Chapter (2)

Stable and unstable equilibrium

-Walrass and Marshal
-Cobweb theorem
- Applications for demand and supply equilibrium

1)MARKET EQUILIBRIUM:
From the discussion so far, it can be concluded that a market system is driven by
two forces, which are demand and supply. This is because these two forces play a
crucial role in determining the price at which a product is sold in the market.
Price is determined by the interaction of demand and supply in a market.
According to the economic theory, the price of a product in a market is determined
at a point where the forces of supply and demand meet. The point where the forces
of demand and supply meet is called equilibrium point.
It is a stage where the balance between two opposite functions, demand and
supply, is achieved. Mathematically, market equilibrium is expressed as:
Qd (P) = Qs (P)
Where:
 Qd (P) is the quantity demanded at price P
 Qs (P) is the quantity supplied at price P
Let us understand the concept of market equilibrium with the help of
an example.
Table 3.3 shows the demand and supply of fans at different price levels.

Price (per fan) Demand in a month Supply in a month

600 80 55
650 75 65
700 70 70
750 50 75

In Table 3.3, it can be observed that at the price of ` 700, the demand
and supply of fans is equal i.e. 70,000 fans. Therefore, market equilibrium
exists at 70,000 where demand and supply are the same.

1
 D S
P1 A surplus B

P E

P2 C deficit E1

S
D

 DD represents a negatively sloped demand curve and SS denotes a

positively sloped supply curve. The equilibrium occurs at point E. At
this point, the supply and demand are in balance; the equilibrium price
OP and the equilibrium quantity OQ are determined.

 The prices above equilibrium level

Let us assume that the market price is OP1. At this price, P1B is the quantity
supplied while the quantity demanded is only P1A. Hence, quantity supplied is
more than the quantity demanded. The surplus quantity in the market is to the
extent of AB. This creates a downward pressure on price. The downward pressure
applies until the price reaches the equilibrium level at which the quantity supplied
equals the quantity demanded.
 The prices below equilibrium level
In the diagram, let us consider the price OP2. At this price level, the quantity
supplied is less than the quantity demanded. CE1 denotes the volume of shortage
of commodity. Due to this excess demand, an upward pressure on the price applies.
This upward pressure pushes up the price to the equilibrium level at which the
quantity supplied equals the quantity demanded

A ) Changes in Market Equilibrium

We've already discussed shifts in Supply and Demand. Now we'll see how they
affect the equilibrium price and quantity.

2
 first a shift in Demand
- Rightward shift in Demand. This could be caused by many things: an
increase in income, higher price of a substitute good, lower price of a
complement good, etc. Such a shift will tend to have two effects: raising
equilibrium price, and raising equilibrium quantity. This is shown in the
figure below..

Price Do Price D1
D1 S Do S
0
P0 E P1 E1

P1 P0 E0
E1

Q1 Qo Q Q0 Q1 Q

(B) (A)

- leftward shift of demand would reverse the effects, resulting in a fall in

both price and quantity. The general result is that demand shifts cause
equilibrium price and equilibrium quantity to move in the same direction.

 A shift of supply
- Rightward shift of supply (caused by lower input prices, better technology,
or entry of new firms). This will tend to have two effects:
- raising equilibrium quantity,
- and lowering equilibrium price.

Price S1 Price
D D So
S1
So
Eo
P1 E1 Po

E1
Po Eo P1

Q Q
Q1 Qo Qo Q1

(B) (A)

3
A leftward shift of supply that supply shifts tend to cause equilibrium price to
raise and equilibrium quantity to decrease.
 Supply and Demand Both Shift
Sometimes, the supply and demand curves will both shift at the same time.
This makes the analysis slightly more difficult.
- Supply and demand both shift right at the same time.
For example, technological improvements lower the cost of producing
computers, while new software makes more people want to have computers.
both shifts tend to increase quantity, so quantity goes up. But for price, the
answer is unclear: one shift tends to decrease price, and the other tends to the
same price .
Price
S
1
S
2

P1 E
P2 E^

D D
2 1
Q1 Q2
Quantity

P'

Q Q' Q"

