Price Determination Flashcards
Describe price determination in a free market economy
In a free market economy, prices are determined by the interaction of demand and supply in a market
A market is any place that brings buyers and sellers together
Markets can be physical (e.g. Waterstones) or virtual (e.g. eBay)
Buyers and sellers meet to trade at an agreed price
Buyers agree the price by purchasing the good/service
If they do not agree on the price then they do not purchase the good/service and are exercising their consumer sovereignty
Based on this interaction with buyers, sellers will gradually adjust their prices until there is an equilibrium price and quantity that works for both parties
At the equilibrium price, sellers will be satisfied with the rate/quantity of sales
At the equilibrium price, the utility/price combination is maximised for the buyers
What is consumer sovereignty?
The economic power, exerted by consumers in a market
What is equilibrium in a market?
Equilibrium in a market occurs when demand = supply
What is market clearing price?
This is the price at which sellers are clearing their stock at an acceptable rate
When does this equilibrium occur?
Disequilibrium occurs whenever there is excess demand or supply in a market
When does excess demand occur?
Excess demand occurs when the demand is greater than the supply
It can occur when prices are too low or when demand is so high that supply cannot keep up with it
At a price of P1, the quantity demanded of electric scooters (Qd) is greater than the quantity supplied (Qs)
There is a shortage in the market equivalent to QsQd
How would a market reply to being in disequilibrium due to excess demand
This market is in disequilibrium
Sellers are frustrated that products are selling so quickly at a price that is obviously too low
Some buyers are frustrated as they will not be able to purchase the product
Sellers realise they can increase prices and generate more revenue and profits
Sellers gradually raise prices
This causes a contraction in QD as some buyers no longer desire the good/service at a higher price
This causes an extension in QS as sellers are more incentivised to supply at higher prices
In time, the market will have cleared the excess demand and arrive at a position of equilibrium (PeQe)
Different markets take different lengths of time to resolve disequilibrium. For example, retail clothing can do so in a few days. Whereas the housing market may take several months
What is excess supply?
Excess supply occurs when the supply is greater than the demand
It can occur when prices are too high or when demand falls unexpectedly
At a price of P1, the quantity supplied of face masks (Qs) is greater than the quantity demanded (Qd)
There is a surplus in the market equivalent to QdQs
How does a market respond to being in disequilibrium due to excess supply?
This market is in disequilibrium
Sellers are frustrated that the masks are not selling and that the price is obviously too high
Some buyers are frustrated as they want to purchase the masks but are not willing to pay the high price
Sellers will gradually lower prices in order to generate more revenue
This causes a contraction in QS as some sellers no longer desire to supply masks
This causes an extension in QD as buyers are more willing to purchase masks at lower prices
In time, the market will have cleared the excess supply and arrive at a position of equilibrium (PeQe)
Explain a real world, example of changes to demand that increase price
During lock downs associated with the Covid-19 pandemic, furniture retailers experienced unexpectedly high demand for their products (especially desks and sofas)
Diagram Analysis
Due to the Covid mandated change of working from home, consumers experienced a temporary change in taste as they sought to set up comfortable home offices
This led to an increase in demand for desks from D1→D2
At the original market clearing price of P1, a condition of excess demand now exists
The demand for desks is greater than the supply
In response, suppliers raise prices
This causes a contraction of demand and an extension of supply leading to a new market equilibrium at P2Q2
Both the equilibrium price (P2) and the equilibrium quantity (Q2) are higher than before
The excess demand in the market has been cleared
Explain a real world, example to changes to supply that increased price
Ukraine is one of the world’s largest producers of wheat. During the Russian-Ukrainian war, exports of wheat have been halted
India imported 13% of the nation’s wheat requirements from the Ukraine Due to the war in the Ukraine, India is experiencing a supply shock in its wheat market
This causes a decrease in supply of S1→S2
At the original market clearing price of P1, a condition of excess demand now exists (shortage)
The demand for wheat is greater than the supply
In response, sellers in India raise prices
This causes a contraction of demand and an extension of supply leading to a new market equilibrium at P2Q2
The equilibrium price (P2) is higher and the equilibrium quantity (Q2) is lower than before
The excess demand in the market has been cleared
Explain a real word example for changes to demand that decreased price
Demand for lobsters in Maine, USA has been falling steadily in recent months
This has resulted in a price fall from $12.35 /pound on the 1st April to $9.35 /pound on the 1st May In recent months the USA has been experiencing an increasing rate of inflation
Inflation lowers the purchasing power of money in a consumer’s pocket and so effectively reduces their real income
With reduced real income fewer luxuries are consumed
This led to a decrease in demand for lobsters from D1→D2
At the original market clearing price of P1, a condition of excess supply now exists
The demand for lobsters is less than the supply
In response, suppliers gradually reduce prices
This causes a contraction of supply and an extension of demand leading to a new market equilibrium in P2Q2
Both the equilibrium price (P2) and the equilibrium quantity (Q2) are lower than before
The excess supply in the market has been cleared
Explain a real world, example to changes to supply that decreased price
In order to help meet their climate targets and to lower energy costs for households, the EU is providing subsidies for solar panels To help meet its climate change targets and lower household energy bills the EU has provided a subsidy to solar panel retailers
This causes an increase in supply of S1→S2
At the original market clearing price of P1, a condition of excess supply now exists (surplus)
The supply of solar panels is greater than the demand
In response, sellers in the EU lower prices
This causes an extension of demand and a contraction of supply leading to a new market equilibrium at P2Q2
The equilibrium price (P2) is lower and the equilibrium quantity (Q2) is higher than before
The excess supply in the market has been cleared
