CHAPTER 4: MARKET EQUILIBRIUM

Learning Outcomes:

1. Students are able to define market equilibrium

2. Students are able to explain the changes of market equilibrium price and quantity due
to changes in demand and supply
3. Students are able to describe price control (maximum and minimum price)
4. Discuss the effect of indirect tax and subsidy on the market equilibrium

DEFINITION OF MARKET EQUILIBRIUM

Market equilibrium is a condition whereby the quantity demanded and quantity supplied are
equal.

QUANTITY DEMANDED (QD) = QUANTITY SUPPLIED (QS)

When market is in equilibrium, the quantity that sellers are willing to sell are exactly balances
the quantity that buyers are willing to buy.

DETERMINATION OF EQUILIBRIUM PRICE AND QUANTITY

1. From Demand and Supply schedules

.
Price (RM) Quantity Demanded (unit) Quantity Supplied (unit)
1 15,000 3,000
2 12,000 6,000
3 9,000 9,000
4 6,000 12,000
5 3,000 15,000

Equilibrium price = RM3 and Equilibrium quantity = 7000 units

2. From Demand and Supply curves

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DISEQUILIBRIUM

Disequilibrium occurs when price level is NOT at the intersection of demand and supply
curve.

Effect of Disequilibrium:

a. Surplus (QS > QD)

Surplus (Excess supply) occurs when supply exceeds demand. At higher price,
producer is willing to sell more than consumer is willing to purchase.

b. Shortage (QD > QS)

Shortage (Excess demand) occurs when demand exceeds supply. At lower price,
consumer is willing to purchase more than producer is willing to sell.

Price (RM) Quantity Quantity Supplied Market Condition

Demanded (unit) (unit) Shortage / Surplus
QD > QS
1 15,000 3,000
Shortage by 12,000 units
QD > QS
2 12,000 6,000
Shortage by 6,000 units
QD = QS
3 9,000 9,000
Equilibrium
QS > QD
4 6,000 12,000
Surplus by 6,000 units
QS > QD
5 3,000 15,000
Surplus by 12,000 units

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CHANGES IN EQUILIBRIUM PRICE AND QUANTITY

1. Effects of changes in demand on equilibrium price and quantity assuming supply is

constant.

a. Demand increases

As shown above, when demand increases, the demand curve shift to the right from
D1 to D2. As a result both price and quantity increase (P1 to P2 and Q1 to Q2).

b. Demand decrease

As shown above, when demand decreases, the demand curve shift to the left
from D1 to D2. As a result both price and quantity decrease (P1 to P2 and Q1 to
Q2).

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2. Effects of changes in supply on equilibrium price and quantity assuming demand is
constant.

a. Supply increases

As shown above, when supply increases, the supply curve shift to the right from
S1 to S2. As a result price decreases (P1 to P2) and quantity increases (Q1 to
Q2).

b. Supply decreases

As shown above, when supply decreases, the supply curve shift to the left from
S1 to S2. As a result price increases (P1 to P2) and quantity decreases (Q1 to
Q2).

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GOVERNMENT INTERVENTION IN THE MARKET

1. PRICE CONTROL

a. Maximum Price (Price Ceiling)

Price ceiling is a legal price set by the government below the equilibrium price
and sellers are not allowed to increase the price. Government imposes price
ceiling when the prices of essential goods in the market are extremely high.

Advantage of price ceiling

The imposition of price ceiling will give advantage to the consumers where
consumers can buy products at lower prices. (Consumers welfare protected)

Disadvantages of price ceiling

1. Price ceiling will create excess demand (shortage) for the products.
2. In the event of shortage, consumers are willing to pay higher price to get
the product that lead to the black market (illegal transactions).
3. Producers of the product will reduce production because they make less or
no profit at the new regulated price. (Unfair to the producers)

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 b. Minimum Price (Price Floor)

Price floor is a legal price set by the government above the equilibrium price and
sellers are not allowed to reduce price. Government imposes price floor when
the prices of commodities (Agricultural sectors) in the market are too low.

Advantage of price ceiling

The imposition of price floor would protect farmers; income that can lead to an
increase in their standard of living.

Disadvantages of price ceiling

1. Price floor will create excess supply (surplus) of the products.

2. In the event of surplus, the government will need to purchase the excess
products by using the tax payers’ money and sometimes the expired
products has to be disposed (Waste of resources)
3. Prices after the imposition of price floor will be higher than equilibrium
price, therefore the consumers have to pay more for the goods purchased
(Unfair to the consumers)

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2. INDIRECT TAX AND SUBSIDIES

Tax is the main sources of revenue for government. Government levy taxes on wide
variety of goods, such as cigarettes and alcohol, on payroll and profits. Taxes basically
aim to restrict consumption by reducing demand and supply or both. There are two
types of taxes:

i. Direct taxes (Income tax)

Direct tax is tax imposed by the government and the burden of tax cannot be
passed to other people. Eg: Income tax, Corporate tax, Petroleum tax, Property
tax, Capital gain tax, inheritance tax and etc.

ii. Indirect taxes

Indirect tax is tax imposed by government on producers or sellers but paid by or

passed to end-users (consumers). Indirect taxes consist of import duties, excise
duties, sales taxes, service taxes and export duties.

