This page contains the NCERT Economics class 12 chapter 5 Market Equillibrium from Book I Introductory Microeconomics. You can find the solutions for the chapter 5 of NCERT class 12 Economics, for the Short Answer Questions, Long Answer Questions and Projects/Assignments Questions in this page. So is the case if you are looking for NCERT class 12 Economics related topic Market Equillibrium question and answers.
Exercises
1. Explain market equilibrium.
Market equilibrium is the condition in a perfectly competitive market where the quantity demanded by consumers equals the quantity supplied by producers, resulting in no excess supply or demand. The equilibrium price is the price at which this balance is achieved, and at this price, the market clears, meaning all goods produced are sold.
2. When do we say there is excess demand for a commodity in the market?
We say there is excess demand for a commodity in the market when the quantity demanded by consumers at a certain price exceeds the quantity supplied by producers. This situation typically occurs when the market price is below the equilibrium price, leading to a shortage of the commodity.
3. When do we say there is excess supply for a commodity in the market?
We say there is excess supply for a commodity in the market when the quantity supplied by producers at a certain price exceeds the quantity demanded by consumers. This typically occurs when the market price is above the equilibrium price, leading to a surplus of the commodity.
4. What will happen if the price prevailing in the market is
(i)
above the equilibrium price?
(ii)
below the equilibrium price?
If the price prevailing in the market is:
(i)
Above the Equilibrium Price:There will be excess supply, as producers are willing to supply more of the commodity than consumers are willing to buy at that price. This surplus may lead to unsold goods, prompting producers to lower their prices to increase demand and reduce the excess supply, moving the market back towards equilibrium.
(ii)
Below the Equilibrium Price:There will be excess demand, as consumers are willing to purchase more of the commodity than producers are willing to supply at that low price. This shortage may lead to consumers competing for the limited goods, which can drive the price up as producers respond to the increased demand, again moving the market towards equilibrium.
5. Explain how price is determined in a perfectly competitive market with fixed number of firms.
Here is how price is determined in a perfectly competitive market with a fixed number of firms:
1.
Market Demand and Supply:The market demand curve, derived from the preferences of price-taking consumers, and the market supply curve, derived from the profit-maximizing behavior of price-taking firms, determine the market conditions. The market demand curve indicates the total quantity that all consumers in the market wish to buy at various prices, while the market supply curve shows how much of the commodity firms wish to supply at different prices.
2.
Equilibrium:Equilibrium in the market is achieved when the quantity that all firms wish to sell equals the quantity that all consumers wish to buy; in other words, when market supply equals market demand. The price at which this equilibrium is reached is the equilibrium price, and the quantity bought and sold at this price is the equilibrium quantity.
3.
Price Determination:The equilibrium price (p^*) is determined at the point where the market demand (q^D^(p^*)) equals the market supply (q^S^(p^*)). This is graphically represented as the point where the market supply curve intersects the market demand curve.
4.
Out-of-Equilibrium Behavior:If the market is not in equilibrium, meaning the market supply does not equal market demand, there will be a tendency for the price to change. An ‘Invisible Hand’, as conceptualized by Adam Smith, operates in such a way that it raises prices in the case of excess demand and lowers them in the case of excess supply, driving the market towards equilibrium.
5.
Fixed Number of Firms:With a fixed number of firms, the market supply curve is less flexible. Any shifts in demand or supply will result in changes in the equilibrium price and quantity. However, the equilibrium price will always be at a level where firms are earning normal profits, as no new firms can enter to drive the price down, nor can existing firms exit to drive the price up.
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?
When there is free entry and exit of firms in a perfectly competitive market and the price is above the minimum average cost, the market will adjust as follows:
1.
Attraction of New Firms:The price being greater than the minimum average cost means that firms are earning supernormal profits. This attracts new firms into the market.
2.
Shift in Market Supply Curve:As new firms enter, the market supply curve shifts rightward, increasing the total quantity supplied at each price level.
3.
Reduction in Market Price:The increase in supply, with demand remaining constant, leads to a surplus at the current price, which puts downward pressure on the price.
4.
Elimination of Supernormal Profits:The market price continues to fall until it reaches the point where it is equal to the minimum average cost. At this price level, firms earn only normal profits.
5.
Stabilization of Firm Entry/Exit:With the price equal to the minimum average cost, there is no longer an incentive for new firms to enter the market, and existing firms do not have a reason to exit since they are not incurring losses.
6.
New Equilibrium:The market reaches a new equilibrium where the market price equals the minimum average cost, and firms earn normal profits. The quantity supplied at this price is determined by the market demand.
7.
Equilibrium Price Equals Minimum Average Cost:With free entry and exit, the equilibrium price in the market will always be equal to the minimum average cost of the firms, ensuring that firms earn normal profits and the market operates efficiently.
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?
