Market Forces: Supply and Demand

Supply and demand (graph)

• economic model of price determination.

(or) how markets determine prices, and how market determined prices result in an orderly, efficient allocation of productive resources
(the three questions)

Other things to remember

• transaction costs
• property rights
• scarcity (of information) 
• Planning

In the absence of any disturbances, the market price will always tend to the market equilibrium

 How does that work? 

Excess Quantity Supplied

• Surplus
• (P2) QS > QD
• Sellers compete with sellers
• forces prices down

Excess Quantity Demanded 

• Shortage 
• (P3): QD >  QS
• Buyers compete with buyers
• forces prices up 

Equilibrium

• Equilibrium Price 
• (or) market clearing price (P1Q1)
• no shortage, no surplus
• no market forces acting on the price 
• quantity supplied meets quantity demanded. 

Recall: The three questions

1. What gets produced? 
2. How is it produced? 
3. Who consumes what is produced?

Markets answer these questions.

• buyers and sellers have different views (Law of Demand, Law of Supply)
• finds equilibrium among the voluntary actions of all buyers and sellers in a market.

Price signals are the means of coordination

• guide resources to their most productive uses
• provide information on relative scarcity
• high prices encourage consumers to find substitutes 
• also encourage producers to allocate more resources
• provide incentives (each actor behaves according to self-interest) 
• promotes general welfare
• Adam Smith's "Invisible Hand"

A few more notes on Market Exchanges

• voluntary (worth saying again)
• both sides expect to benefit 
• If we do not expect to benefit, we do not act 
• NOT a zero-sum game 
• markets reduce transaction costs
• (the costs of time and information in carrying out market exchanges) 
• therefore promoting exchange