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CH-11 PRICE DETERMINATION AND SIMPLE APPLICATIONS

Meaning of Equilibrium
In economics, the term equilibrium means the state in which there is no tendency on the part of consumers and producers
to change. The two factors determining equilibrium price are demand and supply.

Equilibrium Price
 ‘Equilibrium price is the price at which the sellers of a good are willing to sell the same quantity which buyers of
that good are willing to buy.
 Thus, equilibrium price is the price at which demand and supply are equal to each other. At this price, there is no
incentive to change.
 Also say that, At equilibrium price, there is neither shortage nor excess of demand and supply.

Market Equilibrium
 Market Equilibrium is determined when the quantity demanded of a commodity becomes equal to the
quantity supplied.

DETERMINATION OF MARKET EQUILIBRIUM UNDER PERFECT COMPETITION

a) Perfect competition is market where large no. of buyers and sellers dealing in homogenous product at a
price fixed by the market force.
b) under perfect competition, market equilibrium is determined when market demand is equal to market
supply. (MD = MS )
c) Let us recall the concepts of market demand and market supply:
 Market demand is the sum total of demand for a commodity by all the buyers in the market.
Its curve slopes downwards due to operation of law of demand.
 Market supply is the sum total of supplies of a commodity by all the producers in the market.
Its curve slopes upwards due to operation of law of supply.
d) Let us understand the determination of market equilibrium through Table 11.1 and Fig. 11.1:
Table 11.1: Market Equilibrium under Perfect Competition
Price of Market Market Supply Shortage (-) Remarks
Chocolate Demand of of Chocolate or Surplus (+)
Chocolate (units)
(units)
2 100 20 (-)80 Excess Demand
4 80 40 (-)40 (As Market demand > Market supply)
6 60 60 0 Equilibrium Level
(As Market demand = Market supply)
8 40 80 (4)40 Excess Supply
10 20 100 (4)80 (As Market supply > Market demand)

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As seen in Table 11.1 and Fig. 11.1,

 both buyers and sellers are negotiating to buy and sell chocolates. Both have different prices to
offer.
 Buyers will like to pay as low as possible and sellers will like to charge as high as possible.
 But market equilibrium will be determined only when both agree to a common price and a
common quantity at that price.
 With increase in price from rs2 to rs4, market demand falls from 100 to 80 chocolates and
market supply rises from 20 to 40 chocolates.
 Market demand curve DD and market supply curve SS intersect each other at point E, which is
the market equilibrium.
 At this point, rs6 is determined as the Equilibrium Price and 60 chocolates as the Equilibrium
Quantity.

Why any other price is not the Equilibrium Price?

• Any price above rs6 is not the equilibrium price as the resulting surplus, i.e. excess supply would
cause competition among sellers. In order to sell the excess stock, price would come down to the
equilibrium price of rs6.
• Any price below rs6 is also not the equilibrium price as due to excess demand, buyers would be ready
to pay higher price to meet their demand. As a result, price would rise up to the equilibrium price of
rs6.

Important Points about Market Equilibrium under Perfect Competition

• Each firm is a price-taker and industry is the price-maker.
• Each firm earns only normal profits in the long run
• Decisions of consumers and producers in the market are coordinated through free flow of prices
known as price mechanism.
• It is assumed that both law of demand and law of supply operate.
• Equilibrium Price is the price at which quantity demanded of a commodity is equal to the quantity
supplied.
• At equilibrium price, there is neither shortage nor excess of demand and supply.
• Equilibrium Quantity is the quantity demanded and supplied at the equilibrium price.

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Excess Demand

 Excess demand refers to a situation, when quantity demanded is more than quantity supplied at the
prevailing market price.
 Under this situation, market price is less than the equilibrium price.
 In Table 11.1, excess demand occurs at price of rs2 and rs4, when market demand is more than market
supply.
 Let us understand the concept of excess demand through Fig. 11.2:
According to Fig. 11.2
market equilibrium is determined at point E at which OQ is the equilibrium quantity and OP is the equilibrium
price. However, if market price is OP 1, then market demand of OQ1 is more than market supply of OQ2. This
situation is termed as excess demand.

 The excess demand of Q2Q2 will lead to competition amongst the buyers as each buyer wants to have
the commodity.
 Buyers would be ready to pay higher price to meet their demand, which will lead to rise in price.
 With increase in price, market demand will fall due to law of demand and market supply will rise due
to law of supply.
 The price will continue to rise till excess demand is wiped out. This is shown by arrows in the diagram.
Eventually, price will increase to a level where market demand becomes equal to market supply at OQ
and equilibrium price of OP is attained.

