Price Mechanism

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  • Topic: Supply and demand, Economic equilibrium, Partial equilibrium
  • Pages : 1 (314 words )
  • Download(s) : 389
  • Published : October 15, 2011
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A particularly notable feature of market economies is the effect of the price mechanism on demand and supply. The price mechanism determines the equilibrium in the market and consists of the interplay of the forces of supply and demand in determining the prices at which commodities will be bought and sold in the market. Market equilibrium is the situation, where at a certain price level, the quantity supplied and the quantity demanded of a particular commodity are equal. Thus,the market can clear, with no excess supply or demand, and there is no tendency to change in either price or quantity. Diagrammatically, market equilibrium occurs where the demand and supply curves intersect, at the point where the quantity demanded is exactly equal to the quantity demanded. Figure 1 reveals that at price 0P1, the quantity demanded (0Q2) exceeds the quantity supplied (0Q1). Competition among buyers for the limited quantity of goods available means that consumers will start bidding up the price. The rise in the price results in an expansion in supply and a contraction in demand (movement along the curves towards the equilibrium point). This will continue to occur as long as there is excess demand. Eventually, we will reach the intersection of the supply and demand curves, where at price 0Pe, the quantity supplied 0Qe exactly equals the quantity demanded by consumers.

If the price is below the equilibrium, then demand would be greater than supply, creating a shortage. In response to pricing below the equilibrium, organizations will increase price and supply more, which will result in less demand; therefore the equilibrium price will rise until there is no shortage and supply equals demand. However, if the price is above the equilibrium, then supply would be greater than demand, thereby creating a surplus. In order to eliminate the surplus, the price would have to be reduced as well as the demand.
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