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The Price Mechanism

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📊 Introduction to Markets 📊

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In economics, a market is any place where these exchanges of goods happen. Whether it's a local farmer's market or a global online marketplace, the fundamental principles are the same. Let's dive in and see how markets operate!

Combining Supply and Demand

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So far, we've explored the supply curve and the demand curve separately. Now, it's time to bring them together to see how markets work!

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When we combine the supply curve (which shows how much producers are willing to sell at different prices) and the demand curve (which shows how much consumers are willing to buy at different prices), we can find the point where they intersect. This point is called Equilibrium.

✅ Equilibrium is when there is no tendency for the market price to change. At this point, the quantity demanded equals the quantity supplied.

👉 But what happens if something changes?

⚖️ Market Disequilibrium: When Things Get Out of Balance ⚖️

What is Market Disequilibrium?

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Market disequilibrium occurs when the quantity demanded does not equal the quantity supplied at a given price. This results in the market not clearing, leading to either excess demand (shortage) or excess supply (surplus).

👉 Changes in the conditions of demand and supply can shift the equilibrium price and quantity, causing a temporary market disequilibrium until a new equilibrium is established.

What are the effects of changes in demand and supply on equilibrium level?

Go through the figures to see these effects:

Diagram	Change	Equilibrium price	Equilibrium quantity
1	Demand increases	Higher	Higher
2	Demand decreases	Lower	Lower
3	Supply increases	Lower	Higher
4	Supply decreases	Higher	Lower

Please note that the Equilibrium price and quantity are denoted with a star i.e P* and Q*

Test Your Knowledge with Scenarios

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Exam Tip: In your higher economics exam, you may encounter real-life case study scenarios where there may be questions asking you to draw diagrams illustrating the market effects for specific goods.

These questions will test your ability to understand and analyse shifts in supply curves. Pay close attention to the details provided in the case study.

Practice drawing BOTH demand and supply curves for scenarios like the ones below to prepare effectively 👇

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Scenario 1

Situation: Due to a significant shortage of sunflower oil and extremely dry weather conditions in Spain, the production and availability of Spanish olive oil are impacted.

Question: "Draw a diagram to show the effect on the market for Spanish olive oil due to the reduced availability of sunflower oil and abnormally dry weather in Spain.”

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😃 Try it for yourself then click here to see the answers:

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Scenario 2

Situation: The government has introduced a 'fat tax' on unhealthy food and imposed stricter restrictions on advertising unhealthy food, impacting its market dynamics.

Question: "Draw a diagram to show the effect on the market for unhealthy food as a result of the introduction of a ‘fat tax’ and increased restrictions on advertising unhealthy food.”

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😃 Try it for yourself then click here to see the answers:

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Scenario 3

Situation: Both the EU and US governments have introduced subsidies to support the aircraft industry. However, there has been a worldwide suspension of most air travel due to the COVID-19 pandemic.

Question: "Draw a diagram to illustrate the effects of these subsidies from the EU and US governments, combined with the global suspension of air travel, on the market for aircraft.”

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😃 Try it for yourself then click here to see the answers:

🛠️ What mechanism can solve market disequilibrium? 🛠️

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The price mechanism is a powerful tool that helps the market adjust and move towards equilibrium, thus solving the market disequilibrium

What is the Price Mechanism?

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The price mechanism is how prices are set in a market based on the interaction between consumers (buyers) and businesses (sellers).

Consumers decide how much they are willing to pay for a product.
Businesses decide how much they want to charge for that product.

These decisions interact in the market, and the price is determined by the forces of supply (how much of a product is available) and demand (how much of a product people want). Essentially, it’s the buyers and sellers together who determine the price of a product.

👉 In short, the price mechanism is the system where supply and demand decide the prices of goods and services.

What are the main functions of the price mechanism?

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Signalling Function

Prices act as signals to show where resources are needed.
Prices rise and fall based on scarcity (shortage) and surplus (extra supply).

📱Example: If the price of smartphones goes up because everyone wants one, this signals manufacturers to make more smartphones.
🍊Example: If there are too many oranges and not enough buyers, the price of oranges will drop to encourage people to buy more.

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Incentive Function

Prices provide incentives for consumers and producers.
Consumers’ choices send information to producers about what they need and want.

🚙 Example: If more people start buying electric cars, it tells car manufacturers to make more electric cars.

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Rationing Function

Prices help ration scarce resources when demand is higher than supply.
When there is a shortage, prices go up, so only those who are willing and able to pay can buy the product.

🎮 Example: If there is a limited supply of a new video game console, the price may increase, and only those who are willing to pay more will get one.

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Through these mechanisms, prices adjust based on the interaction of supply and demand, helping the market reach equilibrium where the quantity demanded equals the quantity supplied. This entire process uses price as a basis for exchange.

What does “Price as a basis for exchange” mean?

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When we say "price as a basis for exchange," it means that price is the value assigned to a good or service, and this value is what people use to make exchanges or trade in a market.

→ Price assigns a specific value to a product or service, making it easier to understand how much something is worth.

🍭 A candy bar priced at £1 means that the candy bar is worth £1.

→ Prices enable buyers and sellers to agree on the terms of exchange.

If you have £1 and want a candy bar, you can exchange your £1 for the candy bar because both you and the seller agree on the price.

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Sometimes the government steps in to control the price mechanism to make essential commodities affordable for everyone, especially for those with lower incomes.

For example:

The Scottish Government supports energy price caps to protect consumers from excessive energy prices. By capping the prices that energy companies can charge, the government helps ensure that energy remains affordable, particularly for low-income households. ⚡️

Energy Price Guarantee Changes in Autumn Statement | FAI

Energy prices had previously been frozen for two years from October 2022 in the “mini budget” at £2500 per year for the typical household. While the price cap is remaining in place this winter it has…

fraserofallander.org

Energy Price Guarantee Changes in Autumn Statement | FAI

How can the price mechanism solve the market disequilibrium?

Price as a basis for market clearing

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“Price as a basis for market clearing" means that prices adjust to ensure that the quantity of goods supplied equals the quantity demanded, preventing surpluses and shortages and ensuring efficient allocation of resources.

👉 Excess demand and excess supply are states of disequilibrium in a market

let’s figure out how the price mechanism works to solve these two states of market disequilibrium by looking at the market for a particular good:

Excess demand

Excess supply

Are there any real life examples of market clearing in Scotland?

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Example: During the Edinburgh Festival, there is a high demand for accommodation. If there are more visitors seeking accommodation than available rooms, prices will increase until the number of rooms available matches the number of visitors willing to pay the higher price.

→ Prices of accommodation for the 2024 Fringe Festival has increased by up to 1500% due to the excess demand!

Edinburgh Fringe Festival accommodation' costs soar by as much as 1,500 percent

Landlords and hotels have been branded 'greedy' by performers with Jason Manford saying he is making a loss even after selling out.

uk.news.yahoo.com