In this lesson, we will learn about
In a competitive market, demand for and supply of a good or service determine the equilibrium price.
When the price at which quantities are demanded and supplied are equal, the market is said to be in equilibrium.
Whenever markets experience imbalances, the market forces drive prices toward equilibrium.
A surplus exists when the price is above equilibrium, which encourages sellers to lower their prices to eliminate the surplus.
A shortage will exist at any price below equilibrium, which leads to the price of the goods increasing.
Changes in the determinants of supply or demand result in a new equilibrium price and quantity. When there is a change in supply or demand, the old price will no longer be an equilibrium. Instead, there will be a shortage or surplus, and the price will subsequently adjust until there is a new equilibrium.
If the market price is above the equilibrium price, the quantity supplied is greater than quantity demanded, creating a surplus. The market price will fall. For example, a producer has a lot of excess inventory that he will put on sale at a lower price; the product demand will rise until equilibrium is reached. Therefore, surplus drives the price down.
If the market price is below the equilibrium price, the quantity supplied is less than quantity demanded, creating a shortage. The market is not clear. It is in shortage. The market prices will rise because of this shortage. For example, is a product is always out of stock, the producer will raise the price to make a profit. The market prices will rise because of this shortage. Once the product price increases, the product’s quantity demand will drop until equilibrium is reached. Therefore, shortage drives the price up.
If a surplus exists, the price must fall in order to entice additional quantity demanded and reduce quantity supplied until the surplus is eliminated. If a shortage exists, the price must rise in order to entice additional supply and reduce the quantity demanded until the shortage is eliminated.
Government regulations will create surpluses and shortages in the market. When a price ceiling is set, there will be a shortage. When there is a price floor, there will be a surplus.
The price floor is legally imposed minimum price on the market. Transactions below this price are prohibited. Policymakers set floor prices above the market equilibrium price which they believed is too low. Price floors are most often placed on markets for goods that are an important source of income for the sellers, such as the labor market. The price floor generates surpluses on the market. For example, minimum wage.
Price ceiling is legally imposed maximum price on the market. Transactions above this price is prohibited. Policymakers set ceiling prices below the market equilibrium price which they believed is too high. The intention of a price ceiling is keeping items affordable for poor people. The price ceiling generates shortages on the market. For example, rent control.