Excess Supply
 Excess supply refers to a situation, when the quantity supplied is more than the quantity demanded at
the prevailing market price.
 Under this situation, market price is more than equilibrium price.
 In Table 11.1, excess supply occurs at price of ` 8 and 10, when market supply is more than market
demand.

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 In Fig. 11.3, if market price is OP 1 (more than equilibrium price of OP), then market supply of OQ 1 is
more than market demand of OQ2. This situation is termed as excess supply.
 Excess supply of Q2Q2 will lead to competition amongst sellers as each seller wants to sell his product.
 Sellers would be ready to charge lower price to sell the excess stock, which will lead to fall in price.

 With decrease in price, market supply will fall due to law of supply and market demand will rise due
to law of demand.
 The price will continue to fall till excess supply is wiped out. This is shown by arrows in the diagram.
Eventually, price will decrease to a level where market demand becomes equal to market supply at
OQ and equilibrium price of OP is attained.
Example: The market demand and market supply of a commodity is given below:
Price (in ` ) 1 2 3 4 5
Market Demand (in 30 25 20 15 10
units)
Market Supply (in 10 15 20 25 30
units)
On the basis of above table, answer the following questions:
(a) What will be the equilibrium price of the commodity?
(b) What will be the quantity demanded and supplied at the equilibrium price?
(c) What will happen, if price is more than the equilibrium price?
(d) What will happen, if price is less than equilibrium price?
Ans: (a) ` 3; (b) 20 units; (c) Excess supply; (d) Excess demand.

VIABLE AND NON-VIABLE INDUSTRY

Viable Industry
 Viable industry refers to an industry for which supply curve and demand curve intersect each other in
positive axes.
 In the viable industry, supply and demand curves must intersect at some positive point as shown in Fig.
11.4.

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 As seen in the given diagram, both demand and supply curves intersect each other in the positive
range of X-axis and Y-axis.

Non-Viable Industry
 Non-viable industry refers to an industry for which supply curve and demand curve never intersect each
other in the positive axes.
 In a non-viable industry, supply curve lies above the demand curve as price is too high for the
consumers.
 It happens when the price, at which producers are ready to produce, is so high that consumers are not
willing to buy even a single unit.
 As a result, the product is not produced. As seen in Fig 11.5, demand and supply curve never intersect
each other in the positive range of both the axes.

1. Price Ceiling 2. Price Floor.

PRICE CEILING
 Government plays an important role in controlling the prices of essential commodities (wheat, sugar,
kerosene etc.) when the equilibrium price determined by free play of demand and supply is too high
for the poor people.
 Price ceiling or maximum price ceiling refers to fixing the maximum price of a commodity at a level
lower than the equilibrium price
IN THE DIAGRAM
Demand curve and Supply curve intersect to each other at point E.
Where equilibrium price is OP and price ceiling is OP 1
The reason for price ceiling is that equilibrium price is too high for the common people to afford.
At P1 producers are willing to supply only P1A and while consumers demand P1N.

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The effect of the ceiling is that shortage, equal to AN is created , which may further lead to black marketing and
hoarding .

It creates a shortage of MN and some consumers of wheat go unsatisfied.

To meet this excess demand, government may enforce the rationing system.
Rationing is a technique adopted by the government to sell a minimum quota of essential commodities
at a price less than equilibrium price to supply goods to the poor community at a cheaper price. Under
this system, consumers are given ration cards/coupons to buy commodities at a cheaper price from
ration shops.
But, price ceiling through rationing system has certain drawbacks:
1. Black Markets: A black market is any market in which the commodities are sold at a price higher than the
maximum price fixed by the government. Black markets exist because consumers are ready to pay a price
more than the price fixed by the government to get more of the limited amount of commodity available.
2. Difficulty in obtaining goods from ration shops: Consumers have to stand in long queues to buy goods from
ration shops. Sometimes, commodities are not available in the ration shops or goods are of inferior quality.

PRICE FLOOR OR MINIMUM SUPPORT PRICE (MSP)

 Government also intervenes in the process of price determination through Price Floor.
 Price Floor refers to the minimum price (above the equilibrium price), fixed by the government, which
the producers must be paid for their produce.
 When government feels that the price fixed by the forces of demand and supply is not remunerative
from the producer's point of view, then it fixes a price (known as price floor) which is more than the
equilibrium price.
 Most well-known examples of imposition of price floor are agricultural price support programmes and
minimum wage legislation.
 Indian Government maintains a variety of price support programs for various agricultural products like
wheat, sugarcane etc. and the floor is normally set at a level higher than the market determined price
for these goods.
The effect of floor price can be better understood with the help of Fig. 11.31.

