The Price Market Mechanism & Market Equilibrium
Price Market Mechanism: The means by which millions of decisions taken by consumers and businesses interact to determine the allocation of scarce resources between competing uses.
It uses the market forces of supply and demand to determine the equilibrium price and quantity of a good or service.
Market Equilibrium: the point at which demand is equal to supply.
Market Clearing Price: The price that is charged at market equilibrium, so called as all products made will be sold at this price.
All buyers can get the exact amount that they want to buy at this price.
All sellers provide exactly the amount that they want to sell at this price.
Therefore, there is nothing left over – the market has cleared.
Changes to equilibrium: Any change in demand and/or supply will lead to a new equilibrium price.
Showing Market equilibrium graphically:
At a price of P quantity demanded (Qd) is equal to quantity supplied (Qs). All products are sold and no products are left over – the market has cleared.
At this price all products that have been offered for sale by suppliers have been bought by buyers all supply has had an equal demand.
Market Forces
Excess Supply: If price were to rise to P1 we would have a position of excess supply.
Buyers would demand less (Q1) at the higher price but firms would wish to supply more (Q2) at this price. This would lead to a situation of too much supply (Q2 – Q1) in the market.
Solution: firms would need to lower price to get rid of excess products. Pushing Q1 up and Q2 down, forcing towards each other (market equilibrium).
Excess Demand: If price were to fall to P2 we would have a position of excess demand.
Buyers would demand more (Q2) at the lower price but firms would wish to supply less (Q1) at this price. This would lead to a situation of too much demand (Q2 – Q1) in the market.
Solution: To improve profitability firms could raise price, thus reducing the excess demand. Pushing Q1 up and Q2 down, forcing them towards each other (market equilibrium).
The Impact of changes in Demand & Supply on Equilibrium
Recap: A change in price corresponds to a movement along either the demand or supply curve, a change to any other factor will cause a shift in either demand or supply.
Example changes which cause shifts in the demand curve:
- Consumer income
- Prices of other goods and services
- Consumer tastes and fashion
- Other factors e.g. advertising
Example changes which cause shifts in the supply curve:
- The impact of changing costs of production
- Technological progress
- Prices of other goods and services
- Government policy e.g. taxes and subsidies
- Other factors e.g. expectations
A new equilibrium price: When there is a new equilibrium price this must be caused by either a shift to one (or both) of supply and demand, and therefore a movement along the other.
Diagram: Shifts in the Demand Curve.
An increase in demand will see the demand curve shift outwards, towards the right from D to D1. This will cause price to rise to P1 and quantity demanded to Q1.
At this point we have a new market equilibrium (P1 Q1).
The shift in demand has led to a movement along the supply curve.
Diagram: Shifts in the Supply Curve.
An increase in supply will see the supply curve shift outwards, towards the right from S to S1. This will cause price to fall to P1 and quantity supplied to rise to Q1.
At this point we have a new market equilibrium (P1 Q1).
The shift in supply has led to a movement along the demand curve.
The Functions of the Price Market Mechanism
The price mechanism plays three important functions in a market
The Rationing Function: Prices ration scarce resources when demand outstrips supply.
Excess demand for a good or service will lead to a rise in the price of a good or service.
This is due to the relative scarcity of the product.
The price rise will lead to a reduction in demand.
The more scarce a product the higher the price.
This leads to a rationing of the product as its use is restricted (fewer people are willing to pay for it).
There will be a movement along the demand curve showing a decrease in quantity demanded and an increase in price.
The Incentive Function: Through their choices, consumers send information to producers about their changing nature of needs and wants.
Consumer demand fluctuates, leading to changing equilibrium prices.
Higher prices act as a motivator for producers to increase the supply of a good or service.
This is due to greater contribution per unit i.e. the difference between selling price and variable cost.
As prices rise so do revenue and profit.
There will be a movement along the supply curve showing a increase in quantity supplied because of an increase in price
The Signalling Function: Where Prices adjust to demonstrate where resources are required.
An increase in price will give an indication to producers that they should increase supply.
An increase in price will give an indication to consumers that they should reduce demand.
A decrease in price will give an indication to producers that they should decrease supply.
A decrease in price will give an indication to consumers that they should increase demand.
All of these signals will push the market towards equilibrium.
The Effectiveness of Markets in Allocating Resources
Efficiency: Is important for economists and there are a variety of efficiencies that come under the umbrella heading economic efficiency.
Allocative efficiency: occurs where consumer satisfaction is maximised in the production of goods and services. Society is producing goods to match the needs of consumers.
At this point quantity supplied will equal quantity demanded.
Productive efficiency: occurs when each unit of output uses the fewest number of resources possible for that unit.
Production has no extraneous wastage.
Illustrating both productive and allocative efficiency can be using a PPF:
All points on the PPF are productively efficient including points A and B
However, if good Y is in greater demand than good X then production at point A will be more allocatively efficient than that of point B.
Therefore allocative efficiency can be found at one point on the PPF but where depends upon society’s preference.
How does the market achieve allocative efficiency?
Allocative efficiency is difficult to identify as we need to match consumer preferences to producer output
I.e. we need to match demand and supply
Markets do not always operate at the market clearing price due to:
- Excess supply (S>D)
- Excess demand (D>S)
But, market forces do push prices towards equilibrium where quantity demanded will equal quantity supplied
Therefore, competitive and free markets help to move the market outcome towards achieving allocative efficiency
Effective Allocation in Action
In diagram A: Suppose the market price is P2. The last unit that consumers value at that price is low at Qd. However, firms produce more than this at Qs.
Consumers are not willing to pay the higher price so price will fall and firms will reduce supply.
This might lead to a reallocation of a firms’ resources to another use e.g. away from apples (to bananas).
In diagram B: Suppose the market price is P2. The last unit that consumers value at that price is high at Qd. However, firms produce less than this at Qs.
Consumers are willing to pay the higher price so price will rise to P1 and firms will increase supply.
This might lead to a reallocation of a firms’ resources from another use e.g. into bananas (from apples).
Result: In the long run, should apples be produced at Q1 and bananas produced at Q1 we will have allocative efficiency.
