- A market occurs where buyers and sellers meet to exchange money for goods.
- The price mechanism refers to how supply and demand interact to set the market price and amount of goods sold
- At most prices planned demand does not equal planned supply. This is a state of disequilibrium because there is either a shortage or surplus and firms have an incentive to change the price.
Market equilibrium occurs where supply = demand. At this point, there is no tendency for prices to change. We say the market clearing price has been achieved.
In the diagram below, the equilibrium price is Pe. The equilibrium quantity is Qe.
If price is below the equilibrium
- If price was below the equilibrium at P2 then demand would be greater than the supply. Therefore there is a shortage of (Q2 – Q1)
- If there is a shortage, firms will put up prices and supply more. As price rises there will be a movement along the demand curve and less will be demanded.
- Therefore price will rise to Pe until there is no shortage and supply = demand
If price is above the equilibrium
- If price was above the equilibrium (e.g. P1), then supply (Q1) would be greater than demand (Q3) and therefore there is too much supply. There is a surplus.
- Therefore firms would reduce price and supply less. This would encourage more demand and therefore the surplus will be eliminated. The market equilibrium will be at Q2 and Pe.
Movements to a new Equilibrium
If there was an increase in income the demand curve would shift to the right. Initially there would be a shortage of the good, therefore the price and quantity supplied will increase leading to a new equilibrium at Q2
An increase in supply would lead to a lower price and more quantity sold.