
When the efficient
quantity is produced,
total surplus (the sum
of consumer surplus
and producer surplus)
is maximized.
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Effects of Underproduction
The efficient quantity is
10,000 pizzas a day.

Underproduction

If production is restricted
to 5,000 pizzas a day,
there is underproduction
and the quantity is
inefficient.
A deadweight loss
equals the decrease in
total surplusthe gray
triangle.
This loss is a social loss.
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Effects of Overproduction
Again, the efficient
quantity is 10,000
pizzas a day.
If production is
expanded to 15,000
pizzas a day, a
deadweight loss
arises from
overproduction.
This loss is a
social loss.

Overproduction

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Exercise 3.1
It is observed in the handphone market that
there are more people using handphones and
also handphones become cheaper. This could
be due to:
(a) an increase in consumers income
(b) a greater preference in using handphone
(c) an improvement in technology of producing
handphone
(d) an increase in wages in the handphone
industry
(e) an increase in the population
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Answers to Exercise 3.1

The correct answer is (C).
When supply shifts right along a given
demand curve, the equilibrium price will
fall and quantity will increase.
An improvement in technology shifts the
supply curve to the right while demand
of handphones remains unchanged.

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Exercise 3.2
One observes that the equilibrium price of DVD
player increases and the equilibrium quantity
also increases. Which of the following best fits
the observed data?

A)
An increase in demand with supply
constant.

B)
An increase in demand coupled with a
decrease in supply.

C)
An increase in demand coupled with an
increase in supply.

D)
A decrease in demand with supply
constant.

E)
Demand constant and an increase in
supply.
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Answers to Exercise 3.2

The correct answer is (A).
When demand shifts right along a given
supply curve, the equilibrium price and
quantity will both increase.
So demand for DVD have increased
while supply of DVD remains
unchanged.

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Exercise 3.3
Suppose a market is in equilibrium. The
area between the market price and the
supply curve is

A) the deadweight loss.

B) total economic surplus.

C) the profit of the producers.

D) producer surplus.

E) consumer surplus.
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Answers to Exercise 3.3

The correct answer is (D).
Producer surplus is the difference
between the price producer receives
from the market and the price he is
willing to sell, which is the marginal cost
and shown in the supply curve.

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Exercise 3.4
What are the effects on the eggs market
when (i) the bird flu makes consumers
concern about eating eggs and (ii)
Singapore ban the import of eggs from
Malaysia? Considers both incidents
occur together.

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Answers to Exercise 3.4

Fear of bird flu reduces demand for egg
Demand curve shifts left
Ban of egg import reduces supply of
egg Supply curve shifts left
The net effect is a lower quantity but
price may be higher, lower or remain
P
P
S
unchanged.
S
P

P
P

D
D
Q

P
P

D
D
Q Q

P
Q

D
D
Q
Q

Exercise 3.5
Is it true that if a product is regulated by
the market system, the maximum
welfare is achieved?

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Answers to Exercise 3.5

The statement is true.
Under the market system, the equilibrium price
and quantity will occur. This will maximize the
social welfare, measured by the sum of producer
surplus and consumer surplus.
Any other outcome will lead to over-production or
under-production which creates deadweight loss.
P

S
CS
PS

Exercise 3.6
Explain changes in respective market equilibrium price and
quantity with a suitable diagram for the following
incidents.
1) In the computer software market, the number of
companies selling computer software decreases.
2) In the market for bicycles, there is an increase in the
price of steel used to make bicycles.
3) In the home heating oil market, the price of natural gas
increases. (Consumers can use either natural gas or
heating oil to warm their houses. Suppose the price of
natural gas increases.)
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Answers to Exercise 3.6

i.

ii.

iii.

A decrease in the number of sellers decreases the supply. Hence the

decrease in the number of companies selling computer software decreases
the supply of computer software and shifts the supply curve of computer
software leftward. Equilibrium price will increase and quantity will decrease.
An increase in the price of steel is an increase in the price of a resource used
to make the good. As a result, the supply of bicycles decreases and the
supply curve shifts leftward. There is no change to the demand, so the
demand curve does not shift. The equilibrium price of a bicycle rises and the
equilibrium quantity decreases.
Natural gas and heating oil are complement goods. When the price of natural
gas increases, the demand for heating oil will increase. So in the market for
heating oil, demand curve shift to the right, resulting in higher equilibrium
price and quantity.

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