Price Determination with Free Entry and Exit. With free entry and exit in a perfectly competitive market, the equilibrium price is always equal to min AC and the equilibrium quantity is determined at the intersection of the market demand curve DD with the price line p = min AC.
–
Price Level for Supply:In a perfectly competitive market with free entry and exit, firms supply at a price level equal to the minimum average cost (min AC). This ensures that firms earn normal profits and there is no incentive for new firms to enter or for existing firms to exit the market.
–
Equilibrium Quantity Determination:The equilibrium quantity is determined by the market demand at the price level equal to the minimum average cost. The market will supply the quantity that is demanded by consumers at this price. If the market demand curve shifts, the equilibrium quantity will change, but the price will remain at the minimum average cost due to the entry and exit of firms adjusting the supply.
8. How is the equilibrium number of firms determined in a market where entry and exit is permitted?
The equilibrium number of firms in a market where entry and exit are permitted is determined by the market’s demand at the price level that equals the minimum average cost (min AC) of the firms. Here’s the step-by-step process.
1.
Equilibrium Price:The market reaches an equilibrium price that is equal to the minimum average cost of the firms. At this price, firms earn normal profits, which is the minimum profit necessary to keep them in the market.
2.
Market Demand at Equilibrium Price:The equilibrium quantity demanded by the market at this price is determined by the market demand curve.
3.
Firm’s Supply at Equilibrium Price:Each firm supplies a certain quantity at the equilibrium price, which is determined by their individual supply curves.
4.
Total Quantity Supplied:The total quantity supplied in the market is the sum of the quantities supplied by all the firms.
5.
Number of Firms:The equilibrium number of firms is then calculated by dividing the total quantity demanded by the quantity supplied by a single firm.
Mathematically, it is expressed as
{n₀ = \dfrac{q₀}{q_{0f}}},
where
–
n₀ is the equilibrium number of firms,
–
q₀ is the total quantity demanded, and
–
q_{0f} is the quantity supplied by a single firm at the equilibrium price.
This process ensures that the market can accommodate all the firms that wish to operate at the equilibrium price, and all the goods that are produced can be sold at this price. The entry or exit of firms will continue until the market reaches this state of equilibrium.
9. How are equilibrium price and quantity affected when income of the consumers
(a)
increase?
(b)
decrease?
(a)
Increase in Consumer Income:
Effect on equillibrium price and quantity when consumer income increases.
–
For a normal good, an increase in consumer income, with all other factors held constant, will lead to an increase in demand at each price level.
–
This results in a rightward shift of the market demand curve.
–
The supply curve remains unchanged as it is not directly affected by changes in consumer income.
–
The new equilibrium will be at a higher price and a higher quantity demanded and supplied, as shown by the shift from DD₀ to DD₂ in above figure.
(b)
Decrease in Consumer Income:
Effect on equillibrium price and quantity when consumer income decreases.
–
For a normal good, a decrease in consumer income would lead to a decrease in demand at each price level.
–
This results in a leftward shift of the market demand curve.
–
Again, the supply curve remains unchanged because it is not directly affected by changes in consumer income.
–
The new equilibrium will be at a lower price and a lower quantity demanded and supplied, as the demand curve shifts from DD₀ to DD₁ in the above figure.
For an inferior good, the effects would be opposite. An increase in income would decrease the demand, shifting the demand curve leftward, leading to a lower equilibrium price and quantity. Conversely, a decrease in income would increase the demand, shifting the demand curve rightward, resulting in a higher equilibrium price and quantity.
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.
The following is the graph depicting the effect of the increase in the price of the shoes on the price of a pair of socks and ht enumber of pairs of socks bough and sold.
Supply and Demand curves depicting 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.
The following is the analysis:
1.
Substitute Goods:If we assume that shoes and socks are complementary goods (goods that are often used together), then an increase in the price of shoes would likely decrease the demand for shoes.
2.
Decreased Demand for Complements:As the demand for shoes decreases, the demand for socks is also likely to decrease because consumers are buying fewer shoes and, therefore, need fewer socks.
3.
Shift in Demand Curve for Socks:This decrease in demand for socks would be represented by a leftward shift in the demand curve for socks. So, the demand curve is moved left from DD₀ to DD₁.
4.
New Equilibrium for Socks:The new equilibrium (where the demand curve for socks intersects the supply curve) would be at a lower price and quantity for socks than before the price of shoes increased. Decreased from P₀ to P₁.
5.
Quantity Bought and Sold:The number of pairs of socks bought and sold would decrease as a result of the decrease in demand. Decreased from q₁ to q’₀.
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.
Diagram depicting the effect of increase in the price of coffee and the equillibrium price of tea.
As we know, coffee and tea are substitute goods. In otherwords, an increase in the price of coffee will affect the demand for tea in the following way:
1.
Initial Equilibrium:Let’s start with the initial equilibrium where the demand curve for tea is DD₀ and the supply curve is SS₀. The market is in equilibrium at price P₀ with quantity q₀.
