1.2.6 Price Determination Flashcards
What is the equilibrium price?
The price where supply is equal to demand.
It is also known as the market clearing price because all products supplied are bought. If the price was higher there’s be unsold goods and if it was lower there would be who would want the good but be unable to buy it.
Excess Demand
> If price is set below equilibrium, then there is excess demand.
(diagram sheet 2) at price P2, suppliers are willing to supply Qs but consumers demand Qd, meaning there is excess demand of the orange shaded area.
As a result there is a shortage in the market. Firms know that they can charge higher prices and still sell their goods. At higher prices and production levels they will make more profits. This will cause an extension in supply and they will now charge P1 for a quantity of Q1. The higher price will lead to a contraction in demand, so they are in equilibrium.
Excess Supply
> If the price is set higher than equilibrium, then there is excess supply.
(diagram sheet 2) At price P2 suppliers are willing to supply Qs but consumers only demand Qd, meaning there is excess supply of the orange shaded area.
As a result, firms have unsold goods. This will encourage firms to lower prices to sell the excess goods, and other firms will have to follow. This causes prices to fall and supply to contract to P1. As a result demand will extend to P1 and the market will be in equilibrium.
Market clearing theory:
> Neo-classical free market economists argue that markets tend to clear. They assume that producers want to maximise profit. Therefore when there is excess demand prices will be driven upwards, whilst they will fall if there is excess supply.
The pressures that force the market towards an equilibrium point can be called free market forces. Critics of the market mechanism argue that free market forces can lead away from equilibrium in many cases, and in some markets, the forces are too weak to restore equilibrium. There are also markets where other forces can impact the market, like government legislation and trade unions.
Equilibrium price is unlikely to always be the desirable price or the ‘right’ price in the market. This will depend on what one defines desirable.
Shifts in demand and supply on equilibrium price/quantity:
> (diagram sheet 2)
An increase in demand from D1 to D2 will lead to an increase in price from P1 to P2 and an increase in output from Q1 to Q2. A decrease would rep the opposite.
An increase in supply from S1 to S2 will increase output from Q1 to Q2 and decrease price from P1 to P2. A decrease would increase price and reduce output.