Theory: The Market Mechanism

Microeconomics: The Market Mechanism

Following on from learning about the supply curve and the demand curve, we must now put them together. To do this graphically is rather quite simple; just draw the axes with price (y-axis) and quantity (x-axis) and then draw the two curves on accordingly.

Don’t forget that price (P) is measured in a particular currency per one unit of the product e.g. dollars ($). So now when both curves are on the diagram, price represents what the sellers receive for a specific quantity supplied, and the price that buyers will pay for a particular quantity demanded. Furthermore, quantity is now indicative of the total quantity demanded and quantity supplied – measured as a figure in a given time period.

This leads us nicely onto the concept of market equilibrium and equilibrium price

or quantity. This occurs when the supply and demand curves intersect each other i.e. at coordinates (P,Q) on the graph above. By definition, the equilibrium price or the ‘market clearing’ price is the price that equalizes the quantity supplied to the quantity demanded.

The MARKET MECHANISM is therefore the tendency for price to change in a free market until the market clears i.e. where S = D. At this point, due to the fact that there is no excess demand or supply, there is no pressure for the price to now change.

It must now be stressed that supply and demand might not always be in equilibrium and that some markets may not respond quickly when conditions alter abruptly. The tendency, however, is that markets will clear.

To better understand why markets tend to clear, one needs to understand the ideas of shortages and surpluses. Shortages occur when the quantity demanded is greater than the quantity supplied and in contrast, surpluses occur when the quantity supplied is greater than the quantity demanded.

Shortage: QD > QS

Surplus: QS > QD

Suppose the market price is above the market-clearing level. Here there will be a surplus. To sell this surplus, or at least prevent it from getting bigger, sellers would lower their asking price. Eventually as the price fell, the quantity demanded would increase and the quantity supplied would decrease until such a point that the equilibrium quantity/price was achieved.

The opposite would occur if there was a shortage. This would cause upward pressure on price as consumers would attempt to try and outbid one another for the existing supply and in turn the producers would respond by increasing price and improve output. Again, the price would eventually reach the equilibrium quantity/price.

Care is to be taken when using the supply-demand analysis/model. Competition seriously affects the market power that buyers and sellers possess in said market. If a market is roughly competitive then both sellers and buyer will have little market power i.e. individually they can’t influence market price. However, assume that the market has only one supplier and so is a monopoly. There would no longer be this simple relationship between price and quantity supplied. But why so? It is because a monopolist’s behaviour is determined by demand – the shape and position of the demand curve. If demand changes in a certain manner, the scenario might be that the monopolist wants to maintain a fixed quantity to supply. So when using the supply-demand curve analysis, we presume that we’re alluding to a competitive market.

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