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As seen in the diagram,

 equilibrium is determined at point E when demand curve DD and supply curve SS of wheat intersect
each other. The equilibrium price of OP is determined.
 Suppose, to protect the producer's interest and to provide incentive for further production,
government declares OP2 as the minimum price (known as Price Floor) which is more than the
equilibrium price of OP.
 At this support price (OP2), the quantity supplied (OQs) exceeds the quantity demanded (OQD) by QSQD.
 This creates a situation of surplus in the market which is equivalent to MN in the diagram.
 The excess supply may be purchased by the government either to increase its buffer stocks or for
exports.
Buffer stock acts as a tool of price floor
 Buffer stock is an important tool
 Buffer stock is a system or scheme in which government buys and store stock when price is lower in
the market and released in case of shortage of the commodity in future.
Minimum Wage Legislation
 Under minimum wage legislation, the government aims to ensure that wage rate of labour does not
fall below a particular level and minimum wages are set above the equilibrium wage level.

Q. Good y is a substitute of good x . The price of y falls . explain the chain of effects of this change in the market of x.
Sol.
 Substitute goods are those goods which can used in place of one another, like tea and coffee.
 Demand for a given commodity varies directly with the price of substitute goods .
 With decrease in price of a substitute goods y , demand for the given commodity x will decrease leading to a
leftward shift in demand curve.

 As shown in diagram.
Original market equilibrium is established
at point E when the original demand
curve DD and supply curve SS intersect
each other at point E where OQ is
Equilibrium quantity and OP is equilibrium
price.
 When Demand decrease to d 2d2, it creates
an excess supply at the old equilibrium
price OP.

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 This leads to competition among the sellers which reduce the price.
 Decrese in price leads to rise in demand and fall in supply
 These changes continuous till the new equilibrium is established at point E 2
 Equilibrium price falls from OP to OP2 and equilibrium quantity falls from OQ to OQ 2.
Previous question
Q1. Explain the chain effects of excess supply of good on its equilibrium price. yr- 2017
Q2. x and y are complementary goods. The price of y falls. Explain the chain of effects of this change in the market
of x. yr- 2017
Q3. Explain the chain effects of excess demand of a good on its equilibrium price. Yr 2017
Q4. What is maximum price ceiling? Explain its Implications.yr-2016
Q5. Explain the chain effects, if the prevailing market price is below the equilibrium price. Yr-2016
Q6. Explain the effect of change in prices of the related goods on demand for the given good. Yr-2016
Q7. Explain the effects of change in income on demand for a good. Yr-2016
Q8. Market of a commodity is in equilibrium. Demand for the commodity ‘’increase’’ explain the chain effects of
this till the market reaches equilibrium again. Use diagram. Yr-2014

HOTS HIGHER ORDER THINKING SKILLS QUESTIONS

Q.1 Explain the effect of increase in income of buyers of a 'normal' commodity on its equilibrium price.
{CBSE, Delhi 2010}
Ans. An increase in income of buyers will increase the demand for normal goods at the given price. It
will lead to excess demand. This leads to competition among buyers, which raises the price. Increase in
price leads to rise in supply and fall in demand. These changes continue till supply and demand become
equal at a new equilibrium price. As there is an increase in demand only equilibrium price rises.
Q.2 What will be the effect on equilibrium price and equilibrium quantity, when price of complementary
goods increases?
Ans. When price of complementary goods increases, keeping other factors constant, then demand for
the given commodity decreases since it becomes relatively expensive to consume the two commodities
(the given commodity and its complement) together. It will lead to excess supply. This leads to
competition among sellers, which reduces the price. Fall in price leads to decrease in supply and rise in
demand. These changes continue till supply and demand become equal at a new equilibrium price. As
there is a decrease in demand only, both equilibrium price and equilibrium quantity will fall.
Q.3 What will be the effect on equilibrium price and equilibrium quantity, when number of firms increases?
Ans. When number of firms increase, keeping other factors constant, then total supply in the market
will also increase due to more firms producing the commodity. It will lead to excess supply. This leads to
competition among sellers, which reduces the price. Fall in price leads to decrease in supply and rise in
demand. These changes continue till supply and demand become equal at a new equilibrium price. As
there is an increase in supply only, equilibrium quantity will rise, but equilibrium price will fall.
Q.4 Explain the effect on equilibrium price when price of inputs increases.
Ans. When price of inputs increase, assuming no change in other factors, then the cost of production
rises. As a result, supply decreases due to fall in the profitability level. It will lead to excess demand. This
leads to competition among buyers, which raises the price. Increase in price leads to rise in supply and
fall in demand. These changes continue till supply and demand become equal at a new equilibrium
price. As there is a decrease in supply only equilibrium quantity will fall, but equilibrium price will rise.
Q.5 Suppose the functions of demand and supply curves of a commodity are given by:
qD = 100-p
qS = 60 + p for p ≥ 15
= 0for0 ≤ p<15

