In a free market situation, the price of a commodity is determined by the interaction of the forces of demand and supply. We have already observed that consumers demand more at lower prices and producers are willing to offer more for sale at high prices. This is because consumers want to maximize their satisfaction from their limited income while producers want to maximize their profits. The two groups therefore act in opposite directions.
During the course of interaction, a point of agreement or intersection by the two forces is reached as shown in the figure below. This point E is known as the equilibrium point. P is the market price or the equilibrium price and Q the equilibrium quantity. P is therefore the price at which both consumers and sellers have agreed to sell and buy the same quantity, we can say that both sellers and buyers are satisfied and there is no tendency for change in price.
Equilibrium price and quantity
P S D
P E
D S
0 Q Qty dd/ss
As noted above, the equilibrium price is determined by the interaction of the forces of demand and supply. From the schedule below GH¢15.00 is the market or equilibrium price and equilibrium quantity is 25units.
Price (GH¢)?Quantity Demanded??Quantity Supply
5???40????10
10???30????15
15???25????25
20???20????30
25???15????40
30???10????45
Let’s assume that the price of the commodity falls below the equilibrium price that is to GH¢ 10.00. This is market disequilibrium and the consequence will be excess demand over supply. Because with price falling sellers will reduce their supply because their profit margin will fall while at the same time consumers, in order to maximize their satisfaction, will increase their demand. That is, while quantity demanded increases from 26units to 30 units, quantity supplied falls from 25units to 15 units creating excess demand of 15units (i.e. 30 – 15 = 15). Study the graph below.
When Price is below the Equilibrium Price
P (GH¢) D S
15 E
10
Shortage
0 15 25 30 Qtydd/ss
Because we assume a free market, equilibrium must be restored again. To restore this equilibrium some upward forces will come into play to force the price up to GH¢15.00 per unit. These upward forces shown by the arrow in the above diagram includes:
i. Because of the excess demand over supply, consumers will begin to compete among themselves for the scarce commodity. Each one will try to get and prevent the other from getting that is each consumer will try to out buy his friend by paying a higher price, price then moves up. Some consumers will be eliminated by the high prices so quantity demanded will fall.
ii. As price moves up producers already in business will begin to increase their supply.
iii. With the higher price the old producers of the commodity begin to earn more profits. These serve as an attraction to other would be producers who then enter into the production of the commodity. The quantity supplied of the commodity thus increased while quantity demanded falls and this narrows the gap between the demand and supply progressively until the difference is eliminated at the equilibrium.
The end result is that both the quantity demanded and quantity supplied will once again come to equality.
Again, let’s say that the price of our commodity has moved up to GH¢20.00 per unit. This is another case of market disequilibrium because at this price there is no longer equality between quantities supplied and demanded, but rather we have an excess of supply over demand of 10 units. This is because, if the price increase from GH¢15.00 to GH¢20.00, it will induce suppliers to offer more for sale to obtain higher profit while at the same time consumers demand will fall because their purchasing power reduces. Once again study the graph below which represents the schedule above.
NOTE: In technical terms there is a difference between “Market Price” and “Equilibrium Price”.
Market price refers to the price which is ruling or prevailing on the market. It depends on the strength of demand relative to the strength of supply and it is the common price charged by all sellers of the product. Whereas equilibrium price, is the price at which the market is in equilibrium, which is there is no tendency for price to change for quantity demanded is equal to quantity supplied.
Some Negative Effects of Shortage
1. Seller’s preference – preferential treatment may be given to the rich, friends, relatives, loyal customers etc.
2. Queues - producers / sellers selling on “first come first serve” basis
3. Hoarding and smuggling
4. Rationing of goods - coupons
5. Conditional sales
6. Black marketing – illegal means of getting the commodity
When price is above equilibrium price
PGH¢ D S
20
15 E
0 20 25 30 Qtydd/ss
Equilibrium must be restored. This is achieved by some downward forces which act to push the price back to GH¢15.00 per unit. These downward forces include.
i. As supply is more than demand, there will be unwanted stock of goods on the market; producers/sellers will be compelled to reduce the price.
ii. With the reduction in price, quantity demanded will increase
iii. When producers are forced to reduce their price of the commodity, only the efficient producers (i.e. those who produce at lower average cost) will be able to do so. Since the inefficient producers cannot reduce price, they will eventually be eliminated from the market. As the number of producers decrease, the quantity supplied of the commodity will also begin to fall. The effect of the increase in quantity demanded as price is reduced and the decreased in quantity supplied as the number of producer’s fall is that both quantities demanded and supplied will come back to equality.
