A market is a social structure that brings together a buyer and a seller to agree a price to exchange goods or services. In a market a firm and its products are priced and evaluated by the consumers or the buyers. The chief function of a market is to adjust prices to accommodate fluctuations in supply and demand in order to achieve efficiency.
The nature of market is such that the market always tries to bring itself to equilibrium.
We denote three scenarios in the common market place.
When Price is greater than the equilibrium price:
Here, we note that the Price P3 is higher than the Equilibrium price P1. As a result of the high price, there will be a large amount of supply in the market, because Firms want to optimize their economic profits and hence produce a large quantity of goods, as they can sell goods at a higher price. However, because of the high prices, buyers are reluctant to purchase the large quantity of goods that are supplied at this high price. Hence, there is an excess supply in the market. Because of this excess supply, firms will try to get rid of the goods, and the only way they can do this is to reduce the price of the product. This process is called “Riding down the Supply line”. The price will eventually set at P1, which is the equilibrium price.
When Price is lesser than the equilibrium price:
In the second case, we note that the price P2 is less than equilibrium price P1. In such a case, the firms notice that their economic profits are not high (Marginal Cost is greater than marginal revenue) when they try to meet the demand of the Market. Hence they would manufacture products lesser than that required by demand. On the other hand, the consumers will try to buy more quantities of the product because their marginal benefit for the product at such low prices is quite high. This leads to a gap between the quantity demanded and supplied. This gap is called “Demand gap”. To fill in this gap, the firms try to increase the quantity produced. This is done by increasing the price of the good sold in the market. This increase in price of the good would certainly decrease the demand to a certain extent, and bring the price and quantity to the equilibrium price and quantity. This is called “Riding up the supply line”.
When Price is equal to the equilibrium price:
In this case, the price demanded and the quantity supplied is in Economic equilibrium. Both the demand and supply of products remain constant. Here, we can say that the market is economically efficient. Markets are seldom fixed at this price and quantity. They oscillate about the equilibrium point.
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