Prices are set as a result of the price mechanism. The price for a good is the price at which the quantity of the good demanded is the same as the quantity of good supplied: this is the equilibrium price, ceteris paribus, for any given supply and demand curve for a certain good or service. This occurs when there is perfect competition in a perfectly competitive market. This is where the market is large enough so that no one individual firm or individual has any appreciable influence on the price of the commodity. In monopolistic or oligopolistic competition this may not be the case, and the price of the good may be determined largely through the actions of one or several important firms or individuals.
Given the conditions stated above; we can show where the price of a good is obtained diagrammatically:
To observe what happens when the price is set at a non-equilibrium level price, we can use the two diagrams below. In diagram 1, the price for a commodity is above the equilibrium price, and in diagram 2 it is below it:
We can see that in diagram 1, there is excess supply: more goods or services are supplied than demanded. Thus there is increased competition between supplies that need to lower their prices to sell their goods. Thus, the price lowers until it reaches the equilibrium price. In diagram 2, more goods or services are demanded than are supplied. Thus, firms can raise their prices as people are prepared to pay more to ensure that they get the good. Excess demand thus pushes the price up to equilibrium level.
Since supply and demand are the determinants of the equilibrium price as explained, a change in either or both of them usually causes a change in the equilibrium price. Let us examine what happens to the equilibrium price if...