EQUILIBRIUM/DISEQUILIBRIUM & ELASTICITIES OF DEMAND AND

SUPPLY

LECTURE THREE

LECTURE OBJECTIVES

At the end of the lecture, the student should :

Describe the nature of market equilibrium/disequilibrium

Explain changes in market equilibrium/ disequilibrium

Understand the concept of price elasticity of demand (define, measure, interpret and
apply)

Explain the determinants of elasticity

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 EQUILIBRIUM

In studying equilibrium, our objective is to determine the market price and quantity and try to
identify the forces that influence such a price and quantity.

Equilibrium can be defined as a state of rest. It is a situation whereby quantity demanded

Qd is equal to quantity supplied s i.e.
In this case, we say that the market is clearing and there are no economic forces
generated to change this point hence it is stable.
We determine this graphically by the interpretation point of the demand and supply curves as
below

Price

Excess supply
Equilibrium price = e

Equilibrium Quantity = Qe

Excess demand

Quantity

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In the above diagram it can be seen that the forces of demand and supply determine the
price in the market, i.e. a price at which both consumers and sellers are happy and where
quantity supplied equals quantity demanded. That price is known as the equilibrium
price.
In the diagram, should the price be above the equilibrium price, forces of demand and
supply will work together and lower the price towards the equilibrium price until the
equilibrium price is reached. For example at p1 consumers will only be willing to buy

0Q1 from the market while sellers will by willing to supply 2 . In this case an excess

supply equals to Q1Q2 will be created. Because of this excess supply, sellers will have to
reduce the price in an attempt to encourage consumers to buy more. Prices will be
reduced until pe is reached where quantity demanded equals quantity supplied.

Should the price be below the equilibrium price (e.g. at ) again the forces of demand

and supply will work together to ensure p e is restored. At suppliers are willing to

supply only Q3 because they consider to be very low. On the other hand, consumers

will be willing to buy since very many of them can afford to pay . In this case an
excess demand (shortage) equal to Q3Q4 will be created. Because of shortages, consumers
will compete among themselves for the little that is available and because of this
competition, prices will be pushed upwards towards pe until eventually pe is reached.

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MATHEMATICAL DERIVATION OF EQUILIBRIUM

Demand function:

Supply function:

Question: determine the equilibrium market price and quantity.

Solution

At equilibrium

Thus.

2024 506 p
2024
pe sh.4
506

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 Price

Quantity

TYPES OF EQUILIBRIUM

1. Stable equilibrium
2. Unstable equilibrium
3. Neutral equilibrium
Stable equilibrium: if there is a force that disrupts the market equilibrium, then there would
be adjustments that bring back to the initial equilibrium. This type of equilibrium is well
explained in the previous section.

Unstable equilibrium: this occurs when the deviation from the equilibrium position tend to
push the market further away from the equilibrium conditions of unstable equilibrium occurs
when the demand curve is positively sloped as in the case of a giffen good or when the
supply curve is negatively sloped as in the case of labor supply.

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Illustration using demand for a giffen good

Price S

D
Excess demand
p1

p2

D S
Qe Q1 Q2 Quantity

Equilibrium point is pe Qe

If price increases from p e to p1 , excess demand over supply is created as shown by the

quantity 2 1

Because of excess demand prices will continue going up and for away from equilibrium
point, hence unstable equilibrium.
Neutral equilibrium:- this occurs when the initial equilibrium is disturbed and the forces of
disturbances lead to a new equilibrium point. It may occur due to shift of either demand of
supply curve, and through effects of taxes etc.

Effects of shifts of demand/supply curve on equilibrium

The equilibrium price will fall on increase depending on the direction in which the shift have
taken place.

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 Price
D0
0
1

Excess supply
pe

1 D0

Qe Q1 Q2 Quantity

An increase in supply is represented by a shift to the right.

Initial equilibrium price and output is pe and Qe , respectively

At this initial price p e with an increase in supply means output increasing to while

demand remains Qe .
Therefore we shall have excess supply.
To encourage consumers to consume more of the good, adjustment will be such that
prices decline. Prices will continue to decline until a new equilibrium price p1 is
realized.
Therefore the new equilibrium prices and output will be 1 1

Notice, because of all in prices to p1 , quantity demanded will increase from Qe to .

