Price determination and mechanism

How is equilibrium determined?

Where supply and demand intersect, and there is no excess supply or demand.

What is excess demand?

When price is set below equilibrium, and there is a shortage in the market (QD>QS).

Suppliers will cause an extension in supply and now charge higher prices (equilibrium).

What is excess supply?

When price is set above equilibrium, and there are unsold goods (QD<QS).

Suppliers will cause a contraction in supply and now charge lower prices (equilibrium).

What is the rationing function? When price increases?

When prices increase, some consumers can no longer afford the product or no longer want to. Therefore, the scarce resources can be rationed and allocated to people who are able to afford them and those who value them most highly.

What is the signalling function? When price increases?

When prices increase, producers move resources into the manufacture of that product.

The change in price indicates to suppliers that market conditions have changed, so they should change the quantity sold.

What is the incentive function? When price increases?

When prices increase, it incentivises producers to increase supply in order to earn more profits.

Examples of price mechanism in real world?

Covid-19: Less import of food, so fewer goods in UK supermarkets. Demand is high but supply is low, so price increases to ration off the excess demand, so only consumers who value the food most highly buy them.

Houses in London: High demand and supply is low due to lack of space. Prices rise through rationing function. Firms also incentivised to allocate resources to the production of more houses, since profitable.

Middle East conflict: Oil prices rise due to fall in supply and high demand. Rationing function.