CU Ecoh Demand and Supply Part A

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C o n c e p t s o f D e m a n d , D e m a n d F u n c t i o n , S u p p l y, S u p p l y F u n c t i o n , M a r k e t
E q u i l i b r i u m , I m p a c t o f c h a n g e s i n D e m a n d a n d S u p p l y, S t a b i l i t y o f E q u i l i b r i u m .
Since economics is concerned with the workings of the price mechanism, it is important to know
about the institution at the centre of that mechanism: the market.
A market is an institutional arrangement under which buyers and sellers can

exchange some quantity of a good or service at a mutually agreeable price. In other
words, a market is a mechanism by which buyers and sellers interact to determine
the price and quantity of a good or service. Those who purchase commodities or
services in the market are known as buyers or demanders and those who sell these
are called sellers or suppliers.
Demand can be defined as the desire for a good backed by adequate

purchasing power. In other words, demand is a desire of an individual for a good,
supported by her ability and willingness to pay. Mere desire for a commodity
without sufficient purchasing power does not constitute demand for it. For example,
a poor woman who hardly makes both ends meet may have a desire to own a
residential housing, but surely she does not possess enough resources to fulfill her
desire. Therefore, her desire would not be treated as demand. A desire
accompanied by ability and willingness to pay makes a real or effective demand.
Demand of an individual for a commodity depends on several factors, price

being the most important of them. The price of the commodity fixes the quantity
demanded, whereas factors other than price determines the level of demand.
(i) Price of the commodity: Quantity demanded of a commodity depends on
the price of the commodity. According to law of demand, quantity
demanded varies inversely with price. As price increases quantity demand
decreases and as price decreases quantity demand increases. This relation
is depicted by the negatively-sloped individual demand curve.
(ii) Income of the individual: Income of the individual is another important
determinant of demand for a commodity. Except for a few commodities,
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the greater the income of the individual grater the demand and vice versa.
The effect of a change in income on individual’s demand is shown by shift
of the demand curve. As income increases individual demand curve shifts
upwards and as income decreases individual demand curve shifts
downward.
(iii) Prices of related commodities: Individual demand for a commodity
depends also on the prices of the related commodities -- substitutes and
complements. Two commodities are said to be substitutes if change in
price of one affects the demand for the other in the same direction. For
example, if an increase in the price of one leads to an increase in the
consumption of the other or vice versa, two commodities are substitutes
for each other. Tea and coffee, wheat and rice, chicken and mutton are
some examples of substitutes. When price of a commodity (say, tea)
decreases (increases) then demand for its substitute (coffee) also
decreases (increases). The effect of an increase (a decrease) in the price
of substitute on the commodity in question is shown by the upward
(downward) shift of the demand curve. Again, two commodities are said to
be complements if both of them are consumed simultaneously. For
example, petrol and motor car are complements; as also bread and butter,
sugar and coffee etc. For two commodities which are complements a
change in the price of one affects the demand for the other in the same
direction. For example, if an increase in the price of one leads to a
reduction in the consumption of the other or vice versa, two commodities
are complements to each other. When the price of a commodity (say,
butter) increases (decreases) then demand for its complement (bread)
decreases(increases). The effect of an increase (a decrease) in the price of
complement on the commodity in question is shown by a downward
(upward) shift of the demand curve.
(iv) Tastes and preferences of the individual: Individual’s tastes and
preferences also play an important role in determining the demand for a
commodity. Tastes and preferences of an individual depend on various
things such as her age, level of education, mental make-up, social
customs, human and religious values, habits, life style etc. The tastes and
preferences of an individual may change from time to time. An increase in
the intensity of desire or preference for one commodity relative to other
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commodities leads to an increase in demand for the commodity. For
example, preferences for cold drink in the younger generation has
increased as compared to normal water. This has resulted in an upward
shift of the individual demand curve for cold drinks. Again, when the
intensity of desire or preference of an individual for a commodity
decreases, the demand curve of the commodity shifts downward.
(v) Individual’s expectations: Individual’s expectations regarding the future
course of change of economic conditions, such as changes in prices,
income, and supply position of the commodity, play an important role in
determining the demand for the commodity in the short run. If the
individual expects a rise in the price of a commodity in the future she
would buy more of it at its current price. On the contrary, if the consumer
expects price of the commodity to fall, she tries to postpone her purchases
for sometime. This behavioural pattern of the individual reduces
(increases) the current demand for the commodity whose price is expected
to fall(increase) in near future. Similarly, an expected increase in income
on account of the better business opportunities or a likely announcement
of revision of pay-scale or dearness allowance, etc. may lead to an
increase in current purchases, and vice versa.
(vi) Demonstration effect: An individual’s demand for a commodity may also
depend on the purchase of others in her surroundings. Other people’s
consumption of the commodity may have a positive or negative effect on
the individual’s consumption of the commodity. For costly items such as
ornaments, dresses, watches etc. individual is often influenced by the
people in her fraternity and increases her consumption of these
commodities when her friends and neighbours do so. This effect is also
known as ‘bandwagon effect’. On the contrary, when some commodity
becomes a thing of common use because other people increasing their
consumption of it, individual may sometime reduce her consumption of the
same. This effect is known as ‘Snob Effect’.
(vii) Other factors: Some other factors also influence individual’s consumption.
These factors include climate, age composition of the family members,
customs and values, physicians advice, credit facilities, advertisements
and promotional campaigns etc.
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The law of demand states the relationship between the quantity demanded
and price of a commodity. According to this law, other things remaining the same,
the quantity demanded of a commodity increases when its price decreases and
decreases when its price increases. Here other things include all other determinants
of demand except the price of the commodity such as individual’s income, prices of
the related commodities, individual’s taste and preferences, individual’s
expectations etc. This law implies that other things remaining the same (ceteris
paribus),demand and price are inversely related. The law of demand is depicted by
the negatively sloped demand curve.
The demand function is a mathematical relation between the quantity