Some Effects of Surplus
1. Conditional sales
2. Discounts, gift, free coupons
3. Credit sales
The Effect of Changes in Demand and Supply on Equilibrium Price
The market equilibrium cannot be retained for a long period. It is because demand and supply conditions keep changing frequently. These changes occur independently of price. Any change in the determinants of demand and supply will shift the demand curve and supply curve. These shifts will also bring new equilibrium. The equilibrium price of a commodity can be affected by changes in supply and demand in four main ways.
a. An increase in demand
b. A decrease in demand
c. An increase in supply
d. A decrease in supplY
a. An Increase in Demand
An increase in demand as already discussed refers to a boldly shift in the demand curve to the right. From the diagram below, using the original demand and supply (DD and SS) curves, the equilibrium point is E. P and Q are the equilibrium price and quantity respectively. But with an increase in demand, a new equilibrium point is established. This gives us a new equilibrium price ofand a new equilibrium quantity. We can therefore conclude that, assuming supply is constant, an increase in demand will increase the price of a commodity and increase the quantity supplied.
An Increase in Demand
0
An increase in demand creates a shortage at the initial equilibrium, and unsatisfied consumers bid up high price. This rise in the price causes a larger quantity to be supplied with the result that at the new equilibrium more is exchanged at a higher price.
b. A decreased in Demand
A decrease in demand is a shift in the demand curve to the left. Study the figure below.
A Decrease in Demand
D S
0
With the DD and SS curves, the equilibrium price is. A decrease in demand shown by , supply being constant, leads to a new equilibrium price and a new equilibrium quantity . The conclusion to be drawn here is that, assuming supply is constant; a decrease in demand will lead to a reduction in price and quantity supplied. In summary, a decrease in demand creates a surplus at the initial equilibrium price, and unsuccessful sellers bid the price down. As a result, less of the product is supplied and offered for sale. At the new equilibrium, both price and quantity exchanges are lower than they were originally.
c. An Increase in Supply
An increase in supply refers to a shift in the original supply curve to the right. As illustrated in the figure below, the original equilibrium point is E. The equilibrium price and quantity are P and Q respectively. With the shift of the supply curve to the right the new equilibrium point is E1. The equilibrium price and quantity are now and respectively. We can therefore conclude that, assuming demand to be constant, an increase in supply will lead to a reduction in price and an increase in quantity demanded
An Increase in Supply
?
0
In summary, an increase in supply creates a surplus at the initial equilibrium price, and unsuccessful suppliers’ force the price down. This fall in price increases the quantity demanded, and the new equilibrium is at a lower price and a higher quantity exchanged.
d. A decreased in Supply
When the supply curve shifts to the left we talk of a decrease in supply. As illustrated in the figure below such a shift will change the equilibrium point from E to E1. P1 and Q1 become the new equilibrium price and quantity respectively.
A decrease in Supply
0
The conclusion to be drawn here is that, assuming demand is constant; a decrease in supply creates a shortage at the initial equilibrium price that causes the price to be bid up. The rise in price reduces the quantity demanded, and the new equilibrium is at a higher price and a lower quantity exchanged.
N.B; student should try and find out the effect of a simultaneous change in demand and supply on the equilibrium price and quantity. For example, the effect of an? increase in demand followed by an increase in supply. Study the figure below.?
?
?
0
The initial equilibrium price and quantity are and. An increase in demand to, will increase the price to and quantity to respectively. The increase in price will cause supply to also increase from to and this will lead to an ultimate fall in price from to,
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