Question 1

Explain market equilibrium.

Accepted Answer

Market equilibrium is a situation in which the quantity demanded of a commodity equals the quantity supplied at a particular price. At this price, there is no tendency for the price to change, as the market clears with no excess demand or supply. — When demand and supply curves intersect, the price at this point is called the equilibrium price, and the quantity is the equilibrium quantity. At this price, buyers are willing to buy exactly the amount sellers are willing to sell.

Question 2

When do we say there is excess demand for a commodity in the market?

Accepted Answer

Excess demand occurs when the quantity demanded of a commodity exceeds the quantity supplied at a given price. This usually happens when the price is below the equilibrium price, causing more consumers to want the product than producers are willing to supply. — At prices below equilibrium, demand is higher than supply, leading to a shortage or excess demand. This puts upward pressure on prices until equilibrium is restored.

Question 3

When do we say there is excess supply for a commodity in the market?

Accepted Answer

Excess supply occurs when the quantity supplied of a commodity exceeds the quantity demanded at a given price. This usually happens when the price is above the equilibrium price, causing producers to supply more than consumers want to buy. — At prices above equilibrium, supply is greater than demand, leading to a surplus or excess supply. This puts downward pressure on prices until equilibrium is restored.

Question 4

What will happen if the price prevailing in the market is
- (i) above the equilibrium price?
- (ii) below the equilibrium price?

Accepted Answer

(i) If the price is above the equilibrium price, there will be excess supply (surplus) because producers want to sell more than consumers want to buy. This surplus will put downward pressure on the price, causing it to fall towards equilibrium.

(ii) If the price is below the equilibrium price, there will be excess demand (shortage) because consumers want to buy more than producers are willing to sell. This shortage will put upward pressure on the price, causing it to rise towards equilibrium. — Prices above equilibrium cause surplus leading to price decrease; prices below equilibrium cause shortage leading to price increase. Market forces push the price towards equilibrium.

Question 5

Explain how price is determined in a perfectly competitive market with fixed number of firms.

Accepted Answer

In a perfectly competitive market with a fixed number of firms, the market price is determined by the intersection of the market demand and market supply curves. Each firm is a price taker and supplies output where its marginal cost equals the market price. The total market supply is the sum of outputs supplied by all firms at each price. The equilibrium price is where market demand equals market supply. — Since firms are price takers, they accept the market price. The fixed number of firms means supply curve is fixed. The equilibrium price is found where demand equals supply, and firms produce at output where price equals marginal cost.

Question 6

Suppose the price at which equilibrium is attained in exercise 5 is above the minimum average cost of the firms constituting the market. Now if we allow for free entry and exit of firms, how will the market price adjust to it?

Accepted Answer

If the equilibrium price is above the minimum average cost, firms earn supernormal profits. This attracts new firms to enter the market due to free entry. As new firms enter, market supply increases, shifting the supply curve to the right. This causes the market price to fall. Entry continues until the price falls to the minimum average cost, where firms earn only normal profit. At this point, no further entry or exit occurs and the market reaches a new equilibrium. — Supernormal profits attract entry, increasing supply and reducing price. Price falls until it equals minimum average cost, eliminating supernormal profits. The market stabilizes with normal profits and equilibrium price at minimum average cost.

Question 7

At what level of price do the firms in a perfectly competitive market supply when free entry and exit is allowed in the market? How is equilibrium quantity determined in such a market?

Accepted Answer

When free entry and exit are allowed, firms supply at a price equal to the minimum average cost, where they earn normal profits. The equilibrium quantity is determined at the point where the market demand curve intersects the market supply curve, which is the horizontal summation of individual firms' supply curves at this price. — Free entry and exit ensure price equals minimum average cost. At this price, firms produce output where marginal cost equals price. Market supply is sum of all firms' outputs. Equilibrium quantity is where demand equals this supply.

Question 8

How is the equilibrium number of firms determined in a market where entry and exit is permitted?

Accepted Answer

The equilibrium number of firms is determined where the market price equals the minimum average cost of production, and the total quantity demanded equals the total quantity supplied by all firms. Entry occurs when firms earn supernormal profits, increasing supply and reducing price. Exit occurs when firms incur losses, reducing supply and increasing price. The number of firms stabilizes when firms earn normal profits and no incentive exists to enter or exit. — Free entry and exit adjust the number of firms until price equals minimum average cost. At this point, total supply by all firms matches demand, determining equilibrium number of firms.

Question 9

How are equilibrium price and quantity affected when income of the consumers
- (a) increase?
- (b) decrease?

Accepted Answer

(a) When consumer income increases, demand for normal goods generally increases, shifting the demand curve rightward. This leads to a higher equilibrium price and quantity.

(b) When consumer income decreases, demand for normal goods decreases, shifting the demand curve leftward. This leads to a lower equilibrium price and quantity. — Income changes affect demand. Increase in income raises demand, increasing price and quantity. Decrease in income lowers demand, decreasing price and quantity.

Question 10

Using supply and demand curves, show how an increase in the price of shoes affects the price of a pair of socks and the number of pairs of socks bought and sold.

Accepted Answer

If shoes and socks are complementary goods, an increase in the price of shoes will reduce the demand for shoes, which in turn reduces the demand for socks. This shifts the demand curve for socks leftward, leading to a decrease in the equilibrium price and quantity of socks.

If shoes and socks are substitute goods, an increase in the price of shoes will increase the demand for socks, shifting the demand curve for socks rightward, increasing the equilibrium price and quantity of socks. — The effect depends on the relationship between shoes and socks. Using supply and demand diagrams, the demand curve for socks shifts accordingly, changing equilibrium price and quantity.

Question 11

How will a change in price of coffee affect the equilibrium price of tea? Explain the effect on equilibrium quantity also through a diagram.

Accepted Answer

If coffee and tea are substitute goods, an increase in the price of coffee will increase the demand for tea, shifting the demand curve for tea rightward. This leads to a higher equilibrium price and quantity for tea.

Conversely, a decrease in coffee price will reduce demand for tea, lowering its equilibrium price and quantity.

The effect can be shown by shifting the demand curve for tea in the supply-demand diagram. — Price change in one substitute good affects demand for the other. Diagrammatically, demand curve shifts right or left, changing equilibrium price and quantity.

Question 12

How do the equilibrium price and quantity of a commodity change when price of input used in its production changes?

Accepted Answer

An increase in the price of an input raises the production cost, causing the supply curve to shift leftward (decrease in supply). This leads to a higher equilibrium price and a lower equilibrium quantity.

A decrease in input price lowers production cost, shifting supply curve rightward (increase in supply), resulting in a lower equilibrium price and higher equilibrium quantity. — Input price changes affect supply. Higher input cost reduces supply, raising price and lowering quantity. Lower input cost increases supply, lowering price and increasing quantity.

Question 13

If the price of a substitute(Y) of good X increases, what impact does it have on the equilibrium price and quantity of good X?

Accepted Answer

If the price of substitute good Y increases, the demand for good X increases as consumers switch to X. This shifts the demand curve for X rightward, leading to an increase in both equilibrium price and quantity of good X. — Higher price of substitute makes good X more attractive, increasing demand and thus raising equilibrium price and quantity.

Question 14

Compare the effect of shift in demand curve on the equilibrium when the number of firms in the market is fixed with the situation when entry-exit is permitted.

Accepted Answer

When the number of firms is fixed, a rightward shift in demand causes a large increase in price and a smaller increase in quantity because supply cannot adjust by entry of new firms.

When entry and exit are permitted, the same demand shift leads to a smaller increase in price but a larger increase in quantity. New firms enter the market attracted by supernormal profits, increasing supply and moderating price rise. — Fixed firms limit supply adjustment, causing price to rise sharply. Free entry allows supply to increase, dampening price rise and increasing quantity more.

Question 15

Explain through a diagram the effect of a rightward shift of both the demand and supply curves on equilibrium price and quantity.

Accepted Answer

When both demand and supply curves shift rightward, the equilibrium quantity increases. The effect on equilibrium price depends on the relative magnitude of shifts:

- If demand increases more than supply, price rises.
- If supply increases more than demand, price falls.
- If both increase equally, price remains unchanged.

Diagrammatically, both curves shift right, and the new equilibrium is at higher quantity with price depending on shifts. — Simultaneous shifts affect quantity positively; price effect depends on which curve shifts more.

Price

Price — Study Notes

Market Equilibrium

5.1 EQUILIBRIUM, EXCESS DEMAND, EXCESS SUPPLY

5.1.1 Market Equilibrium: Fixed Number of Firms

Practice Questions — Price

All 5 Chapters in Introductory Microeconomics