demanded of a commodity and the factors affecting demand. The general form of
the demand function is:
Qd = F( P, M, P’, T, O)
where Qd = Quantity demanded of the commodity;
P = Price of the commodity;
M = Money income of the individual;
P’ = Prices of the related commodities;
T = Tastes and preferences of the individual;
O = Other factors (including individual’s expectations,
demonstration effect)
The demand function states that quantity demanded of a commodity depends on
price of the commodity, money income of the individual, prices of the related
commodities, tastes and preferences of the individual and other factors (including
individual’s expectations, demonstration effect). The general form of the demand
function can be transformed into ‘ceteris paribus demand function’ assuming all
factors except price of the commodity constant:
Qd = f( P ), f’< 0
This demand function is graphically shown by a negatively sloped demand curve. f’
stands for the first derivative of the demand function with respect to price and it
measures the slope of the demand function. Demand function being negatively
sloped f’ is negative.
The quantity demanded of a commodity by an individual may change because of change in any of
its determinants. But to distinguish change in quantity demanded due to change in price from that due to
change in factors other than price we use two different concepts--change in quantity demanded and
change in demand.
Change in quantity demanded occurs when the price of the commodity changes, other factors
determining the demand remaining constant. In this case demand curve does not shift, and we move from
one price quantity combination point (say, A) to another combination point (say, B) along any demand
curve (Fig:1). This movement along the demand curve indicates change in quantity demanded due to a
change in the price of the commodity. In Fig.1, the movement from A to B along the demand curve DD’
indicates a change in quantity demanded from 0Q1 to 0Q2due to a change in price from 0P1 to 0P2.
Change in demand takes place when any factor other than the price of the commodity such as
income of the individual, prices of the related commodities, taste and preference of the individual etc.
changes. In this case demand curve itself shifts either upward or downward. The demand, therefore,
changes even at the constant price. If the demand curve shifts rightward or upward due to say, an increase
in the income of the individual, more of the commodity will be demanded at the given price. In Fig: ,as
the demand curve shifts from DD’ to D 1D1’, the demand increases from OQ 1 to OQ2 at the prevailing
price OP1. Again if the demand curve shifts leftward or downward due to say, a change of taste of the
individual against the commodity, less of the commodity will be demanded at the given price. In Fig: 2,
as the demand curve shifts from DD’ to D 2D2’, the demand decreases from OQ1 to OQ3 at the prevailing
price OP1.
Supply is defined as the quantities of a good (or service) which a seller is

willing to sell at various market prices during a period of time, other things
remaining the same. The seller may herself be a producer (firm), like a poultry
owner or a soft-toy maker, who directly supplies her products in the market, or may
be a trader of the commodities produced by some other producer. In any case the
quantity of goods offered by her at different prices would be called the supply by an
individual firm or supplier.
The supply of a commodity depends primarily on its price and cost of its
production. There are other factors which also determine the supply. The price of
the commodity determines the quantity supplied, whereas factors other than price
determines the level of supply.
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(i) Price of the commodity: Quantity supplied of a commodity depends on
the price of the commodity. According to law of supply, quantity supplied
varies directly with price. This relation is depicted by the positively-sloped
supply curve. As price increases quantity supplied increases and as price
falls quantity supplied decreases. This is because as price increases,
production becomes more profitable and therefore, the producer likes to
produce more causing supply to increase, and vice versa.
(ii) Technology of production: The quantity supplied of a commodity also
depends on the technology of production. The cost of production depends
on the technology. If advanced technology is used in the production then
cost of production would be less whereas if age-old technology is used cost
of production would be higher. Thus, at a given price the firm using
advanced technology would produce more than that using backdated
technology.
(iii) Prices of the factors of production: The prices of the factors of
production also determine the quantity supplied by a firm. The cost of
production depends on, among other things, the prices of the factors of
production. With higher cost of production due to a rise in the prices of the
factors of production, less would be supplied than before at various prices.
(iv) Objective of the firm: The objective of the firm also determines the
supply of the firm. If the firm aims at maximising sales or revenue rather
than profits, the firm will produce more and supply more at given price.
(v) Prices of other products: Prices of the other products, sometime
determine the firm’s supply of the product in question. For example, an
increase in the price of rice compared to wheat may induce the cultivator
to withdraw land from the production of wheat causing a reduction in the
supply of wheat at a given price.
(vi) Other factors: Some other factors also influence firm’s supply. These
factors include expectation of the firm regarding future prices, government
policies such as taxes and subsidies, weather and climate etc.
The law of supply states the relationship between the quantity supplied and
price of a commodity. According to this law, other things remaining the same, the
quantity supplied of a commodity by a firm increases when its price increases and
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decreases when its price falls. Here other things include all other determinants of
supply except the price of the commodity such as technology of production, prices
of the factors of production, firm’s objective, prices of other products etc. This law
implies that other things remaining the same (ceteris paribus), quantity supplied
and price are directly related. The law of supply is depicted by the positively sloped
supply curve.
The supply function is a mathematical relation between the quantity supplied

