How Prices are Determined in a Market

Understanding Price Determination

In a market economy, prices are determined by the interaction between supply and demand. This process allocates resources efficiently and establishes an equilibrium price.

Supply and Demand

Supply is the amount of a good or service that producers are willing and able to sell at various prices. Demand is the quantity that consumers are willing and able to purchase at different prices. The supply and demand curves illustrate these relationships:

• Supply curve slopes upward from left to right, showing that suppliers offer more at higher prices.
• Demand curve slopes downward from left to right, indicating that consumers buy more at lower prices.

Equilibrium Price and Quantity

The equilibrium price is where the supply and demand curves intersect. This is the only price where the quantity supplied equals the quantity demanded. At this point, the market clears and there is no surplus or shortage.

Worked Example

Problem: If the supply curve is Qs = 5P and the demand curve is Qd = 25 - P, find the equilibrium price and quantity.

Solution:

1. Set Qs = Qd to find the equilibrium: 5P = 25 - P
2. Solve for P: 6P = 25 ⇒ P = 25/6 = $4.17
3. Substitute P into either equation to find Q: Qs = Qd = 5(4.17) = 20.83

Therefore, the equilibrium price is $4.17 and the equilibrium quantity is 20.83 units.

Market Efficiency and Resource Allocation

At the equilibrium price and quantity, the market is efficient because resources are allocated optimally. Consumer surplus (the difference between willingness to pay and market price) and producer surplus (revenue minus costs) are maximized with no deadweight loss from under or overconsumption.

See resources from BBC Bitesize and exam board specifications for more details.