Therefore we can conclude by saying that an increase in supply leads to low price and
to increase in quantity demanded

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This is a situation where quantity demanded is not equal to quantity supplied. , and
the market does not clear. Hence both consumers and suppliers will have to change their
DISEQUILIBRIUM
behavior.

Conditions for disequilibrium

i) Price restriction by government

Government from time to time control prices of different commodities through
maximum price policies and minimum price policies.

Maximum (ceiling) price policy

Here prices are set below equilibrium price because sometimes the equilibrium price
might be regarded as being too high for the poor consumers to afford essential
commodities. In an effort to protect poor consumers from exploitation, the
government fixes a maximum (ceiling) price so that commodities that are regarded as
essential can be within easy reach of the poor consumer. This can be shown in the
diagram below.

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 Price

Excess demand

Quantity
2

In the above diagram it can be seen that a maximum price p1 has been set below, the

equilibrium price pe . As a result excess demand represented by Q1Q2 is created since at p1

supplier is willing to supply only while consumers are willing to buy .

However if the ceiling is above p e , say , it will serve no purpose since the equilibrium

pe Qe will still be maintained. At there will be excess supply and the producer would be

better off reducing the price to pe to reduce wastage as a result of over production.

Consequences of maximum price policy

1) Shortages can be created since demand will exceed supply.

2) The government might be forced to ration the little that is available in order to
ensure that at least everybody gets something.
Activities like black marketing, smuggling and hoarding are likely to take place
because the price below equilibrium level might be regarded as too low by the
producers

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1) The level of investment is likely to be discouraged because of low business profit
private business will be getting very low profits to plough back into their
business.
2) Due to low investment, there might be unemployment. i.e. very few jobs will be

economy.
3) On the positive side we can say that the welfare of the consumer is likely to
increase since the consumer will be able to afford the prices in the market.
Minimum (floor) price policies

Here price are set above the equilibrium price, the reason being that the government
might consider the equilibrium price to be a very low to motivate producers to
continue production effectively. In order to encourage producers to produce more.
The government sets a minimum price.

Minimum price are mainly found in the agricultural sector since the agricultural
sector often suffers from price fluctuation. Below is a diagram which illustrates the
working of minimum price policies.

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 Price

D
S
Excess supply
p1

pe

S
D
Q1 Qe Q2 Quantity

In the diagram it can be seen that a result of fixing a minimum price p1 above the

equilibrium price e excess supply Q1Q2 is created since consumers are willing to

be buy , while suppliers are willing to supply

In this case the government has to purchase the excess supply and either store it so
that it can be re-supplied during the period of shortage or export to the outside market
on order to earn the country foreign exchange.

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2) Failure to meet production target as another condition to disequilibrium
Failure to meet production target especially in the agricultural sector due to unfavorable
climatic condition among other could lead to disequilibrium in the market. Let

Planned production

SA Actual production

Price

1 A e p 2 Quantity
Excess
demand

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Let P A . That is, owing to unfavorable climatic condition, supposing the producer fails

to meet his targeted production of and instead he realizes only . This would imply that
there would be shortage as demand would exceed supply . Because of this excess
demand (shortage) the prices will move upwards. The consumers will be willing to pay a
price p1 for units of output. This is shown as point V p1Q1 along the demand curve.

On the other hand, if P A , this implies more production than planned, there would be
excess supply and prices would be pushed down wards below the equilibrium.

However, this situation of disequilibrium may not be permanent. Once conditions improve,
equilibrium may be attained. That would be in the long run.

3)Lagged responses as a cause of disequilibrium

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 Price

Increase in demand

Quantity

Suppose we assume that consumer income has increased. This will lead to the
shift of demand curve to the right from 0 0 to

The effects will be the disturbance of equilibrium from pe Qe and creation of

excess demand over supply

This is so because it will take the producers time before the they produce enough
to meet this excess demand.
Because of this short-term shortages prices will be pushed upwards towards

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 From the law of demand and supply we know that as price increase demand will
decline and supply increase.
This will continue until a new equilibrium point is attained p2 Q2
It should be noted that before this new equilibrium point was attained there was a
lag. This could be because of inferior technology that could not allow production
to take place on time to avoid shortage. Another reason could be imperfect
knowledge about the market conditions. If consumers could have perfect
knowledge on alternative sources of product such shortage could not arise.

