1.2.6 Price determination

Question 1

Equilibrium price and quantity - price determination

Answer 1

The equilibrium point refers to the point at which there are no more forces bringing about change. Price equilibrium is where supply is equal to demand, so where the demand and supply curves cross. This price is also known as the market clearing price because all products supplied to the market are cleared (bought), but no buyers are unable to buy the good. If the price was higher, there would be unsold goods and if the price was lower, there would be consumers who would want to buy the good but would be unable to do so.

Question 2

Excess demand

Answer 2

If price is set below equilibrium, then there is excess demand. At the price P2, suppliers are willing to supply QS but consumers demand QD, meaning there is excess demand of the orange shaded area.
Solution: As a result, there is a shortage in the market. Firms know they can charge higher prices and still sell their goods, so this will cause an extension in supply and they will now charge P1 for quantity Q1. This higher price will lead to a contraction in demand.
The prices are now in equilibrium.

Question 3

Excess supply

Answer 3

If the price is set higher than the equilibrium, then there is excess supply. At price P2, suppliers are willing to supply QS but consumers only demand QD, meaning there is excess supply of the orange shaded area. Prices would have to fall.
Solution: As a result, firms have unsold goods. This will encourage them to put on sales to sell the excess goods, causing prices to fall and supply to contract to P1. As a result, demand will extend to P1. The market will now be in equilibrium.

Question 4

Excess demand (market shortage) solution

Answer 4

Firms know they can charge higher prices and still sell their goods, so this will cause an extension in supply and they will now charge P1 for quantity Q1. This higher price will lead to a contraction in demand. The prices are now in equilibrium.

Question 5

Excess supply (overproduction) solution

Answer 5

This will encourage them to put on sales to sell the excess goods, causing prices to fall and supply to contract to P1. As a result, demand will extend to P1. The market will now be in equilibrium.