07. Market equilibrium, the price mechanism and market efficiency Flashcards
Explain the concept of equilibrium.
The point where the supply and demand curve intersect is known as the market equilibrium. It is the point where both producers and consumers are satisfied.
Equilibrium is a state of balance where supply = demand.
Explain the effect of change in demand upon the equilibrium.
- Equilibrium can be shifted by non-price determinants of supply and demand.
- Point A is the market equilibrium before the COVID lockdowns.
- At Point B the market is in disequilibrium. There is a large surplus of nuts (Q1 - Q2). Lockdowns have reduced demand and prices take a while to reduce.
- At Point C the market is at equilibrium. The price has been reduced to clear the oversupply of nuts.
- This is how prices are determined by the market.
Explain the effect of change in supply upon the equilibrium.
- Point A is the market equilibrium before the lockdowns.
Supply shifts from S1 to S2 as a result of good harvests. - At price level P1, quantity supplied increases to Q2 (Point B).
- There is a surplus of nuts, so producers lower prices (P1 -> P2) to get rid of their stock. The equilibrium is restored at Point C.
What is price mechanism
The forces of supply and demand reach an equilibrium point at which a price is determined. This is known as the price mechanism.
What are the functions of price mechanism?
1) Signalling
2) Rationing
3) Incentivising
Signalling
- Prices covey loads of information to economic decision makers. Prices show producers how consumer preferences are changing. For example, if large parts of the population are becoming vegan, prices for meat and cheese will decrease while prices for beans and tofu will increase. This shows firms what people really want.
- In the absence of a functioning price mechanism, producers would continue to expend society’s scarce resources on raising livestock which won’t be eaten. Therefore the economic question “what should be produced with our scarce resources?” would be answered inadequately.
Rationing
- If a resource or product is relatively scarce, it will have a relatively high price. If a resource or product is relatively abundant, it will have a relatively low price.
- Since consumers pay for the benefit they assume they will receive from a good or service, high prices will deter consumption from all but those consumers who assume they will receive the highest benefit. i.e. the good will be rationed to just those consumers who want or need it the most.
- High prices also deter consumers from wasteful consumption. If gas is scarce, it has a high price. As a consumer, I will therefore only use my heating when it is absolutely necessary. This means that the available gas is rationed.
Incentivising
- If consumer demand for a certain product is relatively high, prices will be relatively high. The high price will incentivise producers to supply more of the product to satisfy consumer demand. Some firms will be incentivised to switch from producing one good to another in order to gain a share of the lucrative market. For example, during the COVID pandemic, some American whiskey producers were incentivised to use their factors of production to produce hand-sanitiser by high prices.
- Low prices will also incentivise consumers to buy up surplus goods, even if these are not the consumer’s regular ‘first-choice’. If there has been an overproduction of biscuits, low prices will incentivise consumers to clear producers’ warehouses of this stock as some consumers will feel the incentive to purchase multiple packets.
What is consumer surplus?
This is defined as the extra utility (satisfaction) gained by consumers from paying a price lower than that which they are willing to pay.
What is producer surplus?
This is defined as the excess of actual earnings that a producer makes from a given quantity of output over and above the amount the producer would be willing and able to accept for that output.
What is social/community surplus?
Community (social) surplus is the sum of consumer and producer surplus; this is the total benefit to society of the equilibrium.
What is allocative efficiency?
Allocative efficiency is an allocation (distribution) of resources that produces the combination of goods and services mostly preferred by consumers. It is when social surplus is maximum.
What is Marginal social benefit?
Marginal social benefit (MSB) is the extra or additional benefit of consuming one more unit of a good.
What is Marginal social cost?
Marginal social cost (MSC) is the extra or additional costs of producing one more unit of a good.
How is equilibrium shown for demand?
The demand curve = the marginal benefit curve.
At equilibrium marginal social benefit is equal to marginal social cost.
