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How The Price Mechanism Determines The Equilibrium Price In The Market And Why Governments May Intervene

1718 words - 7 pages

Matthew McDowellAssuming there is pure competition in the market place, and no government intervention, we are able to focus on how the price mechanism determines the equilibrium price in the market. Markets can be effective at resolving the basic issues of what and how much to produce at a certain price level although left to operate on its own, the market can still create unsatisfactory outcomes. When markets do not produce the desired outcome, it is known as market failure and when this occurs, governments may intervene in the market.How the price mechanism brings about the equilibrium price in the market can be determined assuming we have pure competition in the market place and no government intervention. Simply put, the concept of pure competition mean that no participant in the market has the power to influence market outcomes directly, such as by setting prices. The price mechanism is the interplay of the forces of supply and demand in determining the market prices at which goods and services are sold and the quantity of which is produced.The quantities of goods and services demanded and supplied is regulated by the prices of those goods and services. If the price of a commodity for sale is too high according to consumer demand, the quantity supplied will exceed the quantity demanded. If the price of a commodity is too low according to consumer demand, the quantity that is demanded will exceed the quantity supplied. There is one price, and only one price, at which the quantity demanded, is equal to the quantity supplied. This is known as the equilibrium price.Figure 1.0 - Excess DemandFigure 1.0 shows that at price 0P1, the quantity demanded (0Q2) exceeds the quantity supplied (0Q1). The price is below equilibrium in this case and the market therefore experiences excess demand. The quantity people are willing to buy at this price is greater than the quantity producers are willing to supply and so it would be expected that this would have an upward pressure on the price. This upward pressure on the price arises from competition in the market place among buyers for the limited quantity of goods available which means that consumers will start bidding up the price. As suppliers start to increase the price, they also start increasing supply as they can now make a bigger profit. The law of supply also states that when price increases, so to does quantity supplied. A rise in price and quantity supplied will result in a contraction of demand as the law of demand states that as the price of a good increases, the quantity demanded will decrease. Movement along the curves towards the equilibrium point will continue to occur as long as there is excess demand, until the intersection of the supply and demand curves, where the price is 0PE and the quantity supplied (OQE), equal to the quantity demanded by consumers is eventually reached. The market is said to clear at the equilibrium price, in this case, 0PE.Figure 1.1 - Excess SupplyIn figure 1.1, at...

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