How disequilibrium concept is applied

The disequilibrium concept can be applied on the cob- Web model.

THE COBWEB THEORY

This model is used to trace the path form disequilibrium to position of equilibrium. In our
previous discussion, we said that one cause of disequilibrium is lagged responses.

The cobweb model assumes that producers output plans are fulfilled but with a time lag. That
is, if a producer is a farmer, he cannot within the short-run increase his output just because
the market is offering very good prices.

This is so because of the nature of the products. The time between planting and harvesting is
long enough risk and uncertainty to prevail.

prices. However demand depends on the prevailing prices in the market.

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Therefore, what is consumed presently is what must have been planted in the previous
period.

Where pt is price in the current year.

pt 1 is price in the previous year.

The cobweb model always begins with a situation of disequilibrium in the market due to
unplanned variation in the supply.

The following diagram can be used to illustrate what the cobweb theory is all about.

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Price
Fig a Convergent cobweb

p1
p3

Quantity
Time

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 Suppose the prevailing price in the market is p1 , quantity demanded will be .

Farmers will base their production decision for period 2 on the price of period 1 1 .

Therefore in period 2 farmers will produce output .

From the diagram, it can be seen that consumers are willing to buy that quantity at .

If farmers base their production decision for the third period on the present price , they
will cut down production to Q3 because they consider the price to be too low.

With this quantity in the market p3 will be offered by the consumer.

Again if farmers base their decision for the fourth period on the present price i.e. p3 , they

will produce , but with produced, consumers will be willing to pay only .
This process goes on as shown in the diagram until eventually equilibrium price is
achieved.
From the diagram, it can be seen that the fluctuation tend to converge towards the
equilibrium, hence, this situation is known as convergent or a situation of stable
equilibrium.

Just like we have convergent fluctuation we can also have divergent fluctuation.

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Price
Fig b Divergent cobweb

p3
p3
1
1

p2
p2
p4
p4

Q3 Q1 Q2 Q4 Quantity
Time

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From the same procedure as in figure a, fluctuation in price tend to become wider over
successive period. In other words, the fluctuation tends to run away from equilibrium prices.
Such a situation is known as divergent situation in that it diverges from the equilibrium price.
Such a situation is known as a divergent situation in that it diverges from the equilibrium
price. It has also been called by some economists a situation of unstable equilibrium.

WEAKNESSES OF COBWEB THEORY

1. It assumes that products (former) are irrational and hence base their production decision
on the previous prices without thinking of price changes but this is rather unrealistic
because in reality farmers always think about changes in prices in the future.
2. The theory also assumes that all the quantity produced is sold in the market but this is
also unrealistic because in the true sense some agricultural products are assumed for
subsistence needs while others are stored waiting for sale in the future when prices are
considered high.

It is thus clear from the previous discussion that the elasticity of demand depends not only on
the ratio of price to quantity demanded, but also on the slope of the demand curve.

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DISTINCTION BETWEEN POINT ELASTICITY AND ARC ELASTICITY OF DEMAND.

The two are different ways of computing elasticity of demand.

1. Point elasticity
Point elasticity is the proportionate change in quantity demanded resulting from a
proportionate change in price at a particular point along the demand curve.

When calculating point elasticity, it is assumed that the slope of the demand function
is known.

From the formula for elasticity,

Q p
pp
p Q

Q
As noted earlier is the reciprocal of the slope of the demand function.
p

Given a demand function

Q
is found by getting first derivative of Q with respect to
p

p
Thus point of elasticity pp b1
Q

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Example

Demand schedule

Price Quantity

0 40
1 35
2 30
3 25
4 20
5 15
6 10
7 5
8 0

Price

p 8
slope
Q 40

Quantity
20 40

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Arc Elasticity

Arc elasticity is a measure of the average elasticity; i.e. the elasticity at the mid point of the chord that
connects 2 points (A and B) along the demand curve defined by the initial and the new price levels.

Price

A
p1

B
p2 D

Quantity
Q1 Q2

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Using example in above demand schedule.

