Price Determination
Economics: Edexcel A A Level, topic 1.2.8
Market Equilibrium
The equilibrium is the point where the demand curve meets the supply curve.
Equilibrium price
- This is the only price where the amount consumers want to buy is equal to the amount producers want to sell.
- If the market is at equilibrium, there is no reason to move away.
- Supply and demand (market forces) dictate the equilibrium quantity and price in a free market.
Disequilibrium
- Disequilibrium is when the market is not at a stable price and quantity.
- If the market is not at equilibrium, economic pressure arises to move the market towards a stable price and quantity.
- E.g if petrol prices were to rise above their equilibrium level, the market would respond and the quantity demanded would fall.
Excess supply and demand
- Excess supply and demand occur at disequilibrium.
- The higher price makes it more profitable for petrol producers, so output expands.
- The difference between the quantity demanded and quantity supplied is now the excess supply.
- When quantity demanded exceeds quantity supplied, there is excess demand.
Pressure to reach equilibrium
- The market price is unstable when there is excess demand or supply.
- Excess supply will force producers to cut the price because it is better to sell at a lower price than not at all. Others will follow.
- Excess demand will signal to producers they can generate more profit by raising the price and will do so.
- So excess demand and supply can lead to price change.
Equilibrium vs Disequilibrium in a Market
Equilibrium is a state of rest, where price and quantity are stable. In disequilibrium, there is pressure from market forces to reach equilibrium.
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Equilibrium
- The point of equilibrium is determined by the forces of demand and supply in an economy. These are called market forces. Here, supply is equal to demand.
- This model of equilibrium assumes perfect competition. It also assumes ceteris paribus (everything else equal), as well as independence between supply and demand.
Disequilibrium
- At disequilibrium, price and quantity are not stable.
- Market forces will move the economy back to a position of stability at equilibrium over time.
Shifts in Equilibrium
Demand and supply curve shifts affect where an equilibrium is.
Demand curve shifts
- A shift in the demand curve (but not in the supply curve) will have the following effects:
- An increase in demand (D->D1) will cause an increase in price. Supply will extend and form a new equilibrium (Q1,P1).
- A decrease in demand (D->D2)will cause the price to fall. Supply will contract and form a new equilibrium (Q2, P2).
Supply curve shifts
- A shift in the supply curve (but not in the demand curve) will have the following effects:
- An increase in supply (S->S1)will cause a decrease in price. Demand will extend and form a new equilibrium (Q1,P1).
- A decrease in supply (S->S2) will cause an increase in price. Demand will contract and form a new equilibrium (Q2,P2).
Elasticity (slopes of demand and supply curves)
- Price elasticity of demand and supply affect how much the equilibrium price and quantity change by.
- E.g a rightward shift in the demand curve along an elastic supply curve will influence quantity more than price.
- An inelastic demand curve is steeper than an elastic demand curve.
Test yourself on Price Determination
What happens at disequilibrium?
What is represented by the distance Q1-Q2?
How would you define the equilibrium price?
What does ceteris paribus mean?
Which of the following is NOT an assumption of the equilibrium model?