Price Determination in the Market System

This article is about the equilibrium price determination, situations of market surplus and market shortage as well as shifts in demand or supply cause the market price to change.

It explains how price is arrived at in a market system as well as the market forces at work in a market system describing how changes in demand or supply will lead to a new price. Such changes are illustrated through neat and accurate diagrams of price and quantity.

Finally, this post also explains the concepts of consumer and producer surplus.

Price relationship between demand and supply

Meeting consumer wants profitably is the central aim of marketing. This means that marketing managers need to know how free markets work to determine prices of products sold by their businesses. If the business can produce the product at the market price, it should be profitable.

In free markets, the equilibrium price is determined when demand equals supply.

Demand and supply analysis helps us understand this relationship:

1. Demand is the amount customers are willing to buy at a given price. Demand is the quantity of a product that consumers are willing and able to buy at a given price in a time period.
2. Supply is the amount businesses are will to sell at a given price. Supply is the quantity of a product that firms are prepared to supply at a given price in a time period.

Law of Demand explains that demand has an inverse relationship with price. It means that:

1. A fall in the price would result in a rise in the demand.
2. A rise in the price would result in a fall in the demand.

Determining the Equilibrium Price

When demand and supply are combined, the equilibrium price will be determined. This Equilibrium Price is the market price being at the point where demand for a product equals supply of a product.

Equilibrium Price is also referred to as ‘the market price’. It occurs when demand and supply are equal, the term ‘equilibrium’ means a state of rest or balance. In economic terms it is when price stays the same unless there is a change in either demand or supply.

On the following chart, the market is in equilibrium. The price is USD5 consumers would only demand a quantity of 40 products. Producers would be willing to supply 100 products. A surplus exists between 40 products and 100 products – the market has produced 60 units that consumers are not willing and able to buy. This would put pressure on firm to lower prices.

In short, lower prices increase demand and decrease production leading to equilibrium. If price is above equilibrium, a surplus would result from supply exceeding demand. A surplus would encourage companies to reduce prices, which in turn, would increase demand until equilibrium is found.

Market Shortage

Market shortage means excess demand.

If the price is lower than the equilibrium, then, stocks will run out – leaving excess demand. Suppliers could make a higher profit by raising the price – to the equilibrium level. Where there is excess demand in a market, this will tend to drive the price upwards.

At USD3.5. Those who are prepared to pay USD2.5. Those who are prepared to pay USD1.5. An even more simple definition is when a consumer is willing to pay more than the actual price they pay.

Producer Surplus

The difference between what a producer is paid for a certain amount of a good and the lowest price they require in order to supply that amount.

Producer surplus is between the dotted lines. It is the dark grey area above the supply curve and below the equilibrium price level.

Some suppliers are willing to supply the market, if the price is at least USD3.5, so they have a surplus of USD$1.5. An even more simple definition is when a supplier is willing to deliver products for less than the actual price they receive.

Summary of price determination in the market system

In short, a market is a place where buyers and sellers meet to trade. In the market economy, it is the market that determines the price of the goods and services that we buy.

The market price, or Equilibrium Price, is determined by the levels of demand and supply in the market. A market in equilibrium is with an equilibrium market price of P and an equilibrium quantity being bought and sold of Q.

Market forces of demand and supply determine the market price. Consumer surplus exists when the price is less than a consumer is willing and able to pay. Producer surplus exists when the price is above what a firm is willing and able to accept.