Assume initial price p1 5 , which then increases to p1 6

p1 Q1
5 15

p2 Q2
6 10

p1 p2 11
Q1 Q2 25

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Income Elasticity of Demand

This can be defined as the responsiveness of quantity demanded to change in income in %

term it can be defined as:

Q Y
So that E I
Y Q

Where

is change in quantity demanded.

Q is original quantity demanded.

is change in income

Y is original income.

Arc income elasticity of demand can be calculated as:

Q Y1 Y2
EY
Y Q1 Q2

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 Income elasticity of demand for most commodities is positive, indicating higher
purchases at higher income. Income elasticity for a few commodities is known as inferior
goods.
Degree of income elasticity varies in accordance with the nature of commodities
consumers consume in general. Where the commodity id a basic necessity, the demand is
not very responsive to change in income. Basic necessities like food are usually bought in
fairly constant amount and on regular basis. In this case EY 1
However, in the case of luxuries, the demand is very responsive to change in income.
Sales of such goods increase rapidly with increase in income. In this case Y

Cross elasticity of Demand

The demand for one product can be influenced by the demand. For example, the demand
for good product depends on the demand for pork, mutton and fish etc. if the price of beef
rises while prices of substitutes (pork, mutton and fish) remains unchanged, consumers
will substitute beef with the cheaper product.
In some cases, an increase in price of one product can lead to s reduction in demand for
other products. This is true of complementary products e.g. electricity and electronic
gadget, petrol to automobile etc. in this case the products are considered to be
complementary or used together rather the substitutes.
Therefore, cross elasticity is the percentage change in quantity demanded of good x due
to 1 % change in the price of good Y it measures the degree of responsiveness of demand
for one product to changes of the price of its substitutes or complementary goods
For instance, cross elasticity of demand for tea (T) is the percentage change in its quantity
demanded with respect to one (1) percent change in price of its substitute coffee (C).

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 Point cross elasticity is calculated by the formula

QT p c
E t ,c
p c QT

Where

C is price of coffee

QT is quantity of tea.

Cross elasticity of demand can either be positive or negative.

A high positive cross elasticity means that the commodities are cross substitutes. If price of
butter increases, the price of its substitutes (margarine) held constant, the quantity demanded of
margarines would increase.
A negative cross elasticity means that the goods are complementary in the market, thus a
decrease in the price of one stimulates the sale of the other.
A cross elasticity of zero means that the goods are independent of each other in the market.

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Numerical example

Compute different price elasticity and state the relationships between the commodities Y, W, X and
Z.

Solution

Take first derivative of commodity Y with respect to all other products.

QY
0.3
pW QY
0.2
QY pX
0.000001
pZ

pW p X Z
We know with certainty that the ratios , and are all
QY QY Y

positive. From this example it is clear that good y and w are

complementary goods since is negative.

E y , x , is positive implying that x and y are substitutes. Good z and y are independent and

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DETERMINANTS OF PRICE-ELASTICITY OF DEMAND

The following are the main determinants of price elasticity of demand.

Availability of close substitutes to the commodity.

Nature of a commodity
Proportion of income which consumers spend on a particular commodity.
Range of uses of a commodity.
Habits
1. Availabity of close substitutes-The higher the degree of the closeness of the substitutes,
the greater the elasticity of demand of the good or service. For instance, coffee and tea
may be considered as close substitute for each other. Therefore, 1 percent increase in
price of say coffee, would lead to more than proportionate decline in quantity demanded
of coffee.
2. Nature of a commodity-Demand for luxury goods (e.g. refrigerator, TV etc) is
more elastic because their consumption can be dispersed with or postponed when their
prices [Link] the other hand, consumption of necessities (e.g. foodstuffs), essential for
life, cannot be postponed and so their demand is inelastic.
3. Proportion of income which consumers spend on a particular commodity-If
proportion of income spent on a commodity is large, its demand will be more elastic, and
vice versa. A classic example of such commodities is salt, which claims a very small
proportion of income whereas clothes, and other durable consumer goods claim a large
proportion of income.
4. Range of uses of a commodity- The wider the range of uses of a product , the higher the
elasticity of demand. As the price of a multi-use commodity decreases, people extend
their consumption to its other uses, thereby increasing the demand. For instance, milk can
be taken as it is, it may be converted into cheese, ghee and butter. The demand for milk
will therefore be highly elastic.

