• Social Scientist

Price Mechanism and Resources Allocation in the Free Market

Theme 2: Market, Demand and Supply

Topic: Price Mechanism and Resources Allocation in the Free Market

Relevance: H1 and H2 Economics

Introduction:

One of the most basic yet important concept in the learning of microeconomics is how are prices of goods and services determined. While individual consumers only cares about the price of a good, however on a deeper level, collectively, the price of the good is closely linked to how much resources are allocated to the production and consumption of that good.


Market Equilibrium

A market is where consumers and producers interact with their demand and supply to determine the market equilibrium price and quantity of a good or service exchanged. Anywhere that consumers and producers interact is known as a market. A free market is where the consumers and producers interact without any intervention by the government.

  • Demand of a good is the quantity of a good or services that consumer are willing and able to purchase at various prices in a given period of time, ceteris paribus.

  • Supply of a good is the quantity of a good that producers are willing and able to produce and sell at various prices over a period of time, ceteris paribus.

'Ceteris paribus' is a Latin phrase means 'other things being equal', a common assumption made by economists.


In the free market without governmental intervention, the market equilibrium price and quantity are determined using the price mechanism. The market equilibrium happens when the demand of a goods equals to its supply, it is the market price and market quantity where there is no further tendency for price and quantity to change, PE and QE as shown in Figure 1.

Figure 1: Market Equlibirum

When the market is in equilibrium, any changes to demand and supply will lead to changes in equilibrium price and quantity. These changes are affected by changes in non-price determinants of demand and supply. The price mechanism is activated when there is either a surplus or shortage in the market.

Market Disequilibrium: Surplus

When the market price (P1) is higher the market equilibrium price (PE), there will be a surplus as quantity supplied (QS) is larger than quantity demanded (QD) as shown in Figure 2.

Figure 2: Surplus

This will lead to a downwards pressure on price as producers will try to clear stock and reduce the surplus. As price decreases (P1 to P2, P2 to PE), quantity demanded will increase while the quantity supplied will decrease, reducing the surplus. Prices will stop to decrease at the equilibrium price where demand equals to supply at (PE and QE). The downward pressure on price will signal producers to allocate lesser resources in the production of this good.

Market Disequilibrium: Shortage

On the other hand, when the market price (P1) is below the market equilibrium price (PE), there will be a shortage as quantity demanded (QD) is larger than quantity supplied (QS) as shown in Figure 3.

Figure 3: Shortage

This will lead to an upwards pressure on price as consumers will compete among themselves for the goods. As price increases (P1 to P2, P2 to PE), quantity demanded will decrease while the quantity supplied will increase, reducing the shortage. Prices will stop to increase at the equilibrium price where demand equals to supply at (PE and QE). The upward pressure on price will signal producers to allocate more resources in the production of this good.

Changes in Demand and Supply:

While the price mechanism allocates resources through changes in price when clearing or surplus and shortages, changes in demand and supply due to changes in non-price determinants is the main reasons affecting the allocation of resources in the free market.


While increase in supply will lead to a surplus, however there will be net effect of an increase in the allocation of resource in the market.

On the other hand, while decrease in demand will also lead to a surplus, however there will be net effect of a decrease in the allocation of resource in the market.


While decrease in supply will lead to a shortage, however there will be net effect of an decrease in the allocation of resource in the market.

On the other hand, while increase in demand will also lead to a shortage, however there will be net effect of an increase in the allocation of resource in the market.


Changes in factors other than the price of the good itself such as taste and preferences, disposable income, population, price of substitutes and complement and consumers’ expectations of economic condition and future prices will affect consumers’ willingness and ability to consume therefore changing the demand for the good.


Changes in factors other than the price of the good itself such as cost of production, prices of good in joint supply, prices of good in competitive in supply, technology and weather conditions will also affect producers’ willingness and ability to consume therefore changing the supply for the good.

Want to learn more about demand and supply?

Click here to learn about "Changes in Demand and Supply".

Want to learn more? Let us know what do you want to learn next.

Don’t forget to share, like and comment on this post!

Subscribe to our mailing list to get the latest update from the Social Scientist Academy.

629 views0 comments

​© 2020 Social Scientist Academy 

Block 265 Serangoon Central Drive #02-271 Singapore 550265

ALL RIGHTS RESERVED