Big picture
Buyers want low prices; sellers want high prices. In a market, the price settles where the quantity buyers want to buy equals the quantity sellers want to sell. This is the equilibrium price. When demand or supply changes, the equilibrium changes too.
This chapter first describes the main forms of market, then shows how price is determined under perfect competition, how it responds to changes, and what happens when the government fixes prices by law (price ceilings and floors). Diagrams and short numericals are essential.
Learning goals
Explain the features of perfect competition, monopoly, monopolistic competition and oligopoly.
Explain why a firm under perfect competition is a price taker.
Explain market equilibrium, excess demand and excess supply.
Find equilibrium price and quantity from schedules or equations.
Explain the effects of shifts in demand and supply, including simultaneous shifts.
Explain price ceilings and price floors and their consequences.
Core ideas
1. Forms of market
Feature | Perfect competition | Monopoly | Monopolistic competition | Oligopoly |
|---|---|---|---|---|
Number of sellers | Very large | One | Large | Few |
Nature of product | Homogeneous (identical) | No close substitute | Differentiated (similar but branded) | Homogeneous or differentiated |
Entry and exit | Free | Barriers to entry | Fairly free | Barriers |
Control over price | None (price taker) | Full (price maker) | Some | Considerable, but firms are interdependent |
Demand curve (AR) of a firm | Perfectly elastic (horizontal) | Downward sloping, less elastic | Downward sloping, more elastic | Indeterminate |
Selling costs | None | Little | High (advertising) | High |
Example | Wheat farmers in a large market (close to the ideal) | Local electricity distribution in some areas | Toothpaste, restaurants, clothing brands | Telecom services, airlines, cement |
Features of perfect competition in detail
Very large number of buyers and sellers: no single buyer or seller can influence the price.
Homogeneous products: all firms sell identical goods, so buyers have no reason to prefer one seller.
Free entry and exit of firms: firms enter when there are profits and leave when there are losses, so in the long run firms earn only normal profit.
Perfect knowledge of market conditions among buyers and sellers.
Perfect mobility of factors of production.
No transport costs (or the same for all).
Because of these features, the industry (all firms together) sets the price through market demand and supply, and each firm simply accepts it. The firm is a price taker, and its demand (AR) curve is horizontal: AR = MR = price.
2. Market equilibrium
Equilibrium is the situation where market demand = market supply. The price at which this happens is the equilibrium price, and the quantity is the equilibrium quantity.
Worked example (schedule)
Price (₹) | Market demand (units) | Market supply (units) | Situation | Pressure on price |
|---|---|---|---|---|
6 | 70 | 38 | Excess demand of 32 | Rises |
8 | 60 | 44 | Excess demand of 16 | Rises |
10 | 50 | 50 | Equilibrium | None |
12 | 40 | 56 | Excess supply of 16 | Falls |
14 | 30 | 62 | Excess supply of 32 | Falls |
Excess demand (demand > supply at a price below equilibrium): buyers compete for the limited goods and bid up the price. As price rises, quantity demanded contracts and quantity supplied expands until they are equal.
Excess supply (supply > demand at a price above equilibrium): sellers can't sell all their goods, so they cut prices. As price falls, quantity demanded expands and quantity supplied contracts until equilibrium is restored.
The same example in equations. The schedule above follows Qd = 100 − 5P and Qs = 20 + 3P.
At equilibrium, Qd = Qs
100 - 5P = 20 + 3P
80 = 8P
P = 10
Q = 100 - 5(10) = 50 (check: 20 + 3(10) = 50)Equilibrium price = ₹10; equilibrium quantity = 50 units.
3. Effects of a shift in demand (supply unchanged)
Change | Effect at the old price | Result |
|---|---|---|
Increase in demand (demand curve shifts right: income rises for a normal good, a substitute becomes dearer, tastes favour the good) | Excess demand | Equilibrium price rises and quantity rises |
Decrease in demand (shifts left) | Excess supply | Equilibrium price falls and quantity falls |
Example. In a hot summer, demand for ice cream increases. At the old price there is excess demand, so the price rises and more ice cream is sold.