2.
Change in Price of Coffee:When the price of coffee increases, consumers will start looking for a substitute, which is tea in this case.
3.
Demand Curve Shift:The demand curve for tea shifts to the right from DD₀ to DD₂ as consumers substitute tea for the now more expensive coffee.
4.
New Equilibrium:The new equilibrium is established at a higher price P₂ with a higher quantity q₂. This is because the new demand curve DD₁ intersects the supply curve SS₀ at the point G.
5.
Further Shifts:If the price of coffee continues to rise or if tea becomes more popular for other reasons, the demand might shift further to the right, leading to yet another new equilibrium with an even higher price and quantity.
6.
Equilibrium Quantity:Each new equilibrium point after the demand shift indicates a higher quantity being bought and sold in the market. The movement from q₀ to q₂ and further represents this increase in equilibrium quantity due to the shifts in demand.
7.
Price Levels:Correspondingly, the price level moves from P₀ to P₁ and beyond, reflecting the higher prices at each new equilibrium point due to the increased demand for tea as a substitute for coffee.
12. How do the equilibrium price and quantity of a commodity change when price of input used in its production changes?
When the price of an input used in the production of a commodity increases, it affects the cost of production for the firms. This change is reflected in the supply curve as follows:
Effect on equillibrium price and quantity when consumer income decreases.
1.
Increase in Input Price:An increase in the price of an input results in an increase in the marginal cost of production for firms using this input.
2.
Shift in Supply Curve:Consequently, the supply curve shifts leftward from SS₀ to SS₂ because, at each price, the market supply will be less than before due to the higher cost of production.
3.
Demand Curve Unchanged:The demand curve remains unchanged at DD₀ since consumer demand does not directly depend on the input prices.
4.
New Equilibrium:The new market equilibrium, compared to the old equilibrium, will be at a higher price P₂ and a lower quantity produced q₂. This is because the new supply curve SS₂ intersects the unchanged demand curve DD₀ at a higher price level and a lower quantity than before which indicated by the new equillibrium point G.
5.
Diagrammatic Representation:In the diagram, this would be shown by the original supply curve SS₀ shifting to the left to become SS₂, while the demand curve DD₀ remains stationary. The initial equilibrium point would move up (from point E)along the demand curve to a higher price and to the left to a lower quantity (to point G).
6.
Effect on Price and Quantity:The market price rises due to the decreased supply at each price level, and the quantity produced decreases because of the higher input costs.
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?
When the price of a substitute good (Y) increases, it affects the demand for good X as follows:
Impact of Price Increase in Substitute Good Y on Equilibrium Price and Quantity of Good X.
1.
Increase in Price of Substitute (Y):An increase in the price of good Y makes it less attractive to consumers, leading them to look for alternatives.
2.
Shift in Demand for Good X:As good X is a substitute for good Y, the demand for good X will increase because consumers will start switching from good Y to good X.
3.
Demand Curve for Good X:The demand curve for good X will shift to the right from DD₀ to DD₁, indicating an increase in demand at each price level.
4.
New Equilibrium for Good X:The new equilibrium will be established at a higher price and quantity for good X. This is because the new demand curve DD₁ intersects the original supply curve SS₀ at a higher price level (P₂) and a higher quantity (q₂) than before. The new equillibrium point moves from E to G as shown in the figure above.
5.
Equilibrium Price and Quantity:The equilibrium price for good X increases from P₀ to P₂, and the equilibrium quantity increases from q₀ to q₂.
6.
Effect on Price and Quantity:The market price for good X rises due to the increased demand, and the quantity of good X bought and sold in the market increases as well.
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.
Here is the comparison of the effect of a shift in the demand curve on the equilibrium when the number of firms in the market is fixed versus when entry and exit are permitted:
Aspect of Market Equilibrium
Fixed Number of Firms
Free Entry and Exit of Firms
Equilibrium Price
Changes with shifts in demand; can increase or decrease depending on the direction of the shift.
Remains constant at the minimum average cost in the long run, as new firms enter or exit to eliminate supernormal profits or losses.
Equilibrium Quantity
Adjusts to new demand but is limited by the capacity of existing firms. Quantity changes can be less flexible due to the fixed number of firms.
Highly responsive; adjusts as new firms enter or existing firms exit, allowing quantity to fully adapt to the new demand level.
Profit Levels
Can experience temporary supernormal profits or losses due to demand shifts, as the number of firms is fixed and cannot adjust immediately.
Firms earn only normal profits in the long run, as entry and exit of firms ensure that profits are normalized.
Number of Firms
Remains constant regardless of demand shifts, as the assumption is that firms cannot enter or exit the market freely.
Changes in response to demand; increases with higher demand as new firms are attracted by supernormal profits, decreases with lower demand as firms exit due to losses.
Supply Flexibility
Limited due to the fixed number of firms. The market cannot adjust the number of firms in response to demand shifts.
High, as the market can expand or contract with the entry or exit of firms, leading to a more flexible supply.
Response to Demand Shifts
Immediate impact on prices and limited impact on quantity, as firms cannot enter or exit to adjust supply.
No impact on prices in the long run, significant impact on quantity, as the market adjusts the number of firms to meet the new demand.
15. Explain through a diagram the effect of a rightward shift of both the demand and supply curves on equilibrium price and quantity.
The effect of a rightward shift of both the demand and supply curves on equilibrium price and quantity can be explained with the help of a diagram as follows:
Simultaneous Shifts in Demand and Supply: Initially the equillibrium is at E where the demand curve DD₀ and supply curve SS₀ intersect. When both the supply and the demand curves shift rightward leaving price unchanged but a higher equillibrium quantity.
Simultaneous Shifts in Demand and Supply: Initially the equillibrium is at E where the demand curve DD₀ and supply curve SS₀ intersect. When both the supply and the Demand curves shift rightward (shift in demand is more than shift in supply) leaving price increased along with a higher equillibrium quantity.
Simultaneous Shifts in Demand and Supply: Initially the equillibrium is at E where the demand curve DD₀ and supply curve SS₀ intersect. When both the supply and the Demand curves shift rightward (shift in supply is more than shift in demand) leaving price decreased along with a higher equillibrium quantity.
1.
Initial Equilibrium:The initial equilibrium is established at the point E where the original demand curve (DD₀) and supply curve (SS₀) intersect. This point determines the original equilibrium price (p₀) and quantity (q₀).
2.
Rightward Shift in Demand:When the demand curve shifts rightward to DD₁, it indicates that at any given price, consumers are now willing to purchase more of the good than before. This creates excess demand at the original equilibrium price.
3.
Response to Excess Demand:Due to the excess demand at price p₀, some consumers are willing to pay a higher price, leading to an increase in the price. The new equilibrium is established at a higher price (p₁) where the new demand curve (DD₁) intersects the original supply curve (SS₀). The new equilibrium quantity (q₂) is greater than the original quantity (q₀).
4.
Rightward Shift in Supply:Simultaneously, if the supply curve also shifts rightward to SS₁, it means that at any given price, suppliers are now willing to offer more of the good than before, perhaps due to improvements in technology or a decrease in production costs.
5.
New Equilibrium:The intersection of the new demand curve (DD₁) and the new supply curve (SS₁) determines the final equilibrium. The final equilibrium quantity will be higher than both the original and the intermediate quantities (q₀ and q₂). However, the final equilibrium price may be higher, lower, or the same as the original equilibrium price (p₀), depending on the relative magnitudes of the shifts in demand and supply.
In conclusion, a rightward shift in both demand and supply curves will definitely lead to an increase in the equilibrium quantity. The equilibrium price, however, will depend on the relative shifts of the demand and supply curves. If the shift in the supply curve is larger than the shift in the demand curve, the price may decrease or remain unchanged. If the shift in demand is larger, the price may increase.
16. How are the equilibrium price and quantity affected when
(a) both demand and supply curves shift in the same direction?
(b) demand and supply curves shift in opposite directions?
(a) both demand and supply curves shift in the same direction?
(b) demand and supply curves shift in opposite directions?
When both demand and supply curves shift in the same direction or in opposite directions, the equilibrium price and quantity are affected in the following ways:
Impact of Simultaneous Shifts on Equilibrium
Shift in Demand
Shift in Supply
Quantity
Price
Leftward
Leftward
Decreases
May increase, decrease or remain unchanged
Rightward
Rightward
Increases
May increase, decrease or remain unchanged
Leftward
Rightward
May increase, decrease or remain unchanged
Decreases
Rightward
Leftward
May increase, decrease or remain unchanged
Increases
Here is an explanation of these changes:
(a)
Both Demand and Supply Curves Shift in the Same Direction:
–
Rightward Shift:If both the demand and supply curves shift to the right, the equilibrium quantity will invariably increase. However, the equilibrium price may increase, decrease, or remain unchanged depending on the relative magnitudes of the shifts in the demand and supply curves.
–
Leftward Shift:If both curves shift to the left, the equilibrium quantity will decrease. Similar to the rightward shift, the equilibrium price may increase, decrease, or remain unchanged, again depending on the magnitudes of the shifts.
(b)
Demand and Supply Curves Shift in Opposite Directions:
–
Demand Shifts Rightward and Supply Shifts Leftward:In this case, the equilibrium price will increase because the increase in demand tends to raise the price, and the decrease in supply also tends to raise the price. The effect on the equilibrium quantity will depend on which shift is greater; if the demand increase is greater than the supply decrease, the quantity will increase, and vice versa.
–
Demand Shifts Leftward and Supply Shifts Rightward:Here, the equilibrium price will decrease because the decrease in demand tends to lower the price, and the increase in supply also tends to lower the price. The effect on the equilibrium quantity will again depend on the relative magnitudes of the shifts.
These outcomes are summarized in the above table, which outlines the impact of simultaneous shifts on equilibrium. The table indicates that while the direction of change in equilibrium quantity is certain when both curves shift in the same direction, the change in equilibrium price is uncertain and depends on the relative shifts. Conversely, when the curves shift in opposite directions, the change in price is certain, but the change in quantity depends on the magnitude of the shifts.
17. In what respect do the supply and demand curves in the labour market differ from those in the goods market?
The supply and demand curves in the labour market differ from those in the goods market in several respects as specified below:
Aspect
Labour Market
Goods Market
Source of Supply
Households supply labour.
Firms supply goods.
Source of Demand
Firms demand labour.
Households demand goods.
Nature of Commodity
Labour refers to hours of work, not a tangible product.
Goods are tangible products that can be consumed.
Wage/Price Determination
Determined at the intersection of the labour demand and supply curves.
Determined at the intersection of the goods demand and supply curves.
Supply Curve
Can be backward bending; higher wages might lead to less labour supplied.
Typically upward sloping; higher prices usually lead to more goods supplied.
Demand Curve
Downward sloping due to the law of diminishing marginal product.
Downward sloping; consumers buy less as price increases.
Adjustments in Supply
May not adjust immediately due to contracts, skill mismatches, etc.
Can often adjust more quickly to price changes.
Elasticity
Influenced by employment options, unionization, etc.
Influenced by availability of substitutes, necessity, etc.
This table summarizes the primary differences in how the supply and demand curves function in the labour market versus the goods market.
18. How is the optimal amount of labour determined in a perfectly competitive market?
The optimal amount of labour in a perfectly competitive market is determined by the intersection of the demand and supply curves for labour, incorporating the Marginal Revenue Product of Labour (MRPL ). Here’s a detailed explanation:
Wage is determined at the point where the labour demand and supply curves intersect.
1.
Profit Maximization: Firms aim to maximize profits by employing labour up to the point where the extra cost of employing the last unit of labour equals the additional benefit earned from that unit.
2.
Wage Rate (w): The wage rate represents the extra cost of hiring one more unit of labour.
3.
Marginal Product of Labour (MPL ): This is the additional output produced by employing one more unit of labour.
4.
Marginal Revenue (MR): This is the additional revenue the firm earns from selling the output produced by the additional unit of labour.
5.
Marginal Revenue Product of Labour (MRPL ): For each extra unit of labour, the firm gets an additional benefit equal to the marginal revenue times the marginal product, which is expressed as MRPL = MR × MPL. This is the value of the output produced by the last unit of labour employed.
6.
Hiring Decision: The firm will hire labour up to the point where the wage rate equals the Marginal Revenue Product of Labour, i.e., w = MRPL.
7.
Value of Marginal Product (VMPL ): In a perfectly competitive market, the marginal revenue is equal to the price of the commodity, so the Marginal Revenue Product of Labour is also known as the Value of Marginal Product of Labour.
8.
Labour Supply Decision: Households determine how much labour to supply at a given wage rate, balancing their preference for income against their preference for leisure.
9.
Equilibrium Wage Rate: The equilibrium wage rate is where the labour supply equals the labour demand. At this rate, the households’ desire to supply labour matches the firms’ desire to hire.
10.
Market Equilibrium: The market for labour reaches equilibrium at the wage rate where the quantity of labour supplied by households equals the quantity demanded by firms, ensuring that the wage rate equals the Value of Marginal Product of Labour.
In summary, the optimal amount of labour is determined at the point where the wage rate equals the Marginal Revenue Product of Labour, ensuring that the quantity of labour supplied by households is equal to the quantity demanded by firms, leading to an equilibrium in the labour market.
19. How is the wage rate determined in a perfectly competitive labour market?
In a perfectly competitive labour market, the wage rate is determined through the interaction of the demand for labour by firms and the supply of labour by households. The process is as follows:
Wage is determined at the point where the labour demand and supply curves intersect.
1.
Profit Maximization: Firms seek to maximize profits by employing labour up to the point where the extra cost of employing an additional unit of labour (the wage rate, w) is equal to the additional revenue generated from that unit.
2.
Wage Rate (w): The wage rate is the cost to the firm for hiring one more unit of labour.
3.
Marginal Product of Labour (MPL ): This is the additional output produced by employing one more unit of labour.
4.
Marginal Revenue (MR): This is the additional revenue the firm earns from selling the output produced by the additional unit of labour.
5.
Marginal Revenue Product of Labour (MRPL ): This is calculated as the Marginal Revenue (MR) multiplied by the Marginal Product of Labour (MPL ), which can be represented by the formula MRPL = MR × MPL. It represents the additional benefit the firm receives from hiring an extra unit of labour.
6.