of a commodity and the factors affecting supply. Supply function is based on the law
of supply. The law of supply states only the nature of relationship between the price
and the quantity supplied. The general form of the supply function is:
Qs = F( P, T, W, P’, O)
where Qs = Quantity supplied of the commodity;
P = Price of the commodity;
T = Technology of production;
W = Prices of the factors of production;
P’ = Prices of other products;
O = Other factors;
The supply function states that quantity supply of a commodity depends on price of
the commodity, technology of production, prices of the factors of production, prices
of other products and other factors. The general form of the supply function can be
transformed into ‘ceteris paribus supply function’ assuming all factors except price
of the commodity constant:
Qs = f( P ), f’> 0
This supply function is graphically shown by a positively-sloped supply curve. f’
stands for the first derivative of the supply function with respect to price and it
measures the slope of the supply function. Supply function being positively sloped
f’ is positive.
An equilibrium is a situation where the parties involved are fully satisfied that
they have struck a right deal under the given situation. It is a situation where the
opposing forces operating attains a position of rest i.e. it is a situation where there
is no tendency for change. An equilibrium once attained will continue so long as the
forces determining the equilibrium do not change.
In the context of a market, when quantity demanded of a commodity equals

quantity supplied, market is said to be in equilibrium. An equilibrium price is the
price at which equilibrium is attained i.e. where the quantity demanded equals the
quantity supplied. Obviously this is the only price at which there is no mismatch
between the quantity demanded and the quantity supplied; and consequently the
only price that can be maintained for long. In Figure: 3 , the price at which the
quantity supplied equals the quantity demanded is Pe, the price where the demand
curve intersects the supply curve. Thus Pe is the equilibrium price. At this
equilibrium price, equilibrium quantity is Qe.
Suppose that consumers’ tastes and preferences change in favour of the

commodity, causing the demand curve for the commodity to shift to the right. This
state of affairs is shown in Figure::4 , where the demand curve shifts from DD’ to
D1D1’. When DD’ is the demand curve, the equilibrium price is OPe. But when the
demand curve shifts to D1D1’, a shortage of (OQ2--OQe) develops at this price. In
other words, the quantity demanded exceeds the quantity supplied at this price by
(OQ2--OQe). Consequently, suppliers raise their prices. Buyers also compete among
themselves and bid price up. After some trial-and-error adjustments, the price will
tend to settle at OP1, the new equilibrium price, and quantity will tend to settle at
OQ1.
On the other hand, suppose that consumer demand for the commodity shifts
to the left, because of, say, a drop in the income of the people. The demand for the
commodity now shifts to the left. Specifically, as shown in Figure: 4, it shifts from
DD’ to D2D2’. As a result, the new equilibrium price will be OP 2, where the new
demand curve intersects the supply curve while the equilibrium supply will be OQ 2.
In general, a shift to the right in the demand curve results in a increase in the
equilibrium price, and a shift to the left in the demand curve results in a decrease in
the equilibrium price, so long of course supply curve slopes upward to the right.
This is quite clear from Figure: 4.
Suppose that, because of technological advancement, producers of the

commodity are willing and able to supply more of it at a given price than they used
to. Specifically, suppose that the supply curve shifts to the right from SS’ to S 1S1’ in
Figure: 5. As supply curve shifts to its right, equilibrium price will fall from OPe
(where the supply curve SS’ intersects the demand curve DD’) to OP 3 (where the
supply curve S1S1’ intersects the same demand curve DD’).
On the other hand, suppose that input prices rise, with the result that the
supply curve shifts from SS’ to S2S2’ in Figure:5. It is obvious that equilibrium price
will increase from OPe (where the supply curve SS’ intersects the demand curve
DD’) to OP4 (where the supply curve S2S2’ intersects the demand curve DD’).
In general, a shift to the right in the supply curve results in a decrease in the
equilibrium price, and a shift to the left in the supply curve results in an increase in
the equilibrium price, given that the demand curve slopes downward to the right.
This is clearly shown in Fig: 5.
An equilibrium is stable if a disturbance results in a return to equilibrium and

unstable if it does not. Stated alternatively, the analysis of stability of market
equilibrium is concerned with the following question: if the market price is not at an
equilibrium value, will changes take place which cause the price to converge to
such a value? If the answer is yes, the market is stable, and if no, unstable.
Again, a market is ‘locally stable’ if it tends to an equilibrium when it starts off
in a small neighbourhood of existing equilibrium and it is ‘globally stable’ if it tends
to an equilibrium wherever it starts off. Global stability implies local stability but not
conversely.
A. Static Stability Analysis

