Introduction

Price is arrived at by the interaction between demand and supply. Price is dependent upon the characteristics of both these fundamental components of a market. Demand and supply represent the willingness of consumers and producers to engage in buying and selling. An exchange of a product takes place when buyers and sellers can agree upon a price.

 

Equilibrium Price

When a product exchange occurs, the agreed upon price is called an "equilibrium" price, or a "market clearing" price. Graphically, this price occurs at the intersection of demand and supply as presented in Figure 1. In Figure

1, both buyers and sellers are willing to exchange the quantity Q at the price P. At this point, supply and demand are in balance.

 

Price determination depends equally on demand and supply. It is truly a balance of the two market components. To see why the balance must occur, examine what happens when there is no balance, for example when market price is below that is shown as P in Figure 1. At any price below P, the quantity demanded is greater than the quantity supplied. In such a situation, consumers would be clamoring for a product that producers would not be willing to supply; a shortage would exist. In this event, consumers would choose to pay a higher price in order

to get the product they want, while producers would be encouraged by a higher price to bring more of the product onto the market.

 

 The end result is a rise in price, to P, where supply and demand are in balance. Similarly, if a price above P were chosen arbitrarily the market would be in surplus, too much supply relative to demand. If that were to happen, producers would be willing to take a lower price in order to sell, and consumers would be induced by lower prices to increase their purchases. Only when the price falls would balance be restored.

A market price is not necessarily a fair price, it is merely an outcome. It does not guarantee total satisfaction on the part of buyer and seller. Typically some assumptions about the behaviour of buyers and sellers are made, which add a sense of reason to a market price. For example, buyers are expected to be self-interested and, although they may not have perfect knowledge, at least they will try to look out for their own interests. Meanwhile, sellers are considered to be profit maximizers. This assumption limits their willingness to sell to within a price range, high to low, where they can stay in business.