Economics Part A

Market Equilibrium Price Explained

Market Equilibrium Price

The equilibrium price reflects the price for a product in a free market. A free market is one in which there are both many supplies and many buyers (the supply and demand curves are aggregate curves). The price of every product is determined by the point at which the supply and demand curves intersect. This point is called the market equilibrium price. The following diagram presents the supply and demand curvefor trousers: The price for a pair of trousers is $35 (point E), which is the market equilibrium price.

Supply and demand curves for trousers

Supply and demand curves for trousers

The explanation:

Only at the market equilibrium price of $35 will the quantity of trousers produced match the equantity of trousers that consumers are willing to buy. In short, the supply equals the demand. At any other price, there will be a gap between demand and supply.


Examples:

  • At a cost of $60 per pair, the procedure 1,000 pairs of trousers (point B), but consumers will want to buy only 300 pairs (point A). At this price, there is a surplus of 700 pairs of trousers. Obviously, factory owners will not produce 1,000 pairs if they end up throwing some of them away. They will reduce the number of trousers they manufacture in tandem with a reduction in price, until the surplus in trousers is eliminated. Only at point E are there no leftover goods. 
  • On the other hand, at $20 per pair, consumers will want to buy 900 pairs of trousers (point C), but manufacturers are willing to produce only 300 pairs (point F). Some consumer demand remains unsatisfied i.e., there is a shortage of 600 pairs of trousers. This causes consumers to search for trousers whenever they can find them, and procedures take advantage of this situation by raising prices. This process will continue until surplus demand is eliminated. This condition is met at point E. 


It can be seen that the term "equilibrium point" was chosen deliberately. Only at the price and quantity levels represented by this point will the market economy be stabilized. If a disturbance occurs in the market (for example, if one of the curves changes), then the equilibrium is upset for a certain duration, and the price and quantity of the produce change over the course of time will result in certain consumer behvior on the one hand, and that of producerson the other. Eventually, the market reaches a new equilibrium.

Non-equilibrium Prices

In some cases, the market price for a certain product is not the direct result of supply and demand. In these situations, a free market does not exist for the item in question. Such situations are created when certain powerful groups are able to impose a price for a specific product a specific sector. This price, which benefits only these groups, is called an imposed equilibrium price.


Three Types of Powerful Groups

  • Monopoly: 
Monopoly is the term used to desceibe a sole producer of a given product in the market. For example: In Country A, the Electric Company is a monopoly, because it is the only firm that produces electric power. Since it hs no competition, a monopoly does not have to set prices according to the supply and demand curves. The lack of competition means there is no reason for the compny to lower prices. Monopolies usually set prices that are higher than the market equilibrium price. 
  • Duopoly: 
Duopoly is a situation in which two companies together form a monopoly. The two suppliers coordinate their actions, and in practice act as one large monopoly.
  • Cartel: 
A cartel refers to a group of manufacturers in a given sector that jointly set prices. The cartel sets a price according to its interests, and in violation of the laws of supply and demand. In practice,  a cartel acts like a monopoly. In some countries, forming a cartel is illegal.

Supply and demand curves for oil in Country A

Supply and demand curves for oil in Country A

 

The explanation: 

Curves S0 and D0 show the supply and demand for oil in Country A. Oil is supplied by only one procedure, which has a monopoly on the sale of oil. For the sake of simplicity, assume that supply curve S0 is completely elastic, which means that the cost of production for each barrel of oil is $20. Were the price of a barrel of oil set through free competition using supply and demand curves S0 and D0, then the market equilibrium price would arrive at point A, where the price is $20 and demand totals 1, 850 barrels of oil. 

Examples At point A, the supplier’s revenue totals $37,000 ($20 x 1, 850 barrels). Total costs are also $37, 000, i.e., no profit is earned. The monopoly supplier, however, can ignore equilibrium point A, and decide to sell a barrel of oil for $50 (no other producer can supply oil at a cheaper price than the monopoly oil compny). Point B portrays the situation if the monopoly decides to sell at $50 a barrel. In this case, revenue totals %50, 000 ($50 x 1, 000 barrels), while costs total $20, 000 ($20 x 1, 000 barrels) and the profit earned is $30, 000. 

However, the monopoly wishes to increase its profits even further and decides to raise the price of barrel of oil to $75 (assuming that to charge more than that for oil would be illegal in that country). Point C reflects this situation, in which revenue totals $60,000, expenses total $16,000, nd profit is $44,000. The monopoly will obviously choose point C.

2. Duopoly

Duopoly is a situation in which two companies together form a monopoly. The two suppliers coordinate their actions, and in practice act as one large monopoly.

3. Cartel

A cartel is a group of manufacturers in a given sector that jointly sets prices. The cartel sets a price according to its interest, in violation of the laws of supply and demand. In practice, a cartel acts like a monopoly. In some countries, forming a cartel is illegal

Market Equilibrium Price Explained591Market Equilibrium Price Explained