The Market Mechanism is the tendency in a free market for price to change until the Market Clears.
Markets clear when Quantity Demanded equals Quantity Supplied at the prevailing price.
Market clearing price.
Price at which markets clears (Qs and Qd Equates)
What do we have in an Equilibrium State ?
- There is no shortage or excess demand
- There is no surplus or excess supply
- Quantity supplied equals quantity demanded
- Anyone who wants to buy at the current price can and all producers who want to sell at that price can.
We are concerned with two concepts that arises here.
- Excess Supply (Surplus)
- Excess Demand (Shortage)
Market Surplus/Excess Supply
So how do we know there is an excess Supply or Surplus in the market ? Let us consider these points.
- The market price is above equilibrium—> Above the point where Qd=Qs
- There is excess supply – surplus—>Suppliers produce more because of High Prices.
- Downward pressure on price—>Because are not willing to buy at a high price.
- Quantity demanded increases and quantity supplied decreases—>This is effect of the downward Pressure.
- The market adjusts until new equilibrium is reached—>There will be a downward pressure until again the market clear or Qd=Qs
Market Shortage/ Excess Demand
A market shortage or in other words Excess demand is a situation in which:
- The market price is below equilibrium—>Below the Point where Qd=Qs
- There is excess demand – shortage—>Because of lower prices people are demanding more and suppliers are not willing to supply at this price. Therefore, we have a shortage.
- Upward pressure on prices—>Due to Shortage there is an upward pressure to increase prices.
- Quantity demanded decreases and quantity supplied increases—>This effect is after an increase in the price (Law of Demand)
- The market adjusts until the new equilibrium is reached—>There will be an upward pressure until the market clear or Qd=
- Supply and demand interact to determine the market-clearing price
- When not in equilibrium, the market will adjust to alleviate a shortage or surplus and return the market to equilibrium
- Markets must be competitive for the mechanism to be efficient
In the Next topic we will discuss how changes in Supply of Demand changes the Equilibrium Price and Quantity.