The role of prices

Price is determined by demand and supply. If demand exceeds supply, price tends to rise. If supply exceeds demand, price tends to fall. This description of the role of price is familiar to most people. It can be illustrated by a simple example. Consider the demand for laptops and the supply of laptops, and how changes in the price of laptops bring supply and demand into equilibrium.

The first step is to draw a demand curve. This shows how many laptops will be

demanded at each price level. We make the reasonable assumption that the relationship is negative. As laptops become cheaper, they become more affordable

and are purchased at a higher rate. As price falls, demand rises. The corollary also

holds: as laptops become dearer, quantity demanded falls. This is termed the law

of demand.

The next step is to construct a supply curve. This indicates the amount supplied

by firms at each price level. We assume that the curve is upward-sloping: that is,

the supply of laptops increases as price rises, and falls as price declines. A higher

price enhances the profitability of laptop production and makes it economical for

producers to offer overtime to their workers or to hire extra employees, even if

they are less productive than the existing workforce. Another option made possible

by higher price is to shift production from other products to laptops.

Now place the demand curve and supply curve together .Suppose

price happened to be at P_1. At this price the amount supplied, OH, exceeds the

amount demanded, OQ. Retailers will find inventories of the product rising.

Producers will find orders slowing down and their own inventories will increase.

Inevitably, someone will give the order to ‘move’ the product by reducing the price.

As price falls, two things happen. First, demand tends to rise: more laptops are

purchased because existing owners take advantage of the reduction in price to buy a new model and new customers appear on the scene. This effect is captured by the movement downwards along the demand curve from A to E. Second, supply tends to fall. The decline in the price spills back into lower profits. Some producers will goout of business; others will operate at a reduced output level. This effect is captured by the movement downwards along the supply curve from B to E. Eventually,demand and supply are brought into equilibrium. Market equilibrium is reached atprice OP_E and quantity of laptops OQ_E. At this point, there is no tendency for priceto either rise or fall. Provided the assumptions of the competitive market hold,there will be continuous pressure to move towards the equilibrium point.

The above analysis contains an implicit assumption about the adjustment

process. We have assumed that if supply exceeds demand, price declines, and if

demand exceeds supply, price increases. In other words, adjustment occurs via

changes in price because of disparity between quantity supplied and quantity

demanded at a particular price. An alternative adjustment process is via changes in

quantities. We consider price disparities at a given output level instead of quantity

disparities at a given price level. If, for any given quantity supplied, the supply

price exceeds the price at which that quantity is demanded, then the quantity

supplied will decrease. If the demand price exceeds the supply price, quantity supplied increases.

These basic forces of demand and supply affect all markets – not just consumer

goods and services, but also raw materials, land, capital and labour. In all cases,

equilibrium is brought into existence and is sustained by movements in price. In

turn, these price movements help restore equilibrium by eliciting predictable

reactions from profit-maximizing producers and utility-maximizing individuals.

This is the essential feature of a market system.

The above discussion has explained how the price of a good or service is determined. The analysis may appear simple, