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Market Equilibrium

The price mechanisms

Market efficiency

IB Economics
Learning Objectives
At the end of this section you should be able to
Explain the concept of equilibrium
Explain the effect of changes in demand and supply
upon the equilibrium
Explain the concepts of excess demand and excess
HL calculate the market price and quantity using
linear functions
Plot changing market equilibriums, identifying new
equilibrium points, excess demand and excess supply
Bringing market demand and supply curves together
Bringing buyers (demanders) and sellers (suppliers)
together creates what economist call a market
When we picture a market in our heads we tend to think of
a fruit and veg market but a market does not even have to
be physical - it is just where buyers and sellers interact.
Transactions can by carried out by phone, mail order or over
the internet.
Watch the mjm foodie video
In order to analyse how a market works we
bring the demand and supply curve together and from now
on we always draw our diagrams with both curves
Equilibrium is when supply satisfies demand and vice versa
Everything produced in the market will be sold
They are equal, there is balance/stability and there is no
tendency for the market to change without external change
In theory the price system should produce equilibrium as
we will see later

Equilibrium S

The free market

Pe equilibrium price is
Pe and quantity is Qe


Qe Quantity of Coffee
Market disequilibrium and eliminating excess supply
Equilibrium is self righting in a free market
Lets says the producers increase their price to P1
At this price there will be Q1 demand
At this price there will be Q2 supply
There is too much supply (excess supply) of Q1 Q2
The market is said to be in disequilibrium
To get rid of the surplus producers will have to supply at a lower price
As they do the quantity demanded will increase until once again demand equals
supply and there is equilibrium once more

O Q1 Q Q2 Q

Excess Supply = Q2 Q1
Market disequilibrium and eliminating excess
This time producers tried to lower their price
There is too much demand at Q2 and not enough supply at Q1
the market is in disequilibrium because there is excess demand
Q2 will be demanded but only Q1 will be supplied which means there
will be a shortage (suppliers will sell out)
There is a shortage off Q2 Q1

In order to eliminate the

S shortage producers have to
raise their prices
P As they do the quantity
demanded will fall
P1 Eventually demand and supply
will be equal again giving
D equilibrium
Q1 Q Q2 Quantity

Excess demand = Q2 Q1
The effects of changes in demand and
supply on the equilibrium
Previously we looked at factors that

Price of holidays
shift the demand curve and supply curve
these are outside disturbances (nothing
to do with the price although they will S1
change the price)
Now we need to look at what those
shifts do to the equilibrium price and
quantities P1
In real life lots of things may change at
the same time but to make it simple we
only deal with single changes and
assume that the ceteris paribus condition
is met D1
Ceteris paribus is Latin for all things Q1 Q2 Quantity of
being equal in other words nothing else holidays
has changed (days)
Lets take the example of an increase in
income for consumers of foreign holidays
When there is an increase in income
there will be an increase in the demand
for holidays
Ceteris paribus there will be a shift of
the demand curve to the right
The effects of changes in demand
and supply on the equilibrium

Price of holidays
Initially the price remains at the
equilibrium price
Q1 will be supplied S1
Q2 will be demanded
There will be excess demand (a P2
To get rid of the shortage prices will P1

need to rise
Until once again equilibrium is
restored but at a higher price of P2
The new equilibrium quantity is Q3 D1
Whenever there is a shift of the Q1 Q3 Q2 Quantity of
demand or supply curve the market (if (days)
it is left alone) will adjust to a new
equilibrium or market clearing price
Complete student workpoint 3.1
The role of the price mechanism
Resources are allocated and re-allocated Price mechanism
in response to changes in price = the forces of
supply and
If there is an increase in the price of a demand
good due to an increase in demand for the
good there is a signal to the producers
The price signal tells producers that
consumers wish to buy this good
We assume that producers are rational
and wish to maximise their profits
There is an incentive for them to produce
Producers allocate more resources to
those goods where the demand is highest
(they will make more profit)
There is not central planning agency
Adam Smith said it was like there was an
invisible hand moving the factors of
production around to produce the goods
and services wanted by the buyers in the
Market efficiency Consumer Surplus Consumer surplus = the
Watch the video extra satisfaction (or
utility) gained by
Consumer surplus video: consumers from paying a
http://www.youtube.com/wat price that is lower than
ch?feature=player_detailpag that they are prepared to
e&v=qTxniCLYgok pay
Market efficiency Producer surplus Producer surplus = the
Watch the video excess of actual earnings that
Read through page 38 a producer makes from a
Make notes given quantity of output, over
and above the amount the
Ask questions if you dont producer would be prepared
understand to accept for that output

Producer surplus
Allocative efficiency Allocative efficiency =
Allocative efficiency means that when a market is in
resources are allocated in the most equilibrium, with no
efficient way from societys point of view external influences, it is
This kind of efficiency is not the same said to be socially
as being efficient at operating like within a efficient or in a state of
firm. This is called productive efficiency allocative efficiency
and we will learn about that later
If we add consumer and producer
surplus together this is the community
Community surplus is the total benefit to
At the equilibrium community surplus is
This is the point of allocative efficiency
There is no other combination of price
or quantity that could give greater
community surplus
This is therefore the optimal allocation
of resources from the point of view of
society as a whole
Allocative efficiency Marginal social costs
The supply curve is (MSC) curve = the
largely determined by supply curve represents
the industrys costs of the marginal social cost
production curve when the costs to
When we assume that industry are equal to the
the costs of the industry costs of society
are equal to the costs to
society then the supply
curve represents the
social cost curve
When we analyse
efficiency we call this
the marginal social cost
curve (we will learn
more about this later)
Allocative efficiency Marginal social
The demand curve is benefits (MSB) curve =
determined by the utility, the demand curve
or benefits, that the represents the marginal
consumption of a good or social benefits curve
service brings to the when the benefits in the
consumers market are equivalent to
If we assume the the benefits to society
benefits in the market are
equal to the benefits to
society we can use the
demand curve to
represent the social
When we analyse
efficiency we refer to the
demand curve as the
marginal social benefit
curve (MSB)
Allocative efficiency
This is only a brief introduction to allocative efficiency
We will come back to it in a lot more detail later
In conclusion
A free market leads to allocative efficiency
Community surplus is maximised so it is the
optimum allocation of resources from societys point
of view
This occurs when demand is equal to supply or
marginal social costs are equal to marginal social

Before we get to the HL bit here is the homework

Homework for all
Complete the data response question
on P44 (copper)
Make sure you read the assessment
The HL bit!
Calculating and illustrating market
equilibrium using linear demand and
supply functions
If you are given the demand function and
the supply function you easily plot the
graphs of both and where they cross is the
Alternatively you can work out the
equilibrium using simultaneous equations
Work through page 39 to 43 and then
complete student workpoint 3.3