Price Determination

Question 1

Equilibrium

Answer 1

A market is at equilibrium when supply equals demand.

Question 2

Excess supply (or surplus)

Answer 2

When the price is above the equilibrium price, the quantity supplied will exceed the quantity demanded leading to excess supply (or a surplus).

Question 3

Excess demand (or shortage)

Answer 3

When the price is below the equilibrium price, the quantity demanded will exceed the quantity supplied, leading to excess demand (or a shortage).

Question 4

Price mechanism

Answer 4

The interaction of supply and demand to determine the price in a market.

Question 5

Functions of the price mechanism

Answer 5

SIR

Signalling: higher prices signal to producers that consumers want more of their goods, so producers supply more of them. Lower prices signal to producers that consumers want fewer of their goods, so producers supply fewer of them.

Incentivising: higher prices increase the incentive to supply, because producers can make more profit. Lower prices decrease the incentive to supply, because producers make less profit.

Rationing: higher prices ration (or limit) goods to the consumers who will pay the most.

Question 6

There is currently excess supply (or a surplus) in the market. Explain how the price adjusts to bring the market back to equilibrium.

Answer 6

When theres excess supply of a good, producers will decrease the price to sell of their suplus

• S - decreasing price SIGNALS producers to supply less
• I - reduces INCENTIVE to supply, leading to contraction in supply
• R - no ration

Question 7

There is currently excess demand (or a shortage) in the market. Explain how the price adjusts to bring the market back to equilibrium.

Answer 7

When there is a shortage of a good - consumers bid up the price
S - this signals and I - incentives producers to supply more, thus there is an extension (not shift) in supply
R - it Rations how much consumers demand, leading to a contraction in demand - Equilibrium is now at a higher price