The determination of market price for a competitive industry through demand and supply was explained in the previous chapter. The analysis of price determination in terms of demand and supply is not merely of great theoretical significance, it has numerous important practical applications also in economic system and life of the country. It is also helpful in analysing and predicting the effects of government policies. In this chapter, some of the applications of demand and supply as well as their elasticities are discussed.
The term ‘equilibrium’ has been derived from the Latin word ‘acqui’ meaning equal and ‘libra’ meaning balance. Thus, equilibrium means equal balance or a state of no change. The equilibrium equates the quantity demanded and quantity supplied. The corresponding price is called the equilibrium price. At this price, there is neither excess demand nor excess supply.
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Stable Equilibrium:
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Equilibrium is said to be stable, if it is self adjusting, i.e., it comes to its original position of equilibrium through the operation of counteracting forces, after disturbance or displacement. In Marshallian stable equilibrium, equilibrium quantity is disturbed, while in Walrasian stable equilibrium, equilibrium price is disturbed. In both the situations, ultimately, equilibrium position is restored. The disturbance in quantity and price are temporary.
In Fig 11.8, the demand curve DD and the supply curve DD intersect each other at point ‘E’ suppose, due to some disturbance, the price rises to OP1. At this price, the quantity supplied OQ1, exceeds quantity demanded OQ1, resulting in excess supply equal to Q1Q2. With profit maximisation objective, the seller would reduce production.
Price would fall, ultimately reaching the original level of OP due to competition among the sellers. If, instead, the price had fallen to OP2 due to a disturbance, quantity demanded OQ2 exceeded quantity supplied OQ1 resulting in excess demanded.
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Here, the competition among the buyers would push up the price, until the equilibrium price OP is restored. It is a case of Walrasian stable equilibrium, where price moves away from equilibrium and corrective forces start through price adjustments. It is more pertinent is the short-run as it is easier to adjust prices rather than quantity in the short-run. Quantity adjustments only follow subsequently.
Now, suppose the quantity were to fall to OQ1. Here, demand price would be higher than the supply price. This would induce more trade and the quantity traded would rise to OQ. As quantity is away from the equilibrium, correcting forces come into operation and the original equilibrium is restored.
Likewise, if the quantity were to increase to OQ2, the supply price would be higher than the demand price. Consequently, less trade would take place and its amount would eventually fall back to OQ, as buyers would not be prepared the higher price sellers were seeking. This equilibrium is a Marshallian stable equilibrium, where quantity moves away from equilibrium and corrective forces start through quantity adjustments.
French economist Leon Walras defines equilibrium as the price, which equates quantity demanded and quantity supplied. On the other hand, English Economist Marshall defines it as the quantity, which equates demanded price and supply price.
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The Walrasian adjustment process works through price movements (corrections) and the Marshallian adjustment process works through quantity movements (corrections), if quantity demanded and quantity supplied do not balance. The two give similar or identical results under stability analysis of the markets.