2.4. Price determination
- Syllabus
- 0455–2027–2028
- Topic
- 2.4
- Level
- —
Learning objectives
2.4.1Price mechanism• how the price mechanism provides answers to the basic resource allocation decisions of what, how and for whom to produce2.4.2Market equilibrium• equilibrium price and equilibrium quantity in a market:• definition of market equilibrium• interpretation of equilibrium using demand and supply schedules• drawing and interpretation of equilibrium using demand and supply curves2.4.3Market disequilibrium• disequilibrium prices and quantities:• definition of market disequilibrium• interpretation of disequilibrium using demand and supply schedules• drawing and interpretation of disequilibrium using demand and supply curves• shortages (demand exceeding supply) and surpluses (supply exceeding demand)
Use prices to allocate scarce resources
The price mechanism is the way changes in prices guide decisions by consumers and producers. Prices carry information, create incentives and ration products, so scarce resources move between competing uses without one central allocator.
| Allocation decision | How the price mechanism answers it |
|---|---|
| What to produce? | Rising demand can raise price and expected profit, signalling producers to expand products consumers value more. Falling price gives the opposite signal. |
| How to produce? | Producers compare costs and choose combinations of labour, capital and other inputs that can supply the product profitably. Relative input prices affect that choice. |
| For whom to produce? | Market output goes to consumers who are willing and able to pay the market price, so income and purchasing power influence access. |
Example: if consumers switch from meat towards vegetables, vegetable prices may rise while meat prices fall. The higher expected return encourages land, labour and capital towards vegetable production; the weaker return discourages some meat production.
The price mechanism can allocate resources, but it does not guarantee equal incomes, equal access or a socially preferred result. Rationing by price means some willing consumers may still be unable to afford the product.
Find market equilibrium
Market equilibrium occurs at the price where quantity demanded equals quantity supplied. This is the equilibrium price, and the common amount traded is the equilibrium quantity; the market clears with neither a shortage nor a surplus.
| Price ($) | Quantity demanded | Quantity supplied | Reading |
|---|---|---|---|
| 12 | 30 | 70 | surplus |
| 10 | 40 | 60 | surplus |
| 8 | 50 | 50 | equilibrium |
| 6 | 60 | 40 | shortage |
At 8,bothsidesplantotrade50units,sotheequilibriumisP_e = 8andQ_e = 50$. Equilibrium is identified by equality, not by the largest quantity or the highest price.
To draw the same result, place price on the vertical axis and quantity on the horizontal axis. Draw demand sloping downward and supply sloping upward. Label their intersection E; project from E to the price axis for Pe and to the quantity axis for Qe.
Equilibrium does not mean every consumer is satisfied or every producer earns a profit. It means only that planned quantity demanded equals planned quantity supplied at that price, so there is no pressure from a shortage or surplus for price to change.
Diagnose shortages and surpluses
A market is in disequilibrium whenever quantity demanded and quantity supplied are unequal at the current price. The gap is either a shortage (excess demand) or a surplus (excess supply).
| Current price relative to equilibrium | Quantity relationship | Disequilibrium | Price pressure |
|---|---|---|---|
| below equilibrium | Qd>Qs | shortage / excess demand | upward |
| above equilibrium | Qs>Qd | surplus / excess supply | downward |
Using the schedule from the previous card: at 6,quantitydemandedis60andquantitysuppliedis40,sotheshortageis60 - 40 = 20units.At10, quantity supplied is 60 and quantity demanded is 40, so the surplus is 60−40=20 units.
With a shortage, buyers compete for limited output and sellers have an incentive to raise price. As price rises, quantity demanded contracts and quantity supplied extends. With a surplus, unsold stock encourages sellers to lower price; quantity demanded extends and quantity supplied contracts. Adjustment continues until Qd=Qs.
On a demand-and-supply diagram, read Qd from the demand curve and Qs from the supply curve at the same horizontal price line. The horizontal distance between those quantities measures the shortage or surplus.
A shortage is not the same as scarcity. Scarcity is the general condition of limited resources; a market shortage is a measurable excess of quantity demanded over quantity supplied at a particular disequilibrium price. Price adjustment is movement along unchanged curves, not a shift of demand or supply.