Hi everybody, we've understood demand and supply in real detail. Let's now put the two together and understand what an economic market is. Here is the definition of a market.
It's any place where buyers meet suppliers to exchange goods and services. That place could be physical. like a market stall or an actual shop.
It can be non-physical, so online through retailers like Amazon and eBay, for example. Within markets, we get prices and quantities, and those prices and quantities can be derived from the equilibrium in them. the market.
Equilibrium is just the Greek word for balance, right? So apply that to a market, it occurs where demand equals supply in a market. Where demand equals supply.
Now, as you can see, I've drawn two diagrams here. I've drawn supply and demand. Where the two cross, so where demand equals supply, that's where I've taken the price and the quantity in both cases.
There are other names that we can use here. So we can call P1 the equilibrium market price, clearly. We can call Q1 the equilibrium market.
market quantity. Another name for equilibrium, we can say it's the point where the market clears, so the market is clear from excess demand and excess supplies, i.e. there is balance between demand and supply. And we can call P1 the market clearing price, we can call Q1 the market clearing quantity. Good to know that jargon as well. So that's what equilibrium looks like.
What does disequilibrium look like? Well clearly disequilibrium will be where demand does not equal supply. So maybe the price is above P1, maybe the price is below P1.
prices above P1 will have something like this, won't we? So the prices at P2, it's pretty clear that that's disequilibrium, because demand and supply are not in balance. If we take that line across, we can see that supply is over there, and demand is over there, right?
The distance between A and B is excess supply. So supply is clearly much more than demand. Well, that's not equilibrium, because equilibrium is rather to be equal.
So this is disequilibrium. What about if the price is below P1? So the price is below P1. Let's say here, let's call that P2.
You can see if we take this line across, that quantity demanded is over there, quantity supplied is only over there. So again, we have a problem here. This time demand is much greater than supply. We call that excess demand. Excess demand.
Now this is clearly disequilibrium because demand is greater than supply. The two are not equal. Demand is greater than supply.
This is disequilibrium too. So equilibrium is where demand is. supply cross, disequilibrium is when demand is not equal to supply. Maybe because the price is above equilibrium or maybe because the price is below equilibrium and we see divergence between supply and demand.
But what's also really, really, really good to know, very useful to know at this stage, is that in a free market, disequilibrium will never last and that is because the market has got these incredible functions that can take away any problems that exist in the form of excess supplies or excess demands. Another name for a market guys is the price mechanism. And the price mechanism has got four functions to it.
And you can see it here. There is a lovely memory device to remember all these four functions. Just remember RC. The market is RC.
A bit like you guys in the morning, right? RC. But yeah, just learn it as RC. Great little memory device.
And that will give you the four key functions of the price mechanism. The A. The market will allocate scarce resources efficiently, effectively, adequately. equilibrium.
So it allocates scarce resources. How? Well, it rations away any excess demands and excess supply. So if there are any problems like this excess supply, like that excess demand, it will be taken away, rationed away.
How? Well, signals will be provided. So the price mechanism will send signals to producers that prices are wrong, prices are either too high or too low.
And also the market mechanism, the price mechanism will provide incentives to producers to change prices in order to make more profit. These are the four functions. Let's understand how the operation of these functions can take away problems of disequilibrium in a free market. A free market, guys, is when there is absolutely no intervention by government at all. There is no involvement of government.
It's just the interaction of producers and consumers. That's it. So in a free market, a price of P2 and the issue of excess supply would not last. Why? How do the functions of the price mechanism get to work?
Well, the first thing that happens is that the signal is... sent to producers that this price is too high. How do producers know? What is the signal?
Well, they see excess stock in their warehouses. They see their shelves in their shops are full of stuff. It's not being sold. If it's a restaurant, they see that their tables are constantly empty.
All the ingredients are left in the kitchen. It's clear that they're not shifting their stock. It's a sign that the price is too high.
So then the market provides an incentive to producers to change their price. And this creates to reduce their price from P2 to P1. Why? If they reduce their price, they reduce their price. So if price they can sell or that excess supply, that excess stock, and make profit from it.
Absolutely. So that's the profit motive, to change price, in this case to reduce price, from P2 to P1, sell some of the excess stock and make profit. If they do that, what will happen? they reduce their price from P2 to P1, there will be a contraction along the supply curve and an extension of demand. So we move along the supply curve downwards, a contraction of supply and a movement down the demand curve, an extension of demand, and we get to P1 and a quantity of Q1.
At P1 and Q1 we're back in equilibrium, right? And here there is no excess supply and no excess demand. We've rationed away the excess supply that was the issue, completely rationed by these movements as the price has been reduced.
And at P1 and Q1, because there are no excess supplies and no excess demands, we have a perfect allocation of scarce resources. We're going to look at that in way more detail. If you go to a later video in the playlist, you'll see how I analyse what I mean by a perfect allocation of scarce resources in more detail.
But before we go into that, But basically, where we're at equilibrium, that is a perfect allocation of scarce resources. Great, so in a free market, any time there is excess supply at the prices above equilibrium, that will be taken away through the functions of the price mechanism, through RC. What about at the prices below equilibrium here?
We can see there is an excess demand. Well, exactly the same order. First, a signal will be sent to producers that now the price is too low. How will producers see this? Well, there will be massive queuing for the good or service.
There'll be huge waiting lists for consumers to buy the good or service. Maybe there'll be huge competition between buyers to get this good or service. A clear sign that the price is too low.
There is this excess demand, supplies can't keep up basically. So then there is an incentive for producers now to increase their price from P2 to P1. Milk it.
If you've got a huge demand for your product, milk it. Raise your price, satisfy some of that extra demand by producing more at a much higher price. A great way to increase your profits. Now obviously, what does that mean?
milk it, but that's a basic idea, isn't it? Milk it, you've got a huge demand, push up your price, make a higher profit from that extra demand. So there is an incentive to increase price here in order to increase profit for the producer.
If that happens, so from P2 to P1 the price is raised, you can see that there is now an extension of supply and a contraction of demand, and we end up at P1, which means that the excess demand has been rationed away. We end up at P1 and Q1, perfect equilibrium, no excess demand, no excess supply. we now have a perfect allocation of scarce resources.
So you understand how disequilibrium, how it looks, but also how it wouldn't last in a free market. The basic interaction between producers and consumers, the basic functions of the price mechanism would take it away, which will always leave us with a perfect allocation of scarce resources at equilibrium. So that covers our market, guys, what equilibrium looks like, what disequilibrium looks like, but also, crucially, the four key functions of the price mechanism.
Stay tuned for the next very important video. video to look how the price mechanism works when there are changes in demand and supply, i.e. when there are shifts. Very important you stay tuned for that. I'll see you in that video, guys.
Thanks for watching.