Application of Price Mechanism to Shifts in Demand and Supply

Introduction

• Review of previous video: Functions of the price mechanism and their operation.
• Objective: Apply these functions to shifts in demand and supply curves.

Demand Curve Shifting Right

• Initial Conditions
  • Demand curve shifts right due to non-price factors.
  • At initial market price P1, demand is greater than supply (excess demand/shortage).
• Price Adjustment
  • Firms observe long queues and competition between buyers.
  • Consumers bid up prices due to high demand.
  • Prices rise from P1 to P2 (upward pressure due to excess demand).
• Functions of the Price Mechanism
  • Signal Function: Higher prices indicate excess demand.
  • Incentive Function:
    • Encourages firms to increase output.
    • Can attract new firms or stimulate existing firms to expand capacity.
  • Rationing Function: Higher prices discourage consumption, shown by contraction along demand curve.
• Outcome
  • Achieve new equilibrium at quantity Q2 and price P2 (allocative efficiency).

Supply Curve Shifting Right

• Initial Conditions
  • Supply curve shifts right due to non-price factors.
  • At initial price P1, supply exceeds demand (excess supply/surplus).
• Price Adjustment
  • Warehouses and stores are full; few buyers.
  • Prices fall from P1 to P2 (downward pressure due to surplus).
• Functions of the Price Mechanism
  • Signal Function: Lower prices indicate excess supply.
  • Incentive Function:
    • Encourages producers to reduce output and liquidate stock.
    • Could lead to firms exiting the market or cutting capacity.
  • Rationing Function: Lower prices encourage more demand, shown by expansion along demand curve.
• Outcome
  • New equilibrium reached at quantity Q2 (allocative efficiency).

Conclusion

• Demonstrated how the price mechanism corrects disequilibrium in both demand and supply shifts to the right.
• Exercise left for the audience: Analyze shifts in demand and supply to the left.
• Emphasis on the magical nature of market dynamics and equilibrium.

Additional Notes

• Review the previous video for foundational understanding.
• Practice identifying disequilibrium and applying the price mechanism functions to solve it.