Equilibrium Wage Rate: The equilibrium wage rate is determined at the point where the wage rate equals the Marginal Revenue Product of Labour, i.e., w = MRPL. At this point, the quantity of labour supplied by households is equal to the quantity of labour demanded by firms.
7.
Supply and Demand Balance: The wage rate is set where the demand for labour (which is based on the MRPL ) intersects with the supply of labour from households. Households make their supply decisions based on the trade-off between earning income and enjoying leisure.
8.
Market Equilibrium: The labour market reaches equilibrium when the wage rate aligns with the value of the marginal product of labour, ensuring that the quantity of labour supplied matches the quantity demanded.
In essence, the wage rate in a perfectly competitive labour market is determined at the point where the supply of labour from households intersects with the demand for labour from firms, and this is where the wage rate equals the Marginal Revenue Product of Labour, following the formula MRPL = MR × MPL.
20. Can you think of any commodity on which price ceiling is imposed in India? What may be the consequence of price-ceiling?
In India, a common example of a commodity on which a price ceiling is imposed is wheat. The government often sets maximum prices for essential commodities like wheat, rice, kerosene, sugar, etc., to make them affordable for the entire population. These price ceilings are usually set below the market-clearing price.
The consequences of imposing a price ceiling can include:
1.
Shortages: When the price is kept below the equilibrium level, the quantity demanded exceeds the quantity supplied, leading to shortages.
2.
Rationing: To manage the limited supply, the government may have to resort to rationing, issuing coupons that allow individuals to purchase only a certain amount of the commodity.
3.
Long Queues: Consumers may have to wait in long lines to purchase the goods from ration shops, also known as fair price shops.
4.
Black Markets: Due to the shortage, some consumers may be willing to pay a higher price, leading to the creation of black markets where the commodity is sold at higher prices.
5.
Quality Reduction: Suppliers may reduce the quality of the goods since they cannot compete on price, leading to a decrease in overall welfare.
6.
Misallocation of Resources: Price ceilings can lead to a misallocation of resources as producers may move away from producing the price-controlled item to more profitable alternatives.
7.
Reduced Supply in the Long Run: Over time, the artificially low prices may discourage producers from investing in the production of the commodity, leading to a reduced supply.
These consequences highlight the potential adverse effects of price ceilings, despite the good intentions behind their implementation.
21. A shift in demand curve has a larger effect on price and smaller effect on quantity when the number of firms is fixed compared to the situation when free entry and exit is permitted. Explain.
How a shift in the demand curve affects price and quantity in markets with a fixed number of firms versus those with free entry and exit is explained below:
Fixed Number of Firms:
Rightward Shift in Demand
Effect of rightward shift in demand on equillibrium price when the number of firms is fixed.
A rightward shift indicates an increase in quantity demanded at any given price. The supply curve remains unchanged due to the fixed number of firms, leading to excess demand at the initial price and a subsequent rise in the equilibrium price. The quantity increases, but only to the extent that the existing firms can increase production.
Leftward Shift in Demand
Effect of leftward shift in demand on equillibrium price when the number of firms is fixed.
Conversely, a leftward shift means a decrease in quantity demanded. With no change in the supply curve, there is now excess supply at the initial price, causing the equilibrium price to fall. The quantity decreases, limited by the inability of the fixed number of firms to reduce supply quickly.
Free Entry and Exit of Firms
Rightward Shift in Demand
Effect of rightward shift in demand on equillibrium price when When Free Entry and Exit of Firms is Permitted
Here, the increased demand leads to higher potential profits, attracting new firms and shifting the supply curve rightward. This moderates the increase in price due to the rightward shift in demand. The equilibrium quantity increases significantly as new firms enter the market.
Leftward Shift in Demand
Effect of rightward shift in demand on equillibrium price when When Free Entry and Exit of Firms is Permitted.
A decrease in demand leads to lower potential profits, causing some firms to exit the market and the supply curve to shift leftward. This lessens the decrease in price due to the leftward shift in demand. The equilibrium quantity decreases as firms leave the market, but the price does not fall as sharply as it would with a fixed number of firms.
Comparative Dynamics:
The key difference between the two scenarios lies in the supply side’s flexibility. In a market with a fixed number of firms, supply is inelastic in the short term, so price changes are more volatile in response to demand shifts. In contrast, markets that allow free entry and exit have a more elastic supply, which can adjust to changes in demand, resulting in less volatile price movements and more significant changes in quantity.
Market Efficiency and Welfare:
In both scenarios, the market strives to reach a new equilibrium efficiently. However, the welfare implications can differ. Price volatility can lead to consumer and producer surpluses changing more dramatically in fixed-number markets, while more elastic markets tend to see a smoother adjustment with potentially less impact on surplus distributions.
In conclusion, the impact of demand shifts on price and quantity is significantly influenced by the market structure, particularly the ability of the supply side to adjust to new market conditions. Fixed-number markets experience greater price volatility, while free-entry markets adjust more through quantity changes, leading to different economic outcomes and welfare implications.