4
- Supply and demand both shift left at the same time
S2
Price

S1

E
P1

P2 E^

D1
D2

Q2 Q1
Quantity

- The demand increase and the supply decrease

Price S2

S1

P2

D2
D1

Q2 Q
1 Quantity

5
  The demand decrease and the supply increase

Price
S1

S2

P1

P2

D1
D2

Q Quantity

ND AND SUPPLY 125

2-ELASTICITY OF DEMAND
Economists have divided the elasticity of demand in three main categories :
- Price Elasticity of Demand: is a measure of a change in the quantity
demanded of a product due to change in the price of the product in
o the market
- Income Elasticity of Demand: is a measure of a change in the quantity
demanded of a product due to change in income of the product in the
market
- Cross-Elasticity of Demand : is a measure of a change in the quantity
demanded of a product due to change in the price of other goods in
the market
 PRICE ELASTICITY OF DEMAND
Price elasticity of demand is a measure of a change in the quantity demanded
of a product due to change in the price of the product in the market. In other words,
it can be defined as the ratio of the percentage change in quantity demanded to the
percentage change in price. It can be mathematically expressed as:
Price elasticity of demand = Proportionate Change in the Quantity Demanded
Proportionate Change in Price
A percentage change in demand and price is denoted with a symbol Δ.
Thus, the formula for calculating the price elasticity of demand is as
follows:

ep =ΔQ ÷ ΔP = ΔQ x P
Q P ΔP Q

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  DIFFERENT TYPES OF PRICE ELASTICITY
The extent of responsiveness of demand with change in the price does not remain
the same under every situation. The demand for a product can be elastic or
inelastic, depending on the rate of change in the demand with respect to change in
price of a product. Based on the rate of change, the price elasticity of demand is
grouped into five main categories .Types of Price Elasticity :
Perfectly Elastic Demand
Perfectly Inelastic demand
Relatively Elastic Demand
Relatively Inelastic Demand
Unitary Elastic Demand
Let us study about these different types of price elasticity of demand in the next
sections.
- PERFECTLY ELASTIC DEMAND
When a small change (rise or fall) in the price results in a large change (fall or rise)
in the quantity demanded, it is known as perfectly elastic demand. Under such
type of elasticity of demand, a small rise in price results in a fall in demand to zero,
while a small fall in price causes an increase in demand to infinity.
the demand is perfectly elastic or =∞.
 Flatter the slope of the demand curve, higher the elasticity of demand. In
perfectly elastic demand,
 the demand curve is represented as a horizontal straight line N

Figure1: Perfectly Elastic Demand

Q Q'

In Figure1, D is the demand curve. Thus, demand rises from OQ to OQ1 and so on,
if the price remains at OP.

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 - PERFECTLY INELASTIC DEMAND
When a change (rise or fall) in the price of a product does not bring any change
(fall or rise) in the quantity demanded, the demand is called perfectly inelastic
demand. In this case, the elasticity of demand is zero and represented as ep = 0.
Graphically, perfectly inelastic demand curve is represented as a vertical straight
line (parallel to Y-axis).
Figure 2: the perfectly inelastic demand curve
D

P'

Q
In Figure 2, DD is the demand curve. Thus, it can be observed that
even when there is a change in the price from OP1 to OP2, quantity
demanded remains the same at OQ1.MAND AND SUPPLY 131
- RELATIVELY ELASTIC DEMAND
When a proportionate or percentage change (fall or rise) in price results in greater
than the proportionate or percentage change (rise or fall) in quantity demanded, the
demand is said to be relatively elastic demand. In other words, a change in
demand is greater than the change in price. Therefore, in this case, elasticity of
demand is greater than 1 and represented as ep > 1. The demand curve of
relatively elastic demand is gradually sloping, which is shown in Figure3:
Figure 3 Relatively Elastic Demand

P'
P

Q Q'
8
In Figure3, DD is the demand curve that slopes gradually down with a fall in price.
When price falls from OP2 to OP1, demand rises from OQ1 to OQ2. However, the
rise in demand Q1Q2 is greater than the fall in price P2P1

- RELATIVELY INELASTIC DEMAND

When a percentage or proportionate change (fall or rise) in price results in less
than the percentage or proportionate change (rise or fall) in demand, the demand is
said to be relatively inelastic demand. In other words, a change in demand is less
than the change in price. Therefore, the elasticity of demand is less than 1 and
represented as ep < 1.

Figure4: Relatively Inelastic Demand

D
P'

Q Q'

3- EXCEPTIONS TO THE LAW OF DEMAND

 (Price ) ( Demand )

14
10

15 20
 Giffen goods:
Good is a commodity that is unexpectedly consumed more as its price
increases.

