What price does
Price is a reflection of worth: it tells you what consumers are prepared to give up to have a good, and what producers must be paid to make it. A high price means buyers value the good highly relative to what else they could buy with the money.
That is more than a description, because price is also how a market economy decides what gets produced. The specification calls it determining an efficient distribution of resources, and the mechanism is worth setting out as three jobs price does at once:
• The signalling function — a rising price signals to producers that consumers want more of this good, and a falling price signals that they want less • The incentive function — a higher price makes production more profitable, so firms have a reason to act on the signal and produce more • The rationing function — when a good is scarce, its price rises, and that allocates the limited supply to whoever values it most
So resources move towards goods people want and away from goods they do not, without any authority deciding it. That is what "the role of markets in the determination of price and the allocation of resources" means.
- Price mechanism
- the way price signals what consumers value and what producers must be paid, rationing scarce goods and giving an incentive to supply more
- Equilibrium price
- the price at which the quantity demanded equals the quantity supplied, where the demand and supply curves intersect
Equilibrium price and quantity
- Equilibrium price
- The price at which the quantity demanded equals the quantity supplied, so the market clears with nothing left over and nobody unable to buy.
- Equilibrium quantity
- The quantity bought and sold at the equilibrium price.
- Surplus
- Excess supply — at a price above equilibrium, more is supplied than is demanded, so goods go unsold.
- Shortage
- Excess demand — at a price below equilibrium, more is demanded than is supplied, so some buyers go without.
The self-correcting movement is the part to be able to explain, because it is the answer to why markets settle at equilibrium at all.
Above the equilibrium price there is a surplus. Firms find stock building up unsold, so they cut prices to clear it. As the price falls, quantity demanded rises and quantity supplied falls, closing the gap — until at the equilibrium price there is nothing left over and the cutting stops.
Below it there is a shortage. Buyers compete for the limited quantity available, so sellers realise they can charge more. As the price rises, quantity demanded falls and quantity supplied rises, again closing the gap.
Notice that nobody decided any of this. Each buyer and seller acted in their own interest and the price found its own level — which is why the market is described as allocating resources without direction.
How shifts change the equilibrium
The market forces of demand and supply affect the equilibrium by moving the curves, and the intersection moves with them. There are four cases, and knowing all four saves working them out under exam pressure.
Worked example
A hot summer increases demand for ice cream. At the same time the price of milk rises. Analyse the effect on the market for ice cream.
- Take the demand change first: hot weather is a change in tastes and conditions, not in the price of ice cream, so the demand curve shifts right.
- On its own that raises both equilibrium price and equilibrium quantity.
- Now the supply change: milk is a raw material, so a higher milk price is a rise in production costs, shifting supply left.
- On its own that raises equilibrium price and lowers equilibrium quantity.
- Combine them. Both changes push price upwards, so the price definitely rises, and by more than either alone.
- The quantity effects pull in opposite directions, so the outcome depends on which shift is larger.
Answer: The equilibrium price rises, because both the rightward shift in demand and the leftward shift in supply push it up. The effect on quantity is uncertain: the demand shift raises it while the supply shift lowers it, so quantity rises if the increase in demand is larger, falls if the rise in costs is larger, and is unchanged if the two are equal.
Common mistake
A change in price does not shift either curve — it is the result of the curves shifting, not a cause. If a question says "the price rose", look for what shifted to make it rise.
Before you practise
- Price reflects what consumers will give up for a good and what producers must be paid to make it.
- Price signals, incentivises and rations, which is how resources are allocated without anyone directing them.
- Equilibrium is where quantity demanded equals quantity supplied.
- Above equilibrium there is a surplus, so sellers cut the price.
- Below it there is a shortage, so buyers bid the price up.
- A rise in demand raises both price and quantity; a fall lowers both.
- A rise in supply lowers price and raises quantity; a fall does the reverse.
- When both curves shift, one of price or quantity is certain and the other depends on which shift is larger.