B. Dynamic Stability Analysis
A disturbance in market equilibrium usually creates an adjustment process in

the market. For example, if the actual price is less than the equilibrium price, the
adjustment may consist of some buyers raising their bids (price) for the commodity.
Static analysis abstracts from the time path of the adjustment process and
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considers only the nature of the change, i.e. whether it is toward or away from,
equilibrium.
In a market either price or quantity is the equilibrating factor. Depending on
two alternative equilibrating factors we have two alternative market models:
i) Walrasian Market Model (where price is equilibrating factor);
ii) Marshallian Market Model (where quantity is equilibrating factor);
The Walrasian market model regards price as the motivating force in the
adjustment of markets to equilibrium. Buyers and sellers respond to price changes
by moving along their respective demand and supply curve until an equilibrium
price quantity combination is achieved.
We define the excess demand E(p) as a function of price p as
E(p) = D(p) – S(p)
That is, at any price p excess demand E(p) is the quantity demanded less the
quantity supplied at that price.
When D(p) > S(p), E(p) > 0
D(p) < S(p), E(p) < 0
D(p) = S(p), E(p) = 0
The Walrasian stability condition is based on the assumption that buyers tend
to raise the price if excess demand is positive, and sellers tend to lower the price if
it is negative. That is for a market to be stable in the Walrasian sense we require
excess demand to be a decreasing function of price i.e.
dE(p)/dp = E´(p) = D´(p) – S´(p) < 0
=> D´(p) < S´(p) or, dD/dp < dS/dp
The Walrasian stability condition is satisfied automatically if the demand
curve has negative slope and the supply curve has positive slope.
Proposition: In a market model if the demand curve is negatively

sloped and the supply curve is positively sloped, the market is
said to be (static) stable in the Walrasian sense.
This proposition suggests that a market for a normal commodity with rising
cost of production is stable in Walrasian sense.
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In fig 6, DD´ and SS´ are the market demand and market supply curves
respectively. The market equilibrium is attained at E where two curves intersect
each other. Pe and Qe are equilibrium price and quantity respectively.
At any price P1 (>Pe), market supply exceeds market demand. This excess
supply will induce the price to fall and to move towards P. At any other price P 2 (<
Pe), market demand exceeds market supply. Due to this excess demand price will
tend to rise and move towards Pe. Hence in case of normal demand and supply
conditions, the Walrasian adjustment process will ensure that the market
equilibrium is stable.
Proposition: In a market model if the demand curve is positively sloped
and the supply curve is negatively sloped, the market is said to be (static)
unstable in Walrasian sense.
So in a market where laws of demand and supply are both violated, the
market equilibrium becomes unstable in Walrasian sense. As we know, the law of
demand is violated if the commodity is a GIFFEN one; and the law of supply is
violated if the industry producing the commodity is a decreasing cost industry.
In Fig; 7, DD´ and SS´ intersect each other at E with equilibrium price and
quantity determined at Pe and Qe respectively. At price P 1 (>Pe), there is excess
demand, hence price will tend to rise further moving away from equilibrium. Again
at price P2 (< Pe), excess supply will induce the price to fall further and move away
from equilibrium. Hence, with positively sloped demand and negatively sloped
supply curves, the Walrasian adjustment process makes the market equilibrium
unstable.
Proposition : In a market model if both demand and supply curves are
downward sloping, then market equilibrium may or may not be Walrasian
(Static) stable. The equilibrium will be Walrasian (static) stable if the
demand curve is flatter than supply curve , and Walrasian (static) unstable if
the demand curve is steeper than the supply curve .
In Fig. 8, the equilibrium is Walrasian (static) stable. The demand curve DD´ is
flatter than the supply curve SS´. At a price below Pe, excess demand is created,
which pushes price up; and at a price above Pe, excess supply is generated which
pushes the price down. Thus, equilibrium will automatically be restored in this
market model.
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In Fig. 9, the market equilibrium is Walrasian (static) unstable. In this market
DD´ is steeper than SS´. At a price below Pe, excess supply appears which reduces
the price further down away from equilibrium. When price exceeds P, excess
demand puts an upward pressure on price, causing the price go up, moving away
from equilibrium. Hence, equilibrium becomes Walrasian (static) unstable.
Mathematical Hindsight:
We know for a market to be stable in the Walrasian sense we require:
d E(p)/dp < 0 =>D´(p) – S´(p) < 0 => dD/dP – ds/dp < 0 …
When dD/dp < 0 and dS/dp < 0, dE(P)/dp to be negative requires
|dD/dp| > |dS/dp| => |dp/dD| < |dP/dS|
 |Slope of DD´| < |Slope of SS´|
 Walrasian static stable equilibrium (see Fig: 8)
Thus when both dD/dP < 0 and dS/dp < 0 and |dp/dD| > |dp/dS|
 |dD/dP| < |dS/dp|,

 dE(P)/dP > 0
 Walrasian static unstable equilibrium (see Fig: 9)
Proposition: In a market model when both demand and supply curves are
positively sloped or upward rising, then market equilibrium may or may not
be Walrasian (static) stable.
In such market two alternative situations may arise. First when demand curve
is steeper than supply curve, the market equilibrium becomes Walrasian (static)
stable equilibrium. Second, when supply curve is steeper than demand curve,
market equilibrium becomes Walrasian (Static) unstable one.
In Fig. 10, the market equilibrium is Walrasian (static) stable equilibrium. Here
DD´ is steeper than SS´. At any price below Pe, there is excess demand which
causes the price go up. At any price above Pe, excess supply in the market reduces
the price. Hence equilibrium is automatically restored in this model.
In Fig 11, the market equilibrium is Walrasian (static) unstable equilibrium.
Here DD´ is flatter than SS´. At any price below Pe, there is excess supply which
pushes price further down. At any price above Pe, there is excess demand causing
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price go up, moving away from equilibrium. Thus equilibrium is Walrasian (static)
unstable one.
For Walrasian stability we require
dE(p)/dp < 0 => D´(p) – S´(p) < 0 => dD/dP – dS/dp <
0
When both dD/dP > 0 and dS/dP > 0, for dE (P)/dP to be negative,
dD/dP < dS/dP => dp/dD > dp/dS => slope of DD´ >
slope of SS´
=> Walrasian static stable equilibrium (see Fig: 10)
When both dD / dp > 0 and dS/dp > 0 and dD/dp > dS/dp ( dp/dD <
dp/dS)
d E (p)/dp > 0
=> Walrasian static unstable equilibrium. (see Fig:11)
The negatively sloped supply curve depicted in Fig 12 yields four equilibrium
points. The successive equilibrium points A, B and E are alternatively stable and
unstable by the Walrasian behavior assumption. The supply curve is steeper than
the demand curve at A., and the equilibrium is stable at this point. Another
intersection B gives unstable equilibrium since the supply curve is less steep than
the demand curve. By similar reasoning, D is again stable, the Walrasian stability
condition is not sufficient to cover equilibrium point C. Point C is classed as ‘semi-
stable’. In Fig 13, a backward bending supply curve SS` intersects negatively sloped
demand curve DD´ at two points F and G. By Walrasian static statbility condition, F
is stable while G is not.
The Marshalian market model assumes quantity as the equilibrating factor in