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5. Habit: some goods are consumed because of habit e.g. smoking, in this case we find that
price changes leave quantity demanded more or less unaffected. In this case their demand
is said to inelastic.

Elasticity of supply.

This is the percentage change in the quantity supplied of a commodity resulting from a
1% change in price.
Elasticity of supply is usually positive because a higher price gives producers an
incentive to increase output.
Like elasticity of demand, elasticity of supply can also be referred with respect to such
variables as interest rates, wage rates, price of raw materials and other intermediate goods
etc.
Symbolically, elasticity of supply ( E sp ) can be expressed as follows.

When a small change in price bring about a very big change in quantity supplied, then we
say that quantity supplied is elastic. On the other hand, if a big change in price brings
about a small change in quantity supplied, then we say that supply is inelastic.

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Determinants of elasticity of supply

1. Availability of factors of productivity

this can be looked at as the ease with which factors of production could be shifted from
one use to [Link] can also be looked at as the number of available resources. When
factors of production are available, supply will highly be elastic and vice versa.

Suppliers will be able to meet demand in good times.

2. Excess capacity of unsold stock (Buffer-stock)

if there exist a lot of stock, incase prices increase, supplier would be able to respond very
fast by increasing supply. In such a case supply is said to be highly elastic.

3. Time factor
This refers to the time it takes to produce and supply a product in the market. In the short
run, supply of most items that take a long time to produce is inelastic. But, in the long run
supply is inelastic.

4. Nature of a commodity
durable/ stockable commodities as clothes etc. have greater elasticity of supply than
perishable goods as milk. This is so because, incase the price of perishable items is low,
producers will still be forced to supply the items. Because it cannot be stored for future
sale when the prices would increase.

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 Usefulness of the concept of elasticity

1. Useful in taxation.
If it is the aim of the government to raise revenue it has to put into consideration
elasticities of the commodities to be taxed, especially price elasticity of demand.

In order to raise revenue the government has to impose heavy taxes on goods which have
inelastic demand. E.g. cigarettes and beer. This is because after taxes are imposed on
such goods consumers will continue to demand the goods in large quantities as before
and therefore the government is able to collect more revenue.

On top of this, the burden of taxes on goods which have inelastic demand falls more on
consumers because sellers are able to pass a greater part of the tax to the consumers
through high prices.

This leaves the production of such goods more or less un affected thus making it possible
for the government to raise enough revenue.

This is shown in the diagram below.

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 Price
D0
S1
S0

p1 C
p0 E
B
S1
1 A
S0 D0
Quantity
Q1 Q0

The original equilibrium price before the imposition of tax was p0 and the new equilibrium

price after tax is p1 .

Distance AC on the diagram represents the tax imposed on the good.

AB of the tax is met by the consumers.

It can be seen from the diagram that the quantity in the market fell by a small proportion

1 0

It can thus be said that when a commodity has inelastic demand it pays the government to tax
that commodity heavily because the greatest part of the tax is met by consumers, thus leaving
the production of that good more or less unaffected, hence enabling the government to collect
more revenue from that good.

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2) Elasticity is important in international trade
Before a country devalues her currency so as to encourage export and discourage imports, it
has to put into consideration the elasticity of demand and supply for her export and imports.

For devaluation to succeed, exports must be highly elastic so that after devaluation, greater
quantities can be sold in the foreign market. Similarly, the export must have elastic supply in
order to meet increased demand in foreign markets.

On the import side, imports must have elastic demand so that after devaluation greater
quantities of imports can be abandoned.

We can therefore say that before any country devalues her currency, it is important to
consider elasticity of demand and supply for export and imports.

3) Elasticity also tells us the degree to which goods are related.

High cross elasticity between two commodities shows that the two commodities are very
related. This is a useful concept especially for formulating pricing strategies. Such elasticity
is especially important in studying how unfair competition of dumped goods affects
performance of domestic industries. This would thus enable the government know how much
import duty to impose on such goods as to protect local industries from collapsing.

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Summary

The cobweb theory model is used to trace the path form disequilibrium to position of
equilibrium.

The concept of elasticity is useful in various ways namely:

The relation of the goods

Taxation.

international trade

NOTE

Elasticity is the percentage change in the quantity supplied/demanded of a commodity resulting

from a 1% change in price.

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