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Price Determination, price mechanism, supply, Demand

9. Price Determination

Price determination. This article will explain what an equilibrium price is and how an equilibrium price is formed using a demand a supply curve. The article will also discuss the price mechanism and its functions. Before reading this article, it is recommended you read our articles on demand and supply.

Welcome to Simply Economics. This article is the eleventh in a series to explain economics to those who want to broaden their scope of the subject. Click here to find out more about the series. This article explains the determinants of price elasticity of supply.

PRICE DETERMINATION AND THE EQUILIBRIUM PRICE

The price of a good is formed due to the level of demand and supply of the good. The equilibrium price is when the supply of a good equals the demand of the good. On a supply-demand diagram it is shown by the intersection of the demand and supply of a good.

Below is an example in order to develop a better understanding of the topic:

Price ($)Quantity demanded per monthQuantity supplied per month
50100500
45200400
40300300
35400200
30500100
Figure 1

EXCESS DEMAND AND SUPPLY

As shown by Figure 1, when the price is high there is a high amount of supply as producers are willing to sell more of their good at a higher price because it means their profit per unit is higher. However, at the higher price, the demand falls because the good becomes less accessible to those who have lower incomes.

For example, at a price of $50 there is an excess supply of 400 units. In order to sell off this surplus of units, producers will decrease the price of their good to encourage consumers to buy more of their good. This will cause supply to contract and demand to extend until the equilibrium price, where supply equals demand, is reached. In this case, the equilibrium price is $40.

At a price of $30 there is an excess demand of 400 units. This causes more competition between consumers and therefore they increase the price they are willing to pay. This causes producers to sell more of their good which increases the supply of their good. This will cause supply to extend and demand to contract until the equilibrium price is reached.

EQULIBRIUM PRICE ON A SUPPLY-DEMAND DIAGRAM

Price Determination, price mechanism, supply, Demand
Figure 2

Figure 2 shows that the intersection of the supply and demand curves is the equilibrium price. The equilibrium price can be abbreviated to Pe and the equilibrium quantity can be abbreviated to Qe as shown in figure 2.

THE PRICE MECHANISM

This system of demand and supply controlling the price of a good is known as the price mechanism. It can only function in free market conditions where there is no government intervention. The price mechanism allows surpluses and shortages of demand and supply to be controlled and eliminated automatically because demand and supply will contract and extend as needed in order to reach the equilibrium price.

WHAT DOES THE PRICE MECHANISM DO?

The price mechanism is the most fundamental way scarce resource are allocated efficiently and it has a few effects:

  • Allocates resources – In the first lesson, it was discussed that resources are scarce and finite. The price mechanism allows the finite resource to be distributed among consumers efficiently (i.e. there is no wasted resources). However, the price mechanism allocates resources to those who are willing to pay most for it which raises concerns for those with lower incomes.
  • Provides signals – The price mechanism signals where more resources should be allocated and where less resources should be allocated. For example, if a good has high demand, then the price of the good will increase. This signals to the producer that more resources (goods) should be allocated in this particular market as more profit can be made here.
  • Provides incentives to producers – If the price of a good increases it provides producers with an incentive to sell more of the good as more profit can be made.

In conclusion, the equilibrium price is when the quantity of supply and demand of a good is equal. It is reached due to the effect of the price mechanism which acts allocates resources efficiently to consumers and provides signals and incentives to producers when and where (which market) to increase their production of goods.

Feel free to ask any questions and sign up below for the latest updates. Click here for more articles. For more articles in the Economics for Beginners series, click here

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