the adjustment of markets to equilibrium. According to Alfred Marshall, buyers and
sellers adjust quantity in response to imbalances in quantities demanded and
supplied, and the price changes follow from these quantity changes.
Marshall defined demand and supply functions in inverse form:
Pd = D-1(Q) and Ps = S-1(Q)
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where P and P are demand price and supply price respectively. P represents the
d s d
per unit price that the demanders are willing to pay for output level Q. similarly P s
stands for the per unit price that the suppliers require for the output level Q. Now
we define excess demand price as F(Q) = Pd – Ps = D-1(Q) – S-

1
(Q)
That is at any Q, excess demand price F(Q) is the demand price less supply price at
that quantity.
When Pd > Ps , F (Q) > 0
Pd < Ps , F (Q) < 0
Pd = Ps , F (Q) = 0
The Marshallian stability condition states that producers will raise their output
when F(Q) > 0 and lower it when F (Q) < 0. Thus, for a market to be stable in
the Marshallian sense we need excess demand price to be a decreasing function of
quantity i.e.
dF (Q)/dq = F´(Q) = D-1´(Q) – S-1´(Q) < 0
=> D-1´(Q) < S-1´(Q) or, dD-1(Q)/dQ < dS-1(Q)/dQ
Just like Walrasian stability Marshallian stability condition is satisfied
automatically if the demand curve has negative slope and the supply curve has
positive slope.
Proposition:
In a market model if the demand curve is negatively sloped and supply
curve is positively sloped, the market is said to be (static) stable in the
Marshallian sense.
This proposition suggests that a market for a normal commodity produced by
an increasing cost industry is stable in Marshallian sense.
Fig.14 shows the demand and supply curve s DD´ and SS´ intersecting at
point E. Qe and Pe are equilibrium quantity and price respectively.
For quantities less than equilibrium quantity (such as Q 1 < Qe in Fig:14 ),
demand price is greater than supply price. In this case suppliers will tend to raise
their output because they realize that the consumers are willing to offer a higher
price than they are charging and hence, it is profitable to expand output. For
quantities above equilibrium supply price exceeds demand price. For example at Q 2
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> Qe in Fig:14, P > P . Hence, suppliers think it profitable to reduce output. Thus in
S D
case of normal demand and supply conditions, the Marshallian adjustment process
will ensure that the market equilibrium is stable.
Proposition:
In a market model if the demand curve is positively sloped and supply
curve is negatively sloped, the equilibrium in the market is said to be (static)
unstable in the Marshallian sense.
Thus in a market where laws of demand and supply are both violated, the
market equilibrium becomes unstable in Marshallian sense.
In Fig:15, such unstable equilibrium has been shown. The equilibrium price
and quantity are Pe and Qe respectively. At quantity Q1 (< Qe), supply price is
greater than demand price. Hence suppliers will reduce output. Again at Q 2 (> Qe),
the demand price is greater than the supply price and hence, suppliers will raise
their output. Thus, a disturbance in this model causes a movement away from the
equilibrium making this market equilibrium (static) unstable in the Marshallian
sense.
Proposition :
In a market model if both demand and supply curve are downward
sloping, then market equilibrium may or may not be Marshallian (static)
stable.
The equilibrium will be Marshallian (static) stable if supply curve is flatter than
demand curve and Marshallian (static) unstable if demand curve is flatter than the
supply curve.
In Fig: 16, the equilibrium is Marshallian (static) unstable. Since DD´ is flatter
than SS´, at a quantity Q1 (< Qe), supply price exceeds demand price which leads
to a fall in output. Again at a quantity Q 2 (> Qe), demand price exceeds supply price
leading to an expansion of output. Thus, equilibrium is (static) unstable in
Marshallian sense.
In Fig: 17, the equilibrium is Marshallian (static) stable. In this figure, DD´ is
steeper than SS´. At a quantity below Qe, demand price exceeds supply price
causing an expansion of output, while at a quantity above Qe, supply price exceeds
demand price leading to a reduction in output. Hence equilibrium is Marshallian
(static) stable.
We know for a market top be stable in the Marshallian sense we require:
dF(Q)/dQ < 0 => D-1´(Q) – S-1´(Q) < 0
 dD-1(Q)/dQ < dS-1(Q)/dQ
 dPd/dQ < dPs/dQ
When dD-1/dQ < 0 and dS-1/dQ < 0 , dF(Q)/dQ to be negative
requires:
 |dD-1/dQ| > |dS-1/dQ|
 |dPd/dQ| < |dPs/dQ|
 |Slope of DD´| > |slope of SS´|
 Marshallian static stable equilibrium (Fig: 16)
Again when both dD-1/dQ < 0 and dS-1/dQ < 0 but
 |dPd/dQ| < |dPs/dQ|
 |dD-1/dQ| < |dS-1/dQ|
then dF(Q)/dQ > 0
 Marshallian static unstable equilibrium (Fig: 17)
Proposition:
In a market model when both demand and supply curve are positively
sloped, the market equilibrium may be or may not be Marshallian (static)
stable.
Again two alternative situations may arise. First, when supply curve is steeper
than demand curve, the market equilibrium becomes Marshallian (static) stable
equilibrium. Second, when demand curve is steeper than supply curve, market
equilibrium becomes Marshallian (static) unstable one.
In Fig: 18, Marshallian (static) equilibrium with positively sloped demand and
supply curve has been depicted. Since supply curve is steeper than demand curve
at any quantity Q1( < Qe) demand price will be greater than supply price leading to
an expansion in output and at any quantity Q2 (> Qe) demand price will be less
than supply price causing a contraction in output. Hence equilibrium is stable in
Marshallian sense.
Fig: 19, shows that when both DD´ and SS´ are positively sloped and DD´ is
steeper than SS´, the equilibrium will be unstable in Marshallian sense. This is
because at Q1 (< Qe) supply price exceeds demand price leading to a further
17
contraction of output while at Q 2 (> Qe) demand price exceeds supply price leading
to an expansion in output. The equilibrium is thus unstable in Marshallian sense.
For Marshallian stability we require:
dF(Q)/dq < 0 => D-1´(Q) – S-1´(Q) < 0
 dD-1/dQ < dS-1/dQ
 dPd/dQ < dPs/dQ
When dD-1/dQ > 0 and dS-1/dQ > 0 , dF(Q)/dQ to be negative requires:
 dD-1/dQ < dS-1/dQ
 dPd/dQ < dPs/dQ
 Slope of DD´ < Slope of SS´
 Marshallian static stable equilibrium (Fig: 18)
Again when both dD-1/dQ > 0 and dS-1/dQ > 0, but
 dPd/dQ > dPs/dQ
 dD-1/dQ > dS-1/dQ
then dF(Q)/dQ > 0
 Marshallian static unstable equilibrium (Fig: 19)
A market equilibrium is said to be dynamically stable if a disequilibrium