Two types of indirect tax:

a. Ad Valorem (Based on percentage)

An ad valorem tax imposes a tax on a good or asset, depending on its
value. Thus it is a tax which is flexible and depends on the value of the
asset or the price of the good. The tax is usually expressed as a
percentage. Eg: Taxes on imported cars.

b. Specific tax (Based on quantity sold)

A tax levied that is based on a certain product amount, but not on its price.
A specific tax is typically incurred by a business in a set amount that is
determined by the number or weight of products or taxable items. Eg:
Taxes on liquor, services tax on pizza and KFC.

Indirect taxes will increase the price of the good sold. This is because the
impositions of indirect taxes on good will increase the production cost of
the good.

Thus, to avoid earning lower profit, producer would reduce the supply of
the good in the market. Once the quantity supplied decrease, the price of
goods will increase as there is an excess demand in the market.

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 WHEN TAX IS IMPOSED, WHO ULTIMATELY PAY THE TAX? WHAT IS THE
INCIDENCE?

The portion of tax shared between buyer and seller depends on the elasticity of
demand and supply. The burden of tax will differ depending on the elasticity of demand
and supply.

a. When demand is less elastic (inelastic) than supply, buyer will shares more of
the burden of tax.
b. When demand is more elastic than supply, seller shares more of the burden of
tax.
c. When demand and supply have the same elasticity, seller and buyer share equal
burden of tax.

a. Incidence of taxation: Demand is less elastic (inelastic) compared to supply.

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 b. Incidence of taxation: Demand is more elastic compared to supply

c. When demand and supply have the same elasticity, seller and buyer share equal
burden of tax.

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 Formula to calculate tax incidence:

1. Value of tax per unit = (P2 – P0) x 1 unit of good

2. Amount of tax paid by

consumer = (P2 – P1) x Q2

3. Amount of tax paid by

seller = (P1 – P0) x Q2

4. Revenue collected by the (P2 – P0) x Q2

government = or
Tax paid by Consumer + Tax paid by Seller

Sample question

Before the imposition of tax, the price that consumers pay for cigarettes was RM7.50
and quantity demanded was 300 packs. When the government imposes tax on
cigarettes, the new price that consumers have to pay is RM9.00 and the new quantity
demanded is 200 packs.

The tax per unit imposed by the government is RM2.00 (RM9.00 – RM7.00). The
amount of tax paid by the consumers is RM300 [(RM9.00 – RM7.50) x 200 packs]
meanwhile the amount of tax paid by the sellers is RM100 [(RM7.50 – RM7.00) x 200
packs]. The total revenue collected by the government for the tax charges on
cigarettes is RM400 [(RM9.00 – RM7.00) x 200 packs)

For the above case, consumers share the burden of tax more compared to sellers
because the demand curve is less elastic (inelastic) which means the consumers are
not sensitive to the price changes.

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 Subsidies can be defined as an incentive from government to encourage producers or
sellers to produce more goods. Subsidy works in exactly the opposite way as taxes as
subsidies would help producers to cut down the cost of production.

When cost of production is lower, producer’s profit will increase and they are willing to
produce more as profit is high. Malaysian Government provides subsidies for
fertilizers, petrol, diesel and others.

BETWEEN SELLERS AND BUYERS, WHO WILL GAIN MORE BENEFITS WHEN
THE GOVERNMENT PROVIDES SUBSIDIES??

Subsidy works in exactly the opposite way as taxes as it will reduce the production
cost of the good. The benefit of subsidy will differ depending on the elasticity of
demand and supply.

a. When demand is inelastic than supply, buyer will enjoys more of the benefit of
subsidy provision.
b. When demand is more elastic than supply, seller enjoys more of the benefit of
subsidy provision.
c. When demand and supply have the same elasticity, both will enjoy the same
benefit of subsidy provision.

Effect of subsidies: Demand is less elastic (Inelastic) than supply

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 Effect of subsidies: Demand is more elastic compared to supply

Effect of subsidies: Demand and Supply have the same elasticity

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 Sample question

The graph shows the price and quantity demanded for 5 kg of cooking oil before and
after subsidy given by the government

Price paid by consumers before subsidy = RM22.00

Price paid by consumers after subsidy = RM20.00
Per unit subsidy given by the government = RM7 (RM27.00 – RM20.00) / RM2.00 + RM5.00
Per unit subsidy enjoys by consumers = RM2.00 (RM22.00 – RM20.00)
Per unit subsidy enjoys by producers = RM5.00 (RM27.00 – RM22.00)
Total subsidy enjoys by consumers = RM200 (RM2.00 x 100 units)
Total subsidy enjoys by producers = RM500 (RM5.00 x 100 units)

Producers enjoy more of benefit of subsidy because the demand curve is more elastic.

END OF CHAPTER

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