Market Equilibrium & Price Mechanisms (NCUK FY PDF)

Market Equilibrium International The price mechanisms and Foundation Year Market efficiency (NCUK) Microeconomics Bringing market demand and supply curves together Bringing buyers (demanders) and sellers (suppliers) together creat...

Market Equilibrium International The price mechanisms and Foundation Year Market efficiency (NCUK) Microeconomics Bringing market demand and supply curves together Bringing buyers (demanders) and sellers (suppliers) together creates what economist call a market When we picture a market in our heads we tend to think of a fruit and veg market but a market does not even have to be physical - it is just where buyers and sellers interact. Transactions can by carried out by phone, mail order or over the internet.  Market equilibrium Watch the mjm foodie video https://www.youtube.com/watch?v=W5nH pAn6FvQ Equilibrium In order to analyse how a market works we bring the demand and supply curve together and from now on we always draw our diagrams with both curves Equilibrium is when supply satisfies demand and vice versa Everything produced in the market will be sold They are equal, there is balance/stability and there is no tendency for the market to change without external change In theory the price system should produce equilibrium as we will see later Price of Coffee Equilibrium S point The free market Pe equilibrium price is Pe and quantity is Qe Market clearing D price Qe Quantity of Coffee Market disequilibrium and eliminating excess supply Equilibrium is self righting in a free market Lets says the producers increase their price to P1 At this price there will be Q1 demand At this price there will be Q2 supply There is too much supply (excess supply) of Q1 – Q2 The market is said to be in disequilibrium To get rid of the surplus producers will have to supply at a lower price As they do the quantity demanded will increase until once again demand equals supply and there is equilibrium once more Price S P1 P D O Q1 Q Q2 Quantity Excess Supply = Q2 – Q1 Market disequilibrium and eliminating excess demand This time producers tried to lower their price There is too much demand at Q2 and not enough supply at Q1 the market is in disequilibrium because there is excess demand Q2 will be demanded but only Q1 will be supplied which means there will be a shortage (suppliers will sell out) There is a shortage off Q2 – Q1 Price In order to eliminate the S shortage producers have to raise their prices P As they do the quantity demanded will fall P1 Eventually demand and supply will be equal again giving D equilibrium Q1 Q Q2 Quantity Excess demand = Q2 – Q1 The effects of changes in demand and supply on the equilibrium Previously we looked at factors that ($) Price of holidays shift the demand curve and supply curve – these are outside disturbances (nothing to do with the price although they will S1 change the price) Now we need to look at what those shifts do to the equilibrium price and quantities P1 In real life lots of things may change at the same time but to make it simple we only deal with single changes and D2 assume that the ceteris paribus condition is met D1 Ceteris paribus is Latin for ‘all things Q1 Q2 Quantity of being equal’ – in other words nothing else holidays has changed (days) Lets take the example of an increase in income for consumers of foreign holidays When there is an increase in income there will be an increase in the demand for holidays Ceteris paribus there will be a shift of the demand curve to the right The effects of changes in demand and supply on the equilibrium ($) Price of holidays Initially the price remains at the equilibrium price Q1 will be supplied S1 Q2 will be demanded There will be excess demand (a P2 shortage) P1 To get rid of the shortage prices will need to rise Until once again equilibrium is D2 restored but at a higher price of P2 The new equilibrium quantity is Q3 D1 Whenever there is a shift of the Q1 Q3 Q2 Quantity of holidays demand or supply curve the market (if (days) it is left alone) will adjust to a new equilibrium or market clearing price  Practice Questions Using fully labelled diagrams, illustrate what will happen to the equilibrium price and quantity in each of the situations below, and then explain what has happened. 1. There has been a health scare relating to the consumption of chicken. 2. There has been an increase in the costs of production in the motorcycle industry. 3. There has been an improvement in the production technology in the textile industry. 4. Manufacturers in the sportswear industry have decided to raise the price of training shoes. The Price Mechanism The role of the price mechanism Resources are allocated and re-allocated Price mechanism in response to changes in price = the forces of supply and If there is an increase in the price of a demand good due to an increase in demand for the good there is a signal to the producers The price signal tells producers that consumers wish to buy this good We assume that producers are rational and wish to maximise their profits There is an incentive for them to produce more Producers allocate more resources to those goods where the demand is highest (they will make more profit) There is not central planning agency Adam Smith said it was like there was an invisible hand moving the factors of production around to produce the goods and services wanted by the buyers in the economy RATIONING FUNCTION The rationing function relates to the buyers of the good. Prices will ration scarce resources when demand outstrips supply. Whenever resources are particularly scarce, demand exceeds supply and prices are driven up. discourage demand, conserve resources, and spread out their use over time. The rationing function of a price rise is associated with a contraction of demand along the demand curve.  SIGNALING FUN C TION A N D INCENTIVE FUNCTION They relates to producers and resource owners. Signaling function Prices adjust to show where resources are required and whether firms/consumers should enter or leave a market. Incentive function Prices motivate producers and consumers to pursue a particular course of action e.g., higher prices provide an incentive to firms to increase output in the pursuit of higher profit The effects of changes in market conditions in individual & related markets D emand side factors Price Supply side factors S Pe D Qe Quantity