situation converges to any equilibrium overtime. Otherwise, it is dynamically
unstable. The dynamic stability in a market model depends on the behavioural
assumptions of the market.
Dynamic analysis of a market may be done in two alternative forms: one
assuming discrete time adjustment and the other, assuming continuous time
adjustment.
18
Cobweb model analyses dynamic stability in a competitive market in a simple
framework. The basic behavioural assumptions of the model are as follows:
(i) Discrete time: The time periods are discrete.
(ii) Linear demand and supply: The demand and supply curves in the
market are linear. Both demand and supply depend on price.
(iii) Demand as a function of current price: The demand in period ‘t’
depends on the price prevailing in period ‘t’:
Dt = a + bPt Eq.
(1)
(iv) ‘Lagged’ supply function: The supply in period ‘t’ depends on the price
prevailing in period ‘t-1’: St = c + dPt-1 Eq.
(2)
(v) Market equilibrium: The market is in equilibrium when Dt =St
Eq.(3)
(vi) Behavioural constants: The terms a, b, c and d are behavioural
constants which determine the dynamic stability in this market model.
By substituting Eq.(1) and Eq.(2) into Eq.(3), the model can be reduced to
single first order difference equation as follows:
bPt -- dPt-1 = c -- a
In order to solve this equation, we first normalise it and shift the time
subscripts ahead by one period to get:
Pt+1 -- d/bPt = (c -- a )/b Eq. (4)
The general solution to (4) will consist of the sum of two components: a
PARTICULAR INTEGRAL (PP) and a COMPLEMENTARY FUNCTION (PC):

Pt = P P + PC Eq.(5)
The particular solution is any solution of the complete non-homogeneous Equation
(4). To get this, we put Pt = Pt+1=P into (4):
P – (d/b) P = (c -- a )/b
or, P[ 1--(d/b)] = (c -- a )/b
or, P = (c--a ) / (b -- d) = (a—c) / (d—b) = PP
19
Note: The particular integral of the difference equation is known as ‘inter-temporal’
price of the model, because once it is attained it will continue over time till any
further disturbance in the model.
The complementary function is the general solution of the homogeneous reduced
equation of Equation (4), Pt+1 -- (d/b) Pt = 0

Eq.(6)
To solve Eq.(5), we take trial solution as:
Pt = Abt (with Abt ≠ 0) Eq.(8)
From Eq(6), it follows that Pt+1 = Abt+1 Eq.
(9)
Substituting Eq.(6) and (7) into (5), we can write:
Abt+1 -- (d/b) Abt = 0
or, Abt (b -- d/b) = 0
Since Abt ≠ 0, b -- d/b = 0 => b = (d/b)
Therefore, complementary function is PC = A ( d/b)t Eq.(10)
The general solution can be written as:
Pt = A (d/b)t + (a—c) / (d—b)
Eq.(11)
Eq.(11) still contains an arbitrary constant A. To eliminate this arbitrary constant, we
resort to the initial condition that Pt = P0 when t = 0.