9
  Articles of distinction/Veblen goods:
These commodities satisfy the desires of the upper class people in the society.
For example, diamonds, rare paintings, vintage cars, and antique goods
 Conspicuous necessities:
There are certain commodities that have turned into necessities of modern
life. For example, the demand for televisions, automobiles, refrigerators, etc. is
generally high in spite of their increasing prices.
 Consumers’ ignorance:
 Situations of crisis:
Crisis such as war and famine negate the law of demand. During crisis,
consumers tend to purchase in larger quantities with the purpose of stocking,
 Future price expectations:
When consumers expect a rise in the prices of commodities, they tend to
purchase commodities at existing high prices.
4- EXCEPTIONS TO LAW OF SUPPLY
According to the law of supply, if the price of a product rises, the supply of the
product also rises and vice versa. However, there are certain conditions where the
law of supply is not applicable. These conditions are known as exceptions to the
law of supply. In such cases, the supply of a product falls with the increase in the
price of a product at a particular point of time. For example, there would be a
decrease in the supply of labour in an organisation when the rate of wages is high.
The exception to the law of supply is represented on the regressive supply curve or
backward sloping curve. It is also known as an exceptional supply curve. Some
important exceptions to the law of supply
are shown in Figure 3.4:

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Let us discuss these exceptions in detail.

a) Agricultural products: The law of exception is not applicable to

agricultural products. The production of these products is dependent on so
many factors which are uncontrollable, such as climate and availability of
fertile land. Thus, the production of agricultural products cannot be
increased beyond a limit. Therefore, even a rise in price cannot increase the
supply of these products beyond a limit.

b) Goods for auction: Auctions goods are offered for sale through bidding.
Auction can take place due to various reasons, for instance, a bank may auction the
assets of a customer in case of his failure in paying off the debts over a period of
time. Thus, supply of these goods cannot increase or decrease beyond a limit. In
case of these goods, a rise or fall in price does not impact the supply.

c) Expectation of change in prices in the future: Law of supply is not

applicable under the circumstances when there is an expectation of change in
the prices of a product in the near future. For instance, if the price of wheat
rises and is expected to increase further in the next few months, sellers may
not increase supply and store huge quantities in the hope of achieving profits
at the time of a price rise.

d) Supply of labour: The law of supply fails in the case of labour. After a
certain point, the rise in wages does not increase the supply of labour. At
higher wages, labour prefers to work for lesser hours. This happens due to
change in preference of labour for leisure hours.

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5-Stable equilibrium in economics

Figure1-1 Figure1-2 figure 1-3

(a) (b) (c)
P D S p D S P D S

Q Q Q
In figure1,1
- DD represents a negatively sloped demand curve and SS denotes a positively
sloped supply curve.
The equilibrium occurs at point E. At this point, the supply and demand are in
balance; the equilibrium price OP and the equilibrium quantity OQ are
determined. It is a classical example of stable equilibrium in economics.
In figure1,2
D represents a negatively sloped demand curve and SS denotes a negatively
sloped supply curve.
The equilibrium occurs at point E. At this point, the supply and demand are in
balance; the equilibrium price OP and the equilibrium quantity OQ are
determined. It is a classical example of stable equilibrium in economics

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 In figure1,3
DD represents a positively sloped demand curve and SS denotes a positively
sloped supply curve.
The equilibrium occurs at point E. At this point, the supply and demand are in
balance; the equilibrium price OP and the equilibrium quantity OQ are
determined. It is a classical example of stable equilibrium in economics.

6)Unstable equilibrium in economics.

Figure1 figure2 figure3

(a) (b) (c)

P S D p S D P S D

Q Q Q
In supply and demand analysis, unstable equilibrium can occur at two occasions:
(1) when there is a negatively sloped supply curve and
(2) when there is a positively sloped demand curve.

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  1. Negatively Sloped Supply Curve
Unstable equilibrium occurs when there are negatively sloped demand curve,
which is normal and a negatively sloped supply curve, which is a rare and
exceptional case.
This negatively sloping supply curve is possible when both increasing production
and decreasing costs occur simultaneously due to various internal and external
economies of scale enjoyed by the firm.
 In figure 2
- - the point E represents equilibrium. OP is the equilibrium price and OM is
the equilibrium quantity.
- -If the price goes above the equilibrium price,
- the quantity demanded is more than the quantity supplied. Because of this
excess demand,
- price goes up further and moves away from equilibrium.
- Similarly, at prices below equilibrium,
- -quantity supplied is more than quantity demanded.
- Due to excess supply, price goes down further and continues to move away
from the equilibrium.
- In both the cases, there is no possibility for the price to move towards
equilibrium. Hence, E represents an unstable equilibrium position.