22. Suppose the demand and supply curve of commodity X in a perfectly competitive market are given by:
qD
= 700 – p
qS
= 500 + 3p for p ≥ 15
= 0 for 0 ≤ p < 15
Assume that the market consists of identical firms. Identify the reason behind the market supply of commodity X being zero at any price less than ₹ 15. What will be the equilibrium price for this commodity? At equilibrium, what quantity of X will be produced?
The reason behind the market supply of commodity X being zero at any price less than ₹ 15.
The market supply of commodity X being zero at any price less than ₹ 15 is due to the fact that firms are not willing to supply any quantity of the commodity at prices below ₹ 15. This could be because ₹ 15 is the minimum price at which firms can cover their variable costs. If the price is below this level, firms would choose not to produce at all rather than incur losses. This price ₹ 15 is likely to be the shutdown point in the short run, which is the minimum price at which a firm covers its variable costs.
To find the equilibrium price and quantity for commodity X, we set the quantity demanded equal to the quantity supplied (qD = qS) and solve for the price (p).
To find the quantity of X at equillbrium:
Given the demand and supply functions:
qD
= 700 – p
qS
= 500 + 3p for p ≥ 15
At equilibrium:
700 – p = 500 + 3p
Solving for p:
700 – 500 = 3p + p
⇒ 200 = 4p
⇒ p = {\dfrac{200}{4}}
⇒ p = 50
∴ The equilibrium price is ₹ 50.
Now, we can find the equilibrium quantity by substituting the equilibrium price back into either the demand or supply equation.
Using the demand equation:
qD
= 700 – p
= 700 – 50
= 650
At the equilibrium price of ₹ 50, the quantity of commodity X that will be demanded/produced/supplied is 650 units.
23. Considering the same demand curve as in exercise 22, now let us allow for free entry and exit of the firms producing commodity X. Also assume the market consists of identical firms producing commodity X. Let the supply curve of a single firm be explained as
qSf
= 8 + 3p
for p ≥ 20
= 0
for 0 ≤ p < 20
(a)
What is the significance of p = 20?
(b)
At what price will the market for X be in equilibrium? State the reason for your answer.
(c)
Calculate the equilibrium quantity and number of firms.
(a) The significance of p = 20 in the supply curve of a single firm:
The price p = 20 represents the minimum price at which a single firm starts to supply commodity X. Below this price, which is min AC, the firm’s supply is zero. This could be interpreted as the minimum price at which the firm can cover its variable costs and possibly some or all of its fixed costs. If the market price is below p = 20, the firm would not find it profitable to produce any output. Therefore, p = 20 can be seen as the break-even point for the firm, below which it would choose not to operate.
(b) The price at which the market for X will be in equillibrium.
To determine the market equilibrium price when there is free entry and exit of firms, we need to consider the market supply curve, which is the horizontal sum of all individual firms’ supply curves. Since the market consists of identical firms, the market supply curve will start from the same price that an individual firm’s supply curve starts from, which is p = 20.
However, we also need to consider the demand curve and where it intersects with the market supply curve to find the equilibrium price. The demand curve is given by qD = 700 – p.
In a perfectly competitive market with free entry and exit, firms will enter or exit the market until the price is equal to the minimum of the average cost i.e., min AC. Since the supply curve of a single firm is given by qSf = 8 + 3p for p ≥ 20, and this represents the marginal cost curve for the firm, the price will also gravitate towards the minimum point of the average cost curve, which is typically where the marginal cost curve starts to rise, at p = 20.
Therefore, we can infer that the market for X will be in equilibrium at p = 20, because at this price, firms are just willing to supply commodity X, and no firm is making enough profit to attract new firms into the market, nor are they making a loss which would cause them to exit the market. This is the price at which the market supply equals market demand, and the system is in equilibrium.
c) To calculate the equillibrium quantity and the number of firms.
To find the equilibrium quantity, we would substitute p = 20 into the demand equation:
qD
= 700 – p
= 700 – 20
= 680
So, the equilibrium quantity demanded in the market is 680 units.
Now, let’s determine the supply of a single firm at the equilibrium price using the supply curve of a single firm:
qSf = 8 + 3p for p ≥ 20
Substituting p = 20 into the firm’s supply function:
qSf
= 8 + 3(20)
= 8 + 60
= 68
Each firm will supply 68 units of commodity X at the equilibrium price of p = 20.
To find the number of firms (N) in the market, we divide the total quantity demanded at equilibrium by the quantity supplied by a single firm:
N
{= \dfrac{q^D}{q^S_f}}
{= \dfrac{680}{68}}
= 10
Therefore, at the equilibrium price of p = 20, the equilibrium quantity is 680 units, and there would be 10 firms in the market each supplying 68 units.
24. Suppose the demand and supply curves of salt are given by:
qD = 1,000 – p
qS = 700 + 2p
(a)
Find the equilibrium price and quantity.