Put t = 0 in Eq.(11), we have P0 = A + [(a—c) / (d—b)] => A = [P0 – {(a—
c) / (d—b)}]
The definite version of the general solution is, thus:
Pt = [P0 – {(a—c) / (d—b)}] (d/b)t + [(a—c) / (d—b)]
Eq.(12)
Eq.(12) represents the time path, where P0 giving the initial price.
Now, suppose if for some reason or the other, Pt ≠ P. Then if Pt → P as t → ∞, the
is said to be dynamically stable. Otherwise, it is dynamically unstable.
For dynamics stability what we require is that
(d/b)t → 0 as t → ∞ so that Pt = P.
For this, we require further: |(d / b)| < 1
or, |1/b | < | 1/d |
20
Since, |1/b | = | Pt / Dt | = absolute slope of the demand function and
|1/d | = | Pt / St | = absolute slope of the supply function, the condition for
dynamic stability can be stated as follows:
absolute slope of the demand curve is less than that of the supply curve.
If, however, |(d / b)| > 1, the equilibrium in the cobweb model is dynamically
unstable. Now,
|(d / b)| > 1 => |1/b | > | 1/d | => absolute slope of the demand curve
is greater than that of the supply curve.
If |(d / b)| = 1, the equilibrium in the cobweb model is dynamically unstable
and price in the market will neither converge to nor diverge from the equilibrium.
Now, |(d / b)| = 1 => |1/b | = | 1/d | => absolute slope of the demand
curve is equal to that of the supply curve.

If (d / b) > 0, then the time path will be monotonic => price will move (either
converge or diverge) from one side (higher or lower side) of equilibrium price.
If (d / b) < 0, then the time path will be oscillatory => price will move (either
converge or diverge) not from one side (higher or lower side ) of the equilibrium
price, but will alternately enter into two sides as t changes.
Stability in Cobweb model in different situations:
1. When demand curve is negatively sloped and supply curve is
positively sloped (i.e. b<0 and d>0) :
Since b< 0 and d>0, (d / b) < 0, then the time path is oscillatory.
Equilibrium is dynamically stable i.e. time path converges to equilibrium, if |

1/b | < | 1/d | => absolute slope of the demand curve is less than that
of the supply curve.(Fig:20 )
Equilibrium is dynamically unstable i.e. time path diverges from equilibrium,
if |1/b | > | 1/d | => absolute slope of the demand curve is greater than
that of the supply curve.(Fig:21 )

Equilibrium is dynamically unstable i.e. time path never converges to
equilibrium and moves cyclically around the equilibrium, if |1/b | = | 1/d | =>
absolute slope of the demand curve is equal to that of the supply
curve.(Fig:22 )
2. When both demand and supply curves are positively sloped(i.e. b,
d >0) :
Since both b , d >0, (d / b) > 0 => the time path will be monotonic.
Equilibrium is dynamically stable i.e. time path converges to equilibrium, if |
1/b | < | 1/d | (or, simply 1/b < 1/d) => (absolute) slope of the
demand curve is less than that of the supply curve. (Fig:23 )

Equilibrium is dynamically unstable i.e. time path diverges from equilibrium,
if |1/b | > | 1/d | (or, simply 1/b > 1/d) => (absolute) slope of the demand
curve is greater than that of the supply curve. (Fig:24 )

But if |1/b | = |1/d| (or, simply 1/b = 1/d) => (absolute) slope of the
demand curve is equal to that of the supply curve, two situations may
arise:
(i) If intercepts of two curves are equal i.e. a = c, two curves
coincide and the market is always in equilibrium.(Fig: 25 )
(ii) If intercepts of two curves are different i.e. a ≠ c, two curves are
parallel to each other and equilibrium does not exist. (Fig:26 )
The stability analysis is redundant in above two situations.
3. When both demand and supply curves are negatively sloped(i.e.
b, d <0) :
Since both b , d < 0, (d / b) > 0 => the time path will be monotonic.
Equilibrium is dynamically stable i.e. time path converges monotonically to
equilibrium, if |1/b | < | 1/d | => absolute slope of the demand curve is
less than that of the supply curve. (Fig:27 )
Equilibrium is dynamically unstable i.e. time path diverges from equilibrium
monotonically, if |1/b | > | 1/d | => absolute slope of the demand curve
is greater than that of the supply curve. (Fig:28 )
But if |1/b | = | 1/d | => absolute slope of the demand curve is equal
to that of the supply curve, two situations may arise:

