Economic Markets and Price Mechanism

Introduction to Markets

• A market is any place where buyers meet suppliers to exchange goods and services.
  • Physical: market stalls, shops.
  • Non-physical: online retailers like Amazon, eBay.
• Markets determine prices and quantities from equilibrium.

Market Equilibrium

• Equilibrium occurs where demand equals supply.
• Equilibrium Price (P1): the market-clearing price.
• Equilibrium Quantity (Q1): the market-clearing quantity.
• At equilibrium, the market clears itself from excess demand and supply; there's balance.

Market Disequilibrium

• Disequilibrium occurs where demand does not equal supply.
  • Price Above Equilibrium (P2):
    • Excess supply: supply exceeds demand.
    • Disequilibrium as prices lead to surplus.
  • Price Below Equilibrium (P2):
    • Excess demand: demand exceeds supply.
    • Disequilibrium as prices lead to scarcity.

Price Mechanism

• Functions of the Price Mechanism: Remember with the mnemonic "RC."
  • Rationing Function: Rations away excess demand and supply.
  • Signaling Function: Signals to producers if prices are too high or too low.
  • Incentive Function: Encourages producers to change prices for profit.

Disequilibrium in a Free Market

• A free market involves no government intervention.
• Price mechanism resolves disequilibrium automatically:
  • Excess Supply:
    • Producers lower prices (P2 to P1) due to excess stock.
    • Results in contraction of supply and extension of demand.
    • Return to equilibrium at (P1, Q1) with perfect resource allocation.
  • Excess Demand:
    • Producers raise prices (P2 to P1) due to high demand.
    • Results in extension of supply and contraction of demand.
    • Return to equilibrium at (P1, Q1) with perfect resource allocation.

Conclusion

• Equilibrium reflects a perfect allocation of scarce resources.
• Disequilibrium is temporary due to the functions of the price mechanism.
• Next topic: how the price mechanism adapts to shifts in demand and supply.