(b)
Now suppose that the price of an input used to produce salt has increased so that the new supply curve is
qS = 400 + 2p
How does the equilibrium price and quantity change? Does the change conform to your expectation?
(c)
Suppose the government has imposed a tax of ₹ 3 per unit of sale of salt. How does it affect the equilibrium price and quantity?
To solve these problems, we’ll use the basic principle that at equilibrium, the quantity demanded (qD) is equal to the quantity supplied (qS).
(a) To find the equillibrium price and quantity:
To find the original equilibrium price and quantity for salt, we set the original demand and supply equations equal to each other:
Given that
qD = 1,000 – p
qS = 700 + 2p
At equilibrium:
1,000 – p = 700 + 2p
⇒ 1,000 – 700 = 2p + p
⇒ 300 = 3p
⇒ p = {\dfrac{300}{3}}
⇒ p = 100
The equilibrium price is ₹ 100.
Now we can find the equilibrium quantity by substituting the equilibrium price back into either the demand or supply equation:
qD
= 1,000 – 100
= 900
So, the equilibrium quantity is 900 units.
(b) Impact on the equillibrium price and quantity when there is an increase in the price of an input
If the price of an input used to produce salt has increased, as per the problem, the new supply curve becomes:
qS = 400 + 2p
To find the new equilibrium, we set the new supply equal to the original demand:
1,000 – p = 400 + 2p
⇒ 1,000 – 400 = 2p + p
⇒ 600 = 3p
⇒ p = {\dfrac{600}{3}}
⇒ p = 200
The new equilibrium price is ₹ 200.
Now we find the new equilibrium quantity:
qD
= 1,000 – 200
= 800
So, the new equilibrium quantity is 800 units.
The increase in the price of an input leads to a decrease in supply, which, as expected, increases the equilibrium price and decreases the equilibrium quantity.
(c) Impact of unit tax on the price and quantity:
If the government imposes a tax of ₹ 3 per unit of sale of salt, this effectively increases the cost of supplying salt and shifts the supply curve upwards by ₹ 3 at each quantity. The new supply equation will reflect the tax by subtracting it from the supply price:
qS
= 700 + 2(p – 3)
= 700 + 2p – 6
= 694 + 2p
Setting this new supply equal to the original demand to find the new equilibrium:
1,000 – p = 694 + 2p
⇒ 1,000 – 694 = 2p + p
⇒ 306 = 3p
⇒ p = {\dfrac{306}{3}}
⇒ p = 202
The new equilibrium price before tax is ₹ 102.
The equilibrium quantity is:
qD
= 1,000 – 102
= 898
So, the new equilibrium quantity after the tax is 898 units,. The imposition of the tax decreases the equilibrium quantity further and increases the price that consumers pay, which is consistent with the expected effects of a tax on a commodity.
25. Suppose the market determined rent for apartments is too high for common people to afford. If the government comes forward to help those seeking apartments on rent by imposing control on rent, what impact will it have on the market for apartments?
If the government imposes rent control, setting a maximum price for apartments that is below the market-determined rent, it will have several impacts on the market for apartments:
1.
Shortage of Apartments: Since the controlled rent is lower than the equilibrium price, the quantity demanded for apartments will increase, while the quantity supplied will decrease. Landlords may not be as willing to rent out their property at the lower price, leading to a shortage of available apartments.
2.
Quality Deterioration: Landlords may not have the same incentives to maintain or improve their properties if they cannot charge what they deem to be a fair market price. Over time, this could lead to a deterioration in the quality of rental apartments.
3.
Black Market: A black market for apartments could emerge, with some landlords offering apartments at higher prices outside of the official market. This could lead to discrimination and a lack of fairness in who gets to rent an apartment.
4.
Reduced Investment: Investors may be less likely to build new apartments or maintain existing ones if they cannot earn a reasonable return on their investment due to rent control. This can exacerbate the shortage of housing over time.
5.
Misallocation of Apartments: Rent control can lead to a misallocation of housing. People who might otherwise move to smaller units as their needs change may choose to stay in larger apartments because the rent is artificially low. This can prevent those larger apartments from being available to larger families who need the space.
6.
Long-Term Shortages: In the long term, the supply of apartments may decrease as developers choose to invest in more profitable ventures. Existing buildings may be converted to condominiums, offices, or other types of real estate that are not subject to rent control.
7.
Waiting Lists and Reduced Mobility: With more people wanting to rent at the lower price, waiting lists can grow longer, and people may find it harder to move to the city or to different parts of the city. This reduced mobility can have negative effects on the labor market and economic dynamism.
In summary, while rent control is often implemented with the intention of making housing more affordable for the common people, it can lead to unintended consequences that may worsen the situation over time. It’s a classic example of how price ceilings can distort market outcomes, leading to shortages and reduced quality of the goods being regulated—in this case, apartments.