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Chapter 5

 

KEY IDEAS YOU NEED TO KNOW:

How do supply and demand balance the amount buyers want to purchase with the amount the sellers want to sell.
What are shortages and surpluses, and how can market competition eliminate them?
How do market-clearing prices ration goods and services.
How do market-clearing prices motivate people to produce goods and services.
How do changes in demand and supply bring about changes in market-clearing prices.
How do market-clearing prices provide important information and incentives to consumers and producers.

Now that we have covered both demand and supply we have to combine both together. The place where what sellers are willing to sell for and buyers are willing to buy for is called market clearing or equilibrium price. This is the price the product will sell for. Price is negotiation between the buyers and the sellers.

In a market economy, prices are the result of the needs of both buyers and sellers.   Sellers will supply more goods at a  higher price than at lower ones.  Buyers will buy more goods at lower prices than at higher ones.   Some price must be satisfactory to both buyers  and sellers. At that price the supply-quantity offered for sale-equals the demand-quantity people are willing to buy.  Since no surplus or shortage exists, there is no pressure on price to change.  This point is called the equilibrium price (market-clearing price), the amount producers will supply and the amount consumers will buy are the same. This is the only price that balances or “clears” the market.

To figure out price one has to look at supply and demand next to each other.

 

Supply and Demand of Chocolate Chip Cookies

Students will buy

At a price of

Sellers will offer

100

.70 cents

2,000

200

.60

1,800

400

.50

1,600

700

.40

1,400

1,100

.30

1,100

1.600

.20

700

2,300

.10

100

When we then plot and draw both curves together we are able to see the market price of the product.

The market price for cookies in this graph is 30 cents. The quantity sold and bought is 1100 cookies.

Why are prices important in a Market Economy?

Prices are key ingredients in our economy because they make things happen. If buyers want to own some items badly enough, they will pay more for them. When sellers want to sell some items badly enough, they will lower their prices. Prices play such an important role in economic life that the United States is often described as a price-directed market economy. Let us see why.

1. Act as Signals to Buyers and Sellers. One of the things that prices do is carry information to buyers and sellers. When prices are low enough, they send a "buy" signal to buyers (consumers), who can now afford the things they want. When prices are high enough, they send a "sell" signal to sellers (retailers), who can now earn a profit at the new price.

2. Encourage Efficient Production. Prices encourage business people to produce their goods at the lowest possible cost. The less it costs to produce an item, the more likely it is that its producers will earn a profit.

Firms that are efficient will produce more goods with fewer raw materials than firms that are inefficient. Producers strive for efficiency as a way of increasing their profits. While these efforts are in the best interests of the sellers, all of us may benefit because we are provided with the things we want at lower costs.

3. Determine Who Will Receive the Things Produced. Finally, prices help to determine who will receive the economy's output of goods and services. The price that a worker receives for doing a job is called a wage. The amount of this wage determines how much the worker has to spend. What the worker can buy with those wages will depend, in turn, upon the prices of the goods and services the worker would like to own.

Disequilibrium:

If the market price supplied is anywhere but at the equilibrium, the market is in a state that economists call disequilibrium.  Disequilibrium occurs when the quantity supplied is not equal to quantity demanded in a market.  Disequilibrium can produce one of two outcomes, excess demand or excess supply.

The problem of excess demand occurs when quantity demanded is more than quantity supplied.  When the actual price in a market is below the equilibrium price, you have excess demand, because the low price encourages buyers and discourages sellers.  As long as there is excess demand, and quantity demanded exceeds the quantity supplied, suppliers will keep raising the price.  When the price has risen enough to close the gap, suppliers will have found the highest price that the market will bear.  If the price is too high, then the market will face a problem of excess supply.  Excess supply occurs when quantity supplied exceeds quantity demanded. Excess supply was a major problem for the tourism industry in the last months of 1999. Hotels, restaurants, and cruise lines assumed that people would be willing to pay a very high price to celebrate the start of the year 2000, and doubled or tripled their usual rates for special "millennium" travel packages.  Unfortunately, many people decided not to travel around January 1, 2000, and many who did travel refused to pay thousands of dollars for dinner or one night in a hotel.  High prices and the large number of choices led to a problem of excess supply. Whenever the market is in disequilibrium and prices are flexible, market forces will push the market toward equilibrium.  Sellers do not like to waste their resources on excess supply, particularly when the goods can not be stored for long.  And when there is excess demand, profit-seeking sellers realize that they can raise prices to earn more profits.  In this way, market prices move toward the equilibrium.

Sometimes a society decides that the free market is not the best provider of goods and services.  To choose who will have vital items, such as food, shelter, and medical care, societies may try some other method.  Markets tend towards equilibrium, but in some cases the government steps in to control prices.  The government can impose a price ceiling, the maximum price that can be legally charged for a good or service.   Rent control is a prime example of a price ceiling.  In other cases, the government can create a price floor, or a minimum price for a good or service.   Minimum wage is a prime example of a price floor, as are agricultural commodity pacts with the government.  With agricultural floors the price of an item is not allowed to fall below a certain price.  If they do the government buys the excess product.  This is an incentive or subside that encourages farmers to produce large supplies of milk, corn, wheat, and other products.  This is an incentive, which motivates farmers. This system of keeping prices at or above market levels takes some of the risk out of operating a farm.  It ensures that the supply of food will not decline drastically because of a fall in farm prices.  

Another method of reaching equilibrium  is to let people stand in line or put their names on a waiting list.  Price controls or rationing are often used during times of severe shortages to make sure that the prices of important items, such as food and gasoline, do not go too high.   During World War II, people were issued ration stamps for meat, butter, sugar, canned goods, shoes, and gasoline.  Each person was thus able to get the minimum amount of these goods needed to survive.   Price controls and ration stamps were also discussed in recent years as a way of dealing with temporary shortages of gasoline and heating oil.

These alternatives to market prices all have side effects.  When prices are not allowed to rise to their market level, suppliers may not supply as much of a good or service as consumers want.  In other words, shortages develop.  These shortages can sometimes become quite serious.  Nevertheless, if prices are kept lower than their market level, more people may be able to buy the product.  When prices are not allowed to drop to their market level, suppliers may be supplying more of a good or service than consumers want.

The market, then coordinates the needs or producers and consumers.  It provides information necessary for both consumers and producers to make crucial decisions for the markets that they deal in from day to day. In some ways, groups or people are like market economics.  We need things from others and others need things from us.  Somehow, we all find our own equilibrium point.  Everyone gets what he or she most needs and can afford.