(i) If intercepts of two curves are equal i.e. a = c, two curves
coincide and the market is always in equilibrium.(Fig:29 )
(ii) If intercepts of two curves are different i.e. a ≠ c, two curves are
parallel to each other and equilibrium does not exist.(Fig:30)
The stability analysis is redundant in above two situations.
Graphical Illustration:
1. When demand curve is negatively sloped and supply curve is
positively sloped (i.e. b<0 and d>0) :
 Dynamically stable equilibrium and convergent time path when |1/b
| < | 1/d | :
Let the demand curve be DD´ and supply curve be SS´ and the equilibrium
price and quantity in the market are Pe and Qe. Now, suppose because of some
disturbance in the market, price in period t = 0 is equal to P 0 (< Pe). At this price
P0, quantity supplied in the market is Q 0 . Given the market demand DD while
quantity supplied is Q1. Since quantity demanded is greater than quantity supplied,
there is excess demand in the market in period t = 0. This will push the market
price up in period t=1 to P1 (P1>P0). At this price P1, quantity demanded in the
market is Q2 while quantity supplied is Q3. Since quantity supplied is greater than
quantity demanded, there is excess supply in the market in period t = 1. This will
push the market price down in period t=2 to P 2 (P2 < P0). At this price P2 once again
quantity demanded in the market is Q 4 while quantity supplied is Q5. Since quantity
demanded is greater than quantity supplied, there is excess demand in the market
in period t = 2. This will push the market price up once again in period t=3 to P 3
(P3>P0). This process will continue till the initial equilibrium is restored. Hence,
equilibrium in the market is dynamically stable.
The time path of price is shown in Fig:31. Since b< 0 and d>0, (d / b) <
0, and since |1/b | < | 1/d | the time path is oscillatory but convergent.
 Dynamically unstable equilibrium and divergent time path when |
1/b | >|1/d |:
In this market, the demand curve is (absolutely) steeper than the supply curve
and the price will continue to diverge from the initial equilibrium price. Hence,
equilibrium in the market is dynamically unstable.
The time path of price is shown in Fig:32. Since b< 0 and d>0, (d / b) < 0,
but |1/b | > | 1/d | the time path is oscillatory as well as divergent.
 Dynamically unstable equilibrium and uniform oscillatory time
path when |1/b | = | 1/d | :
Here absolute slope of the demand curve is same as that of the supply curve
and the price will continue to move around the initial equilibrium price and will
neither converge to or diverge from the equilibrium . The equilibrium in the market
is dynamically unstable.
The time path of price is shown in Fig:33. Since b< 0 and d>0, (d / b) < 0,
but |1/b | = | 1/d | the time path is oscillatory but uniform (i.e. neither
convergent nor divergent).
2. When both demand and supply curves are positively sloped(i.e. b,
d >0) :
 Dynamically stable equilibrium and convergent time path when |
1/b | < | 1/d |
In this market, the demand curve is flatter than the supply curve and the price
will continue to converge to the initial equilibrium price. Hence, equilibrium in the
market is dynamically stable.
The time path of price is shown in Fig:34. Since b> 0 and d >0, (d / b) > 0,
and |1/b | < | 1/d | the time path is monotonic and convergent.
 Dynamically unstable equilibrium and divergent time path when |
1/b |> | 1/d |
In this market, the demand curve is steeper than the supply curve and the
price will diverge from the initial equilibrium price. Hence, equilibrium in the market
is dynamically unstable.
The time path of price is shown in Fig:35. Since b> 0 and d >0, (d / b) > 0,
and |1/b | > | 1/d | the time path is monotonic but divergent.
3. When both demand and supply curves are negatively sloped (i.e.
b, d <0) :
 Dynamically stable equilibrium and convergent time path when |
1/b | < | 1/d |:
24
In this market, the demand curve is flatter than the supply curve and the price
will continue to converge to the initial equilibrium price. Hence, equilibrium in the
market is dynamically stable.
The time path of price is shown in Fig:36. Since b< 0 and d < 0, (d / b) >
0, and |1/b | < | 1/d | the time path is monotonic and convergent.
 Dynamically unstable equilibrium and convergent time path when
|1/b | > | 1/d |:
In this market, the demand curve is steeper (in absolute term) than the supply
curve and the price will continue to diverge from the initial equilibrium price. Hence,
equilibrium in the market is dynamically unstable.
The time path of price is shown in Fig:37. Since b< 0 and d < 0, (d / b) > 0, and
|1/b | > | 1/d | the time path is monotonic and divergent.

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SM/SOUTH CITY/ECOH/MICRO/DEMAND & SUPPLY/PART-A/NOVEMBER 2008 E-mail: mail2sm@in.

A market is an institutional arrangement under which buyers and sellers can

Demand can be defined as the desire for a good backed by adequate

Demand of an individual for a commodity depends on several factors, price

The demand function is a mathematical relation between the quantity

Supply is defined as the quantities of a good (or service) which a seller is

The supply function is a mathematical relation between the quantity supplied

In the context of a market, when quantity demanded of a commodity equals

Suppose that consumers’ tastes and preferences change in favour of the

Suppose that, because of technological advancement, producers of the

An equilibrium is stable if a disturbance results in a return to equilibrium and

A. Static Stability Analysis

A disturbance in market equilibrium usually creates an adjustment process in

Proposition: In a market model if the demand curve is negatively

 |dD/dP| < |dS/dp|,

The Marshalian market model assumes quantity as the equilibrating factor in

we define excess demand price as F(Q) = Pd – Ps = D-1(Q) – S-

A market equilibrium is said to be dynamically stable if a disequilibrium

PARTICULAR INTEGRAL (PP) and a COMPLEMENTARY FUNCTION (PC):

equation of Equation (4), Pt+1 -- (d/b) Pt = 0

resort to the initial condition that Pt = P0 when t = 0.

curve is equal to that of the supply curve.

Equilibrium is dynamically stable i.e. time path converges to equilibrium, if |

that of the supply curve.(Fig:21 )

Equilibrium is dynamically stable i.e. time path converges to equilibrium, if |

demand curve is less than that of the supply curve. (Fig:23 )

curve is greater than that of the supply curve. (Fig:24 )

Equilibrium is dynamically stable i.e. time path converges monotonically to

to that of the supply curve, two situations may arise:

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