1.2.6 Price determination

How are prices determined in a free market economy?

By the interaction of demand and supply through buyer and seller participation, leading to equilibrium.

What is the equilibrium?

Where demand = supply

Price is the market clearing price - sellers are clearing their stock at an acceptable rate

What is disequilibrium?

A situation where supply does not equal demand, resulting in either excess demand or supply

Market response to excess demand?

• 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

Market response to excess supply?

• 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

Real world example of excess demand (increase in price)

During COVID, demand for furniture e.g. desks exponentially increased

• 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 of excess supply (decrease of 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

• 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