4. Effects of a shift in supply (demand unchanged)
Change | Effect at the old price | Result |
|---|---|---|
Increase in supply (supply curve shifts right: better technology, lower input prices, subsidy, good harvest) | Excess supply | Equilibrium price falls and quantity rises |
Decrease in supply (shifts left: higher input prices, a tax, crop failure) | Excess demand | Equilibrium price rises and quantity falls |
Example. A bumper harvest of tomatoes increases supply, so tomato prices fall and more tomatoes are bought.
5. Simultaneous shifts in demand and supply
When both curves shift, one effect is certain and the other depends on the relative size of the shifts.
Change | Equilibrium price | Equilibrium quantity |
|---|---|---|
Demand and supply both increase | Rises if demand rises more; falls if supply rises more; unchanged if equal | Rises |
Demand and supply both decrease | Depends on relative shifts | Falls |
Demand increases, supply decreases | Rises | Depends on relative shifts |
Demand decreases, supply increases | Falls | Depends on relative shifts |
6. Free entry and exit
Under perfect competition, if firms earn abnormal (supernormal) profits, new firms enter, market supply increases, and price falls until only normal profit remains. If firms make losses, some leave, supply decreases, and price rises until losses disappear. In the long run, price = minimum average cost, and firms earn normal profit.
7. Applications: price ceiling and price floor
Sometimes the government fixes prices by law instead of letting the market decide.
Price ceiling (maximum price). The government sets a maximum price below the equilibrium price, to make essential goods affordable for the poor (for example, wheat, rice, kerosene or essential medicines in some periods).
Consequences:
Excess demand (shortage), because at the low price more is demanded and less is supplied.
Rationing through ration cards and the public distribution system (fair price shops), so each household gets a fixed quantity.
Black marketing: some sellers sell illegally at prices above the ceiling to buyers willing to pay more.
Long queues and poor quality of goods supplied at the controlled price.
Example. Equilibrium price ₹10 and quantity 50. A ceiling at ₹8 gives demand 60 and supply 44: a shortage of 16 units.
Price floor (minimum price). The government sets a minimum price above the equilibrium price, to protect producers' incomes. Examples: the minimum support price (MSP) for crops such as wheat and rice, and minimum wage laws.
Consequences:
Excess supply (surplus), because at the high price more is supplied and less is demanded.
The government must buy the surplus and keep it as buffer stock (through the Food Corporation of India), or use it for welfare schemes and exports.
Storage costs and possible wastage of food grains.
Consumers pay a higher price.
Example. With the same market, a floor at ₹12 gives supply 56 and demand 40: a surplus of 16 units, which the government must buy.
A reliable problem-solving routine
For equilibrium, set Qd = Qs, solve for P, then substitute to find Q; check with both equations.
For a price below equilibrium, find the shortage (Qd − Qs); above, the surplus (Qs − Qd).
For a shift, decide which curve moves and in which direction, then state the effect on price and quantity.
For simultaneous shifts, state the certain effect first, then explain how the other depends on the relative shifts.
For a ceiling, expect shortage, rationing and black markets; for a floor, expect surplus and buffer stocks.
Connections that matter
Consumer equilibrium and demand gives the demand curve and its shifts.
Producer behaviour and supply gives the supply curve and its shifts.
Class 12 economics: current challenges discusses MSP, buffer stocks and the public distribution system.
Common mistakes
Saying a price ceiling is set above equilibrium. A binding ceiling is below it; a binding floor is above it.
Reversing the effect of excess demand. Excess demand pushes price up.
Claiming both price and quantity are certain in simultaneous shifts. Only one is certain.
Calling a perfectly competitive firm a price maker. It is a price taker.
Confusing monopolistic competition with monopoly. Monopolistic competition has many sellers of differentiated products.
Revision checklist
I can compare the four forms of market.
I can explain why a perfectly competitive firm is a price taker.
I can find equilibrium from schedules and equations, and explain excess demand and supply.
I can explain the effects of single and simultaneous shifts in demand and supply.
I can explain the effect of free entry and exit.
I can explain price ceilings and floors and their consequences.