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(i) What does p = 15 indicate?
(ii) Find the equilibrium price and equilibrium quantity.
(iii) Whether the given commodity comes under the category of viable industry.
(iv) Calculate market demand and supply at price of ` 25 and ` 10. Show that at price of ` 25, there is
excess supply and at price of ` 10, there is excess demand.
Ans.
(i) p=15 indicates that the minimum average cost of the firm is ` 15 and firm will not supply the
commodity for any price less than ` 15.
(ii) Calculation of Equilibrium Price and Equilibrium Quantity
At equilibrium, qD = qS
It means, 100-p = 60 + p
2p = 40 or p or Equilibrium Price = ` 20.
Putting the value of equilibrium price in the equation of demand curve:
qD or Equilibrium Quantity= 100-20 = 80 units.
(iii) Yes, the given commodity comes under the category of viable industry as there is some price, at
which supply and demand happen to coincide.
(iv) At price of ` 25: Market Demand =100-25 = 75 units;
Market Supply = 60 + 25 = 85 units. There will be excess supply at price of ` 25.
At price of ` 10: Market Demand = 100 -10 = 90 units;
Market Supply = 60+10=70 units. There will be excess demand at price of ` 10.
Q.6 Mention the various cases in which equilibrium price remains same.
Ans. The equilibrium price remains same when:
(i) Increase in demand = Increase in supply.
(ii) Decrease in demand = Decrease in supply.
(iii) Demand increases and supply is perfectly elastic.
(iv) Demand decreases and supply is perfectly elastic.
(v) Supply increases and demand is perfectly elastic.
(vi) Supply decreases and demand is perfectly elastic.
Q.7 "Demand and supply are like two blades of a pair of scissors". Comment
Ans. The given statement is correct. Both the blades of a pair of scissors are equally important to cut a
piece of cloth. Similarly, both demand and supply are needed for determining price in the market. There
is no use for demand for a product if there is no supply for the product and supply is not needed if there
is no demand for the product. One of the two may play more active role in price determination in the
short run. But, both are needed to determine the price in the long run.
Q.8 If market demand function is given as: Q MD = 25 - 2P and market supply as: Q MS = 3P, then what will be
the equilibrium price and equilibrium quantity?
Ans. At equilibrium, QMD = QMS
It means, 25 - 2P = 3P
Or,5P = 25
P or Equilibrium Price = ` 5.
Putting the value of equilibrium price in the equation of market demand function:
Equilibrium Quantity= 25-2x5=15 units.
Q.9 There are 10,000 identical individual buyers in the market for commodity X, each with a demand
function given by Qdx = 12 - 2PX and 1,000 identical producers of commodity X, each with a supply function
given by Qsx = 20PX.
(i) Find the market demand function and the market supply function for commodity X.
(ii) Obtain the equilibrium price and equilibrium quantity.

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(iii) Suppose the government decides to collect a sales tax of ` 2 per unit sold from each of the 1,000
sellers of commodity X. What effect will this have on the equilibrium price and quantity of commodity X?
Ans.
(i) Market Demand function: QMdx = 10,000 (12 - 2Px) = 1,20,000 -20,000 Px
Market Supply function: QMsx = 1,000 (20 Px) = 20,000PX
(ii) At equilibrium, QMdx = QMsx
It means, 1,20,000 - 20,000 Px = 20,000PX
or, Px = ` 3
Putting the value of equilibrium price (Px) in the market demand function, we get:
QMdx = 1,20,000 - 20,000 x3= 60,000 units.
Equilibrium Price = ` 3, Equilibrium Quantity = 60,000 units.
(iii) When sales tax of ` 2 per unit is imposed and collected from each of the 1,000 sellers of
commodity X, then the new equilibrium price becomes: Px - 2.
New Market Supply function: QMsx = 20,000 (Px -2)= 20,000PX - 40,000
For equilibrium, QMdx = QMsx
It means, 1,20,000 - 20,000 Px = 20,000PX - 40,000
or, Px= ` 4
Putting the value of equilibrium price (Px) in the market demand function, we get:
QMdx = 1,20,000 - 20,000 x4= 40,000 units.
New Equilibrium Price = ` 4, New Equilibrium Quantity = 40,000 units.
Thus, the equilibrium price increases and equilibrium quantity falls due to sales tax of ` 2 per unit.
Q.10 Market for a good is in equilibrium. There is simultaneous "decrease" both in demand and supply but
there is no change in market price. Explain with help of a schedule how it is possible.
{CBSE, All India 2012}
Ans. A simultaneous decrease in both demand and supply may not influence the market price. This can
be illustrated with the help of following schedule:
Price of Original Original New Demand New Supply
Demand Supply (units) (units) (units)
(units)
2 100 20 90 18
4 80 40 72 36
6 60 60 54 54
8 40 80 36 72
10 20 100 18 90
As seen in the given table, initially, the equilibrium (market) price is ` 6 per unit and the equilibrium
demand and supply is 60 units.
When both demand and supply decrease by 10%, then both demand and supply fall from 60 units to 54
units. It means, at market price of ` 6, both demand and supply are equal. So, a simultaneous
decrease in both demand and supply may not change the market price.

