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Practice each question, then open the answer or worked solution.
Explain market equilibrium.
Market equilibrium is referred to as that state in the market where supply is equal to demand. When a market is at equilibrium, the corresponding price will not change unless there is an external factor which is instrumental in changing the supply or the demand. Under the condition of market equilibrium, the price at which a product is sold is known as the equilibrium price.
When do we say there is excess demand for a commodity in the market?
When the market demand for a product/commodity is greater than the market supply, it can be understood that there is an excess demand for that commodity in the market.
When do we say there is excess supply for a commodity in the market?
When the market supply for a commodity is greater than the market demand, it can be understood that there is an excess supply for that commodity in the market.
What will happen if the price prevailing in the market is (i) above the equilibrium price? (ii) below the equilibrium price?
i) When the price of a product prevailing in the market is above the equilibrium price, supply will be more than demand. Since the product can be sold at a price greater than the equilibrium price, the firm will produce more quantities of the given product and increase the supply. But the demand will be low since the competing firms will also increase their production and supply, creating excess supply.
ii) When the price of a product prevailing in the market is below the equilibrium price, supply will be less than demand. Since the product can only be sold at a price lower than the equilibrium price, the firm will produce fewer quantities of the given product and decrease the supply. The competing firms will also do the same, and therefore the supply will not adequately meet the demand creating excess demand.
Explain how price is determined in a perfectly competitive market with a fixed number of firms.
In a perfectly competitive market with a fixed number of firms, the price will be determined by the supply and demand that exists in the market. Since the demand and supply will be the same, the price of any commodity will be at equilibrium. This is known as the equilibrium price.
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 the equilibrium price is greater than the minimum average cost of the firms, more firms will enter the market and produce more quantities of the given commodity. This is due to the high-profit levels that can be gained due to the market’s condition. But in the longer run, the market price will start to fall because of the rise in supply caused by the rush. Therefore, the market equilibrium price will decline, and the profit levels will return to normal.
At what level of price do the firms in a perfectly competitive market supply when free entry and exit are allowed in the market? How is equilibrium quantity determined in such a market?
In a perfectly competitive market, when free entry and exit are allowed, the equilibrium price will be the same as the minimum average cost in the long run. All the firms will earn zero to normal economic profit.
How is the equilibrium number of firms determined in a market where entry and exit are permitted?
When free entry and exit are permitted, the market price will remain the same as the minimum average cost. Therefore, firms will enter or exit the market. Since there is no profit to be gained by producing the given commodity, no company will be incentivised to enter the market. This is how an equilibrium number of firms is determined in such a market.
How are the equilibrium price and quantity affected when the income of the consumers (a) increase? (b) decrease?
(a) An increase in the income of the consumers is likely to increase the equilibrium price. Since the consumers have more money to spend, the demand for a given commodity will increase, and the quantity of the product produced will also increase.
(b) A decrease in the income of the consumers is likely to decrease the equilibrium price. Since the consumers have less money to spend, the demand for a given commodity will decrease, and the quantity of the product produced will also decrease.
Solution coming soon.
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.
Shoes and Socks are complementary goods, and a change in one product’s price will affect how the other product’s supply. Since shoes and socks are usually bought together, when there is an increase in the price of shoes, the demand for socks will face a decline. Due to the decline in demand for shoes and socks, the number of socks sold and bought will decrease.