Price Theory
Mock PastPapers

## Market Equilibrium

EQUILIBRIUM PRICE: Equilibrium price is price established in the market when quantity demanded is to equal quantity supplied of a commodity. Equilibrium price also changes from time to time. It is also known as market clearing price. i.e. it is set or fixed at a point of intersection of demand and supply curves in a free enterprise economy.

Equilibrium price is important in the following ways:

• It shows efficiency in resource allocation as there are no surpluses or shortages in the market.
• It shows economic welfare maximization because decisions of producers agree with those of the consumers.
• It  helps  the  government  in  the  policy  of  price control  by  avoiding the effects  of  minimum  and maximum price

EQUILIBRIUM QUANTITY:

This  is  the  quantity  exchanged  when  the  market  is  in  balance,  quantity  demanded  and  quantity supplied are equal, therefore there is no shortage or surplus in the market which means that neither buyers or sellers are inclined to change the price or  the  quantity  which is an essential condition for equilibrium. The only quantity that accomplishes this task is at the intersection of the demand curve and supply curve.

An illustration of Equilibrium price and Equilibrium quantity: In the illustration above, where the two curves meet is the equilibrium point and Pe represents the equilibrium price while Qe represents the equilibrium quantity.

Deriving the market equilibrium using the demand and supply functions:

Market equilibrium is derived by using the demand function and the supply function where quantity demanded (Qd) is equal to quantity supplied (Qs)

When solving for equilibrium price and quantity you need to  have a demand function and a supply function.

E.g. if your monthly demand function is Qd= 10000- 80P and your monthly quantity supply function is Qs= 20P, Then set Qd= Qs and solve. To find equilibrium quantity we substitute equilibrium price(100) into either the demand function or supply function as follows;

(a)Using the demand function THE CONCEPT OF CONSUMER’S SURPLUS

Consumer’s surplus is the difference between what a consumer is willing to pay and what   he/she actually pays for the commodity.

OR

It is the extra utility/ additional satisfaction a consumer enjoys without paying for it.

It is given by the following formula:

NOTE:  Consumer’s  surplus  is  limited  by:  income  inequality  among  consumers,  changing marginal  utility  of  money,  differences  in  tastes  and  preferences  and  presence  of  goods  of ostentation.

Illustration of the consumer surplus The consumer surplus is illustrated by the shaded area below the demand curve above the market price at which the consumer buys the commodity.

Example:

Using the consumer’s demand schedule below, calculate the consumer surplus when the market price is shs.150. Method 1:

Consumer surplus = Planned expenditure - Actual expenditure

But actual expenditure = Market price × Number of units purchased.

= (300+250+200+150) - (150×4)

=Shs. 900 - 600

=Shs. 300

Question 2:

You are provided with the following table; Calculate the consumer surplus if 5 units of a commodity are purchased at shs.1500.

PRODUCER’S SURPLUS

This refers to the difference between what the producer is willing to charge and what he actually charges for the commodity.

Or

Producer’s surplus refers to the excess earnings between what the producer was willing to receive for the commodity and what he/she actually receives after selling it.

The producer’s surplus occurs when a producer receives a price for his produce which is above the additional costs he incurred   to produce the product.

Producer’s surplus is given by the following formula

Producer’s surplus = Actual revenue –Expected revenue.

An illustration of the producer’s surplus. In the illustration above the producer’s surplus is shown by the shaded area above the supply curve and below the equilibrium price.

Formula: producer surplus= actual revenue – planned revenue

Example Given the market price is shs.550. Calculate the producer surplus if 6 units are sold.

Producer surplus =Actual revenue – Planned revenue

But actual revenue = units sold*market price

= (550*6) – (300+350+400+450+500+550)

= 3300 - 2550

= Shs. 750