1.3.4 - Price determination

Market equilibrium occurs at the price where quantity demanded equals quantity supplied. At this price, buyers' planned purchases exactly match sellers' planned sales, determining the equilibrium price and quantity.

On a standard diagram, equilibrium is the intersection of the downward-sloping demand curve and upward-sloping supply curve. Read the price horizontally to the price axis and the quantity vertically to the quantity axis.

Identify the non-price determinant, shift the correct curve, keep the other curve fixed unless evidence says it also changes, and locate the new intersection. Then compare both equilibrium price and quantity with their original values.

When demand and supply shift together, one outcome may be certain while the other is ambiguous. Demand right plus supply left must raise price, but quantity may rise, fall or stay unchanged depending on the relative shift sizes. Demand left plus supply right must lower price, while quantity is ambiguous.

Price changes create movements along the existing demand and supply curves. Adjustment continues until planned quantity demanded again equals planned quantity supplied.

If a price is below equilibrium, buyers want 90 units but firms offer 50, leaving excess demand of 40. A rising price reduces purchases and encourages sales until the gap closes.

A buyer willing to pay $10 who pays$7 receives $3 consumer surplus. A seller willing to supply a unit for at least$4 who receives $7 receives$3 producer surplus.

Demand represents marginal willingness to pay and supply represents the minimum acceptable price linked to marginal cost. Adding the unit-by-unit gaps gives the total surplus areas.

Draw the original and new curves, mark both equilibria, then compare the complete areas bounded by demand or supply, the relevant price and the traded quantity. Do not compare price alone when the curve defining willingness to pay or minimum supply price has moved.

A good harvest shifts supply right, lowers price and expands quantity, increasing consumer surplus. A fall in demand for hotel rooms shifts demand left and normally reduces producer surplus.

If demand rises, excess demand pushes price upward. The higher price signals stronger scarcity, gives firms an incentive to increase output, and rations the limited current supply. These responses help reallocate scarce resources.

The same signalling, incentive and rationing functions operate at each scale. A higher world cocoa price signals scarcity to producers internationally, while a local hotel price mainly coordinates rooms and visitors in that location.

Markets can overlap: a global commodity-price change alters national import costs and then local retail prices. The relevant market is defined by the product, geography and participants able to substitute or trade.

An indirect tax raises producers' cost of supplying each unit. The consumer price rises, the net price producers receive falls, and equilibrium quantity falls. The vertical wedge between the two prices is the tax per unit; multiplying it by post-tax quantity gives government tax revenue.

Tax incidence is the division of the tax burden between consumers and producers. Consumer incidence is the rise in the price paid; producer incidence is the fall in the net price received. Together they equal the tax per unit.

The side less able to change quantity after the tax has fewer avoidance options, so bears more of the wedge. Statutory responsibility—who sends the payment to government—does not determine economic incidence.

A production subsidy is a government payment that lowers producers' effective cost and encourages production. Supply shifts right/down; the price consumers pay falls, the price producers receive including subsidy rises, and equilibrium quantity increases.

The vertical difference between the producer receipt and consumer price is the subsidy per unit. Multiplying this wedge by the post-subsidy quantity gives government expenditure.

The effect depends on subsidy size, PED, PES, time lags and whether firms pass benefits through. Support may build capacity or correct underconsumption, but can cause dependency, overproduction or government failure.

Subsidy incidence divides the per-unit subsidy between consumers and producers. Consumer incidence is the fall in the price consumers pay; producer incidence is the rise in the effective price producers receive. Together they equal the subsidy per unit.

As with tax incidence, the less responsive side captures more because it changes quantity less and has fewer alternatives. Legal payment to producers does not imply producers retain the full benefit.