Price determination

Economics · The allocation of resources. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

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The idea

In a market, price is set by demand and supply together. Market equilibrium is where the quantity demanded equals the quantity supplied. On a diagram it is the point where the demand and supply curves cross. The price there is the equilibrium price, and there is no pressure for it to change.

At any other price the market is in disequilibrium. Above the equilibrium price, firms offer more than buyers want: a surplus. Below it, buyers want more than firms offer: a shortage. A surplus pushes the price down and a shortage pushes it up, until equilibrium is reached.

These price changes are the price mechanism. They signal what to produce, how and for whom.

Rules to remember

Equilibrium price: the price at which quantity demanded = quantity supplied
In a schedule, find the row where the two quantities are equal
Price above equilibrium: surplus = quantity supplied − quantity demanded; price then falls
Price below equilibrium: shortage = quantity demanded − quantity supplied; price then rises
What to produce: firms make the goods consumers will pay a profitable price for
How to produce: firms choose the cheapest mix of resources to keep costs low
For whom to produce: goods go to those willing and able to pay the price

Common mistake

Students link a high price with a shortage. It is the other way round: a price above equilibrium causes a surplus, and a price below equilibrium causes a shortage.

Worked example

For onions, at Rs 20 per kg quantity demanded is 100 kg and quantity supplied 70 kg; at Rs 30 they are 80 kg and 80 kg; at Rs 40 they are 60 kg and 110 kg. Find the equilibrium price, and describe the market at Rs 40.

Look for the price where the two quantities are equal: at Rs 30, 80 kg = 80 kg.
At Rs 40, quantity supplied (110 kg) is greater than quantity demanded (60 kg).
Surplus = 110 − 60 = 50 kg, so the price will tend to fall towards Rs 30.

Answer: Equilibrium is Rs 30 per kg with 80 kg traded. At Rs 40 there is a surplus of 50 kg.

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