Problem :
Estimate market equilibrium :price and quantity
equilibrium ?
The quantity of peanuts demanded each week (q, measured in bushels) depended
on the price of peanuts (p, measured in dollars per bushel) according to the
equation:
Quantity demanded Qd = 1,000 - 100p (1)
Because this equation for Qd contains only the single independent variable p, we
are implicitly holding constant all other factors that might affect the demand for
peanuts.
To complete this simple model of pricing, suppose that the quantity of peanuts
supplied also depends on price:
Quantity supplied = Qs= 125 +125p: (2)
Here the positive coefficient of price also reflects the marginal principle that a
higher price will call forth increased supply—primarily .
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7)Cobweb theorem as an illustration of stable and
unstable equilibrium
Cobweb theory is the idea that price fluctuations can lead to fluctuations in
supply which cause a cycle of rising and falling prices. In a simple cobweb
model, we assume there is an agricultural market where supply can vary
due to variable factors, such as the weather. It is used to illustrate the
danger that time lags may introduce fluctuations into the economy. This
simple dynamic model of cyclical demand with time lags between the
response of production and a change in price (most often seen in
agricultural sectors).
Cobweb theory is the process of adjustment in markets.It traces the path
of prices and outputs in different equilibrium situations. Path resembles a
cobweb with the equilibrium point at the center of the cobweb.

Assumption
- have a perfectly competitive market
- production period is long
- the price is determined by contemporary production
- quantity supplied is determined by contemporary price , farmers have
to decide how much to produce a year in advance , before they know
what the market price will be. (supply is price inelastic in short-term
- A key determinant of supply will be the price from the previous year.
- A low price will mean some farmers go out of business. Also, a low
price will discourage farmers from growing that crop in the next year.
- Demand for agricultural goods is usually price inelastic (a fall in price
only causes a smaller % increase in demand)

15
Cobweb theory and price convergence

At the equilibrium point, if the demand curve is more elastic than the supply
curve, we get the price volatility falling, and the price will converge on the
equilibrium

16
1) If there is a very good harvest, then supply will be greater than expected
and this will cause a fall in price.

2) However, this fall in price may cause some farmers to go out of

business. Next year farmers may be put off by the low price and produce
something else. The consequence is that if we have one year of low prices,
next year farmers reduce the supply.

3)If supply is reduced, then this will cause the price to rise.

4)If farmers see high prices (and high profits), then next year they are
inclined to increase supply because that product is more profitable.

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In theory, the market could fluctuate between high price and low price as
suppliers respond to past prices.

Cobweb theory and price divergence

Price will diverge from the equilibrium when the supply curve is more
elastic than the demand curve, (at the equilibrium point)

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If the slope of the supply curve is less than the demand curve, then the
price changes could become magnified and the market more unstable,
moving away from equilibrium point .

1) If there is a very good harvest, then supply will be greater than expected
and this will cause a fall in price.

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2) However, this fall in price may cause some farmers to go out of
business. Next year farmers may be put off by the low price and produce
something else. The consequence is that if we have one year of low prices,
next year farmers reduce the supply.

3)If supply is reduced, then this will cause the price to rise.

4)If farmers see high prices (and high profits), then next year they are
inclined to increase supply because that product is more profitable.

In theory, the market could fluctuate between high price and low price as
suppliers respond to past prices.

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 8.Taxes and Elasticity
The relative burden, or incidence, of a tax is determined by the price elasticity of
demand (PED) of the consumer in response to a price rise. If the consumer is
unresponsive, and PED is inelastic, the burden will fall mainly on the consumer.
However, if the consumer is responsive to the price rise, and PED is elastic, the
burden will fall mainly on the firm.

 Tax burden
- When demand is elastic, the tax burden is mainly on the producer .
Figure (1)
- When demand is inelastic the tax burden is mainly on the consumer.
Figure (2)
- When demand is perfectly inelastic the hole tax burden is mainly on the
consumer. Figure (3)
- When demand is perfectly elastic the hole tax burden is mainly on the
producer Figure (4)
- Figure (2)

Figure (1) Figure (2)

Figure (3) Figure (4)

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The Effect of an Import Tariff

When the country moves to free trade, domestic consumption amount is

OQ2 , while domestic production amountOQ1. The amount Q1Q2 is imported.
better than no trade (autarky).
- PW  t is the free trade price plus the tariff., domestic consumption decrease
from the amount OQ2 to OQ4, while domestic production increase from the
amount OQ 1to OQ3. The amount Q3Q4 is imported.

