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 the demand curve shifts:
In diagram 1 it has shifted to the left, so fewer goods are demanded at each price and in diagram 2 it has shifted to the right so more goods are demanded at each price. In diagram 1, we see that the decrease in quantity demanded at a specific prices means the equilibrium price of the good comes down. In diagram 2 the converse happens and the shifting of the demand curve leads to an increase in the equilibrium price from P1 to P2. So we see that an increase in the demand, for example, foreign holidays, leads to an increase in the price for them (and as a consequence an increase in the quantity supplied of them) and thus an increase in the number of foreign holidays traded. Thus, if the demand curve shifts to the left there is a decrease in the market price and if it shifts to the right there is an increase in the market price.
The demand curve can shift to the right for a variety of reasons; non-price determinants of demand. It could increase due to an increase in real incomes (this is the level of money that people have left after tax deductions, inflation etc.). If people have higher incomes, they have more to spend and thus buy more goods. So the demand for goods generally rises: this is especially true for goods with a high income elasticity of demand, luxury goods, such as foreign holidays, whose demand increases as real incomes increase. The converse is true when incomes decrease in times of recession. There are exceptions: for some goods, inferior goods, the demand curve may shift to the left when incomes rise. This is to do with substitutes: as incomes rise people are less likely to buy inferior goods which are perceived to be of a lower quality and are likely to start buying higher quality goods instead. For instance, when real incomes rise, less people might buy cheap English wine and people might start to buy better Italian wine as they feel they can afford it.
The availability of credit with which to buy expensive or...