price-determination

Price Determination & Equilibrium

Price determination

• 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

Equilibrium

• Equilibrium in a market occurs when demand = supply

• At this point the price is called the market clearing price

  • This is the price at which sellers are clearing their stock at an acceptable rate

• Any price above or below P creates disequilibrium in this market

  • Disequilibrium occurs whenever there is excess demand or supply in a market

Market Disequilibrium

Disequilibrium – excess demand

• 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

Diagram analysis

• At a price of P₁, the quantity demanded of electric scooters (Q_d) is greater than the quantity supplied (Q_s)

• There is a shortage in the market equivalent to Q_sQ_d

Market response

• 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 (P_eQ_e)

  • 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

Disequilibrium – 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 

• During the later stages of the pandemic the market for face masks was in disequilibrium

Diagram analysis

• At a price of P₁, the quantity supplied of face masks (Q_s) is greater than the quantity demanded (Q_d)

• There is a surplus in the market equivalent to Q_dQ_s

Market response

• 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 (P_eQ_e)

Use of Diagrams to Show Market Changes

• Real world markets are constantly changing and are referred to as dynamic markets

• Market equilibrium can change every few minutes in some markets (e.g. stocks and shares), or every few weeks or months in others (e.g. clothing)

•  Any change to a condition of demand or supply will temporarily create disequilibrium and market forces will then seek to clear the excess demand or supply

Real world example: 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

Real world example: changes to supply that increase 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 Ukraine