Explain with the help of a diagram how a free market would react if minimum price which had been set above the equilibrium be removed. (8 marks)
Answers
Answer:
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Explanation:
Price discovery
In its simplest form, the constant interaction of buyers and sellers enables a price to emerge over time. It is often difficult to appreciate this process because the retail prices of most manufactured goods are set by the seller. The buyer either accepts the price. or does not make the purchase. While an individual consumer in a shopping mall might haggle over the price, this is unlikely to work, and they will believe they have no influence over price. However, if all potential buyers haggled, and none accepted the set price, then the seller would be quick to reduce price. In this way, collectively, buyers have influence over market price. Eventually a price is found which enables an exchange to take place. A rational seller would take this a step further, and gather as much market information as possible in an attempt to set a price which achieves a given number of sales at the outset. For markets to work, an effective flow of information between buyer and seller is essential.
Market clearing
Equilibrium price is also called market clearing price because at this price the exact quantity that producers take to market will be bought by consumers, and there will be nothing ‘left over’. This is efficient because there is neither an excess of supply and wasted output, nor a shortage – the market clears efficiently. This is a central feature of the price mechanism, and one of its significant benefits.
Example
The weekly demand and supply schedule for a brand of soft drink at various prices (between 0p and 80p) is shown below.
PRICE (p)QUANTITY SUPPLIEDQUANTITY DEMANDED8020000701800200601600400501400600401200800301000100020800120010600140004001600
Equilibrium
As can be seen, this market will be in equilibrium at a price of 30p per soft drink. At this price the demand for drinks by students equals the supply, and the market will clear. 1000 drinks will be offered for sale at 30p and 1000 will be bought – there will be no excess demand or supply at 30p.
How is equilibrium established?
At a price higher than equilibrium, demand will be less than 1000, but supply will be more than 1000 and there will be an excess of supply in the short run.
Graphically, we say that demand contracts inwards along the curve and supply extends outwards along the curve. Both of these changes are called movements along the demand or supply curve in response to a price change.
Demand contracts because at the higher price, the income effect and substitution effect combine to discourage demand, and demand extends at lower prices because the income and substitution effect combine to encourage demand.
In terms of supply, higher prices encourage supply, given the supplier’s expectation of higher revenue and profits, and hence higher prices reduce the opportunity cost of supplying more. Lower prices discourage supply because of the increased opportunity cost of supplying more. The opportunity cost of supply relates to the possible alternative of the factors of production. In the case of a college canteen which supplies cola, other drinks or other products become more or less attractive to supply whenever the price of cola changes. Changes in demand and supply in response to changes in price are referred to as the signalling and incentive effects of price changes.
If the market is working effectively, with information passing quickly between buyer and seller (in this case, between students and a college canteen), the market will quickly readjust, and the excess demand and supply will be eliminated.
In the case of excess supply, sellers will be left holding excess stocks, and price will adjust downwards and supply will be reduced. In the case of excess demand, sellers will quickly run down their stocks, which will trigger a rise in price and increased supply. The more efficiently the market works, the quicker it will readjust to create a stable equilibrium price.
Answer:
Back Up
When the supply and demand curves intersect, the market is in equilibrium. This is where the quantity demanded and quantity supplied are equal. The corresponding price is the equilibrium price or market-clearing price, the quantity is the equilibrium quantity.
Putting the supply and demand curves from the previous sections together. These two curves will intersect at Price = $6, and Quantity = 20.
In this market, the equilibrium price is $6 per unit, and equilibrium quantity is 20 units.
At this price level, market is in equilibrium. Quantity supplied is equal to quantity demanded ( Qs = Qd).
Market is clear.
Surplus and shortage:
If the market price is above the equilibrium price, quantity supplied is greater than quantity demanded, creating a surplus. Market price will fall.
Example: if you are the producer, you have a lot of excess inventory that cannot sell. Will you put them on sale? It is most likely yes. Once you lower the price of your product, your product’s quantity demanded will rise until equilibrium is reached. Therefore, surplus drives price down.
If the market price is below the equilibrium price, quantity supplied is less than quantity demanded, creating a shortage. The market is not clear. It is in shortage. Market price will rise because of this shortage.