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Foreign-Exchange Market
Supply of and Demand for Foreign Currency

• You could analyze changes in foreign exchange rates by using supply and
demand diagrams. Construct an example for the $/£ exchange rate where the
dollar appreciates relative to the pound. Carefully label your diagram and
have the initial exchange rate equal to 1.60.
• The demand for dollar increase ,the demand curve will shift to D/D/
• Central banks, such as the Federal Reserve, buy and sell foreign
exchange to influence the values of their currencies.
• Suppose the U.S. demand for British goods increases, which causes the
demand for pounds to shift to the right. As a result, the dollar
depreciates and pound appreciates.
Either the Bank of England or the Fed may intervene to stop the pound
appreciation by selling pounds in the foreign exchange market

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Demand for a Pure Public Good
 All consumers must consume the same quantity of the good, as pure
public goods cannot be divided into individual units
 Therefore, on the demand curve, the variables on the vertical axes are
the maximum amounts that people would pay per unit of the pure
public good as a function of the amount of the good actually available

Efficiency of a Pure Public Good

• The marginal social benefit of any given amount of a pure public

good is the sum of the individual marginal benefits received by all
consumers

24
• Efficient quantity per time period corresponds to the point at
which output is increased; sum of marginal benefits to
consumers equals marginal social cost of the good
• Efficiency conditions are:

MSB = ∑MB = MSC

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26
 1. TECHNIQUES OF DEMAND FORECASTING

1.QUALITATIVE TECHNIQUES
Qualitative techniques rely on collecting data on the buying behavior of consumers
from experts or through conducting surveys in order to forecast demand.
1.1 SURVEY METHODS
Survey methods are the most commonly used methods of forecasting demand in
the short run. This method relies on the future purchase plans of consumers and
their intentions to anticipate demand. Thus, in this method, an organization
conducts surveys with consumers to determine the demand for their existing
products and services and anticipate the future demand accordingly .
OPINION POLLS
1.2Opinion poll
Opinion poll methods involve taking the opinion of those who possess knowledge
of market trends, such as sales representatives, marketing experts, and consultants.
 Expert opinion method:
In this method, sales representatives of different organisations get in touch
with consumers in specific areas.
 Delphi method:

27
 In this method, market experts are provided with the estimates and
assumptions of forecasts made by other experts in the industry.
 Market studies and experiments:
This method is also referred to as market experiment method. In this
method, organizations initially select certain aspects of a market such as
population, income levels, cultural and social background, occupational
distribution, and consumers’ tastes and preferences. Among all these
aspects, one aspect is selected and its effect on demand is determined while
keeping all other aspects constant.

 QUANTITATIVE TECHNIQUES
Quantitative techniques for demand forecasting usually make use of statistical
tools. In these techniques, demand is forecasted based on historical data. These
methods are generally used to make long-term forecasts of demand. Unlike survey
methods, statistical methods are cost effective and reliable as the element of
subjectivity is minimum in these methods:
- TIME SERIES ANALYSIS
- BAROMETRIC METHODS
- ECONOMETRIC METHODS : REGRESSION ANALYSIS

2.1 REGRESSION ANALYSIS

The regression analysis method for demand forecasting measures the relationship
between two variables. Using regression analysis a relationship is established
between the dependent (quantity demanded) and independent variable (income of
the consumer, price of related goods, advertisements, etc.). For example,
regression analysis may be used to establish a relationship between the income of
consumers and their demand for a luxury product. In other words, regression
analysis is a statistical tool to estimate the unknown value of a variable when
the value of the other variable is known. After establishing the relationship, the
regression equation is derived assuming the relationship between variables is
linear. The formula for a simple linear regression is as follows:
Y = =a + bX
Where Y is the dependent variable for which the demand needs to be forecasted; b
is the slope of the regression curve; X is the independent variable; and a is the Y-
intercept. The intercept a will be equal to Y if the value of X is zero. Determination
of linear regression equation involves the following steps:
1. Identifying the dependent (Y) and independent (X) variables.

28
2. Computing the value for the slope (b) of the regression curve using the
following formula:

3,Computing the value for the Y-intercept using the following formula:
a = Y − bX
4. Developing a linear regression equation for the trend line using
the following formula:
Y =a + bX
Let us understand the concept of regression analysis with the help of
an example.
Example 2: A manufacturer of shirts has traced the relationship between the sales
of shirts and the corresponding advertising and promotion. Calculate the linear
regression to forecast sales figures if the manufacturer has invested `53, 00,000 on
advertising in 2014. The figures for sales and advertising expenses in the past are
given below:

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