Understanding Price Formation: Supply and Demand Dynamics
Training Price
Price is the amount of money you must pay to purchase a particular good. In market economies, prices are formed through the interaction of supply and demand, assuming perfect competition. The requirements for perfect competition are:
- A large number of buyers and sellers (no monopoly).
- No single buyer or seller can influence prices independently.
- Buyers and sellers do not act in coalitions to impose prices.
- No price fixing by authorities.
- Full information about traded goods is available.
In perfect competition, price formation occurs as follows: Firms adjust their supply to meet demand. In this process, prices are adjusted.
If prices are too high, supply exceeds demand, leading to accumulated stock. Traders and companies lower prices to clear stock. If prices fall, supply decreases, and demand increases, moving towards an equilibrium between supply and demand at a specific price level.
If prices are very low, supply is minimized, and demand is maximized, creating scarcity. This allows suppliers to raise prices, reducing demand. Through successive approximations, supply and demand equalize at a given price. The price at which supply equals demand is the equilibrium price, and the quantity traded at that price is the equilibrium quantity.
Above the equilibrium price, there’s excess supply, leading to a downward trend in prices. Conversely, below the equilibrium price, there’s a shortage, causing prices to rise. These trends are illustrated in the following graph:
Furthermore, any equilibrium price is transient. Both the supply of goods and demand can change due to factors like shifts in tastes or preferences, changes in family income, or fluctuations in production costs. In such cases, the supply and demand curves shift, altering the equilibrium price.
In a market economy, prices serve as indicators, guiding companies on whether to increase or decrease supply and how to allocate resources. An increase in price signals scarcity and profitability, encouraging production. Conversely, a price decrease indicates insufficient demand, prompting reduced production. Companies follow market signals through the price system for their benefit. Scarcity translates to higher prices and greater returns, assuming costs remain constant. Therefore, companies increase production. When prices fall, indicating reduced demand, profits decrease, leading to reduced production and resource reallocation to more demanded goods. Thus, the price system dictates what, how much, and how companies produce.
Demand and Supply
The relationships between businesses and families in the market are regulated through the interaction of demand and supply. The result of this interaction is the prices of goods and services, which are key indicators that tell companies what and how to produce.