Topic 4.1 - Individuals, firms, markets and market failure
Snapshot of the AQA syllabus topic area we’ll be covering in this post.
THE DETERMINATION OF EQUILIBRIUM MARKET PRICES: PRICE DETERMINATION IN COMPETITIVE MARKETS
AQA students must understand the following content [taken from the syllabus]
How the interaction of demand and supply determines equilibrium prices in a market economy.
The difference between equilibrium and disequilibrium.
Why excess demand and excess supply lead to changes in price.
INFORMATION YOU NEED TO KNOW
Introduction:
Prices are heavily influenced by the interaction between supply and demand in a thriving market economy. Equilibrium, a delicate balance that assures that the amount of goods or services that consumers want and the amount that producers can supply, are in balance. Understanding this equilibrium is crucial to understanding market pricing movements and how they affect the whole economy.
How demand and supply determine equilibrium and disequilibrium
When supply and demand are in balance, equilibrium results. The quantity of a good or service that consumers are willing and able to buy at a specific price is referred to as demand. Supply, on the other hand, is the volume that manufacturers are able and willing to provide at the same price. The equilibrium price, also known as the market-clearing price, is the point where these two forces meet.
On the other hand, when there is an imbalance between supply and demand, disequilibrium results. When the quantity wanted outweighs the quantity provided at the going rate, there is excess demand. Customers may be willing to pay more for the goods in this case, and providers may have trouble meeting the demand. Conversely, over supply occurs when the amount supplied exceeds the amount required. In this situation, producers might be forced to decrease their prices or look for new markets to get rid of their surplus stock.
How price changes lead to excess demand and supply
Price changes brought on by excess supply or demand serve as a means of reestablishing equilibrium. In the event of excessive demand, suppliers are persuaded to raise prices in order to take advantage of the increased demand and boost profitability. Price increases may deter some consumers from making purchases, which serves to temper demand and finally bring it in line with supply. On the other hand, if there is an excess of supply, companies may lower their prices to increase demand and get rid of their extra inventory. More sales can result from lower pricing, which will balance supply and demand.
Price adjustments are an essential market mechanism for preserving equilibrium. The elegance of a market economy rests in its adaptability to changing circumstances. Rising prices serve as signals for companies to increase production and satisfy consumer demand when demand exceeds supply. Similar to how falling prices stimulate consumers to make more purchases when supply is greater than demand, producers are signalled to reduce production when prices are falling.
It's crucial to remember that equilibrium does not always occur right away. Price adjustments and the stabilisation of supply and demand could take some time. Furthermore, transitory disequilibrium might be introduced by outside forces like unforeseen events, market restrictions, or governmental initiatives.
Conclusion:
In a market economy, equilibrium prices are established by the interaction of supply and demand. The delicate balance between the quantities demanded and supplied is represented by the equilibrium price. Excess demand or supply are examples of deviations from this equilibrium that cause price changes that help the market return to equilibrium. Understanding these ideas is essential if you want to understand how market pricing dynamics affect how the economy works.
WORKED EXAMPLE OF A TRANSITION TO A NEW EQUILIBRIUM POINT
Let's consider the market for smartphones to illustrate the transition from one equilibrium price to a new equilibrium price.
Initially, the market is in a state of equilibrium, where the quantity of smartphones demanded by consumers matches the quantity supplied by producers at a particular price. Let's assume the equilibrium price is £500, and at this price, 1,000 smartphones are demanded and supplied per month.
However, due to technological advancements and increased consumer preferences, the demand for smartphones starts to rise. Consumers become willing to pay higher prices to obtain the latest features and improved functionality. As a result, there is excess demand in the market. At the existing equilibrium price of £500, the quantity demanded exceeds the quantity supplied. Let's say the quantity demanded at this price increases to 1,200 smartphones per month. That means consumers demand 200 more units than before.
With an excess demand of 200 additional units, there is an incentive for producers to increase their prices. As smartphone prices rise, some consumers may reconsider their purchases or opt for alternative options, thereby moderating the demand. Simultaneously, higher prices encourage producers to expand their production to take advantage of the increased profitability.
As prices gradually increase, the excess demand diminishes, and the market moves toward a new equilibrium. Let's assume that at a price of £550, the quantity demanded and supplied become equal again, with both reaching 1,200 smartphones per month. This new price and quantity combination represents the new equilibrium point in the market.
The price mechanism plays a pivotal role in the transition from the initial equilibrium to the new equilibrium. Rising prices act as signals to both consumers and producers. For consumers, higher prices indicate a limited supply or increased demand, prompting them to adjust their purchasing decisions. For producers, higher prices suggest higher profitability, incentivising them to expand production and increase supply.
Through these price adjustments and the resulting changes in consumer behavior and producer decisions, the market gradually moves from the state of excess demand to a new equilibrium, where the quantity demanded and supplied are once again balanced. This process demonstrates how the price mechanism helps to steer the market toward a new equilibrium point, allowing for the efficient allocation of resources and meeting consumer preferences.
It's important to note that the transition to a new equilibrium is a dynamic process and can take time as market forces adjust. Additionally, factors such as changes in consumer preferences, technological advancements, or shifts in input costs can influence the movement of the market and the establishment of a new equilibrium price.
SUPPORTING DIAGRAMS WITH ANOTHER EXAMPLE