Multiple Choice Questions: Choose the Correct Answer

1. Under perfect competition, equilibrium price of the commodity is determined by:
(a) demand for the commodity alone (b) supply of commodity alone
(c) both demand and supply (d) the government

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2. In the situation of market equilibrium:
(a) market demand = market supply (b) market demand > market supply
(c) market demand < market supply (d) none of these

3. In a situation of excess supply, market price tends to

(a) rise (b) fall
(c) remain constant (d) none of these

4. If demand for a product falls, equilibrium price will:

(a) fall (b) rise
(c) either of the two (d) neither of the two

5. The market price is related to:

(a) short period (b) very short period
(c) long period (d) very long period

6. What will be the effect on equilibrium price if supply is decreased without any change in demand?
(a) No change in price (b) Price will fall
(c) Price will rise (d) None of these

7. A fall in input prices would cause:

(a) fall in equilibrium price and rise in quantity
(b) rise in equilibrium price and fall in quantity
(c) fall in equilibrium price as well as quantity
(d) rise in equilibrium price as well as quantity

8. Supply being perfectly inelastic, what will be the effect of increase or decrease in demand on price and
equilibrium quantity?
(a) Price increases or decreases respectively
(b) No effect on equilibrium quantity
(c) Both (a) and (b)
(d) None of these

9. When will increase in supply bring down the price, leaving the quantity demanded unchanged?
(a) When demand for the commodity is perfectly elastic
(b) When demand for the commodity is perfectly inelastic
(c) When demand for the commodity is less elastic
(d) When demand for the commodity is more elastic

10. What would price ceiling lead to when the maximum price is fixed lower than the equal price?
(a) Excess demand (b) Excess supply
(c) Deficient demand (d) None of these

11. The period of time, when supply is fully adjusted to change in demand is called:
(a) short period (b) very short period
(c) mid period (d) long period

12. Market supply curve of perishable goods is a vertical straight line parallel to Y-axis. It happens in which of the
following periods?
(a) Long period (b) Short period
(c) Very short period (d) All of these

13. The minimum assured price offered by the government to the farmers for the purchase of their output is called:

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(a) ceiling price (b) equilibrium price
(c) support price (d) market price

14. At Px = Rs.5, demand for Good-X is 30 units and supply of Good-X is 20 units, it is a situation of:
(a) excess demand (b) excess supply
(c) equilibrium (d) none of these

15. Decrease in the number of consumers causes:

(a) equilibrium price to rise (b) equilibrium price to fall
(c) no change in equilibrium price (d) none of these

16. Increase in the income of the buyers (in case of an inferior good) will cause:
(a) fall in equilibrium price and quantity
(b) rise in equilibrium price and quantity
(c) fall in equilibrium price and quantity to rise
(d) rise in equilibrium price and quantity to fall

17. When both the demand and supply curves shift to indicate increase in demand and supply in the same
proportion:
(a) only equilibrium price remains unchanged
(b) only equilibrium quantity remains unchanged
(c) equilibrium price remains unchanged but equilibrium quantity decreases
(d) equilibrium price remains unchanged but equilibrium quantity increases

18. Which of the following statements is correct, in the case of excess demand?
(a) Market supply will be less than market demand
(b) Equilibrium price and equilibrium quantity will increase
(c) Both (a) and (b)
(d) Neither (a) nor (b)

Answers
1. (c) 2. (a) 3. (b) 4. (a) 5. (b) 6. (c) 7. (a) 8. (c) 9. (b) 10. (a)
11. (d) 12. (c) 13. (c) 14. (a) 15. (b) 16. (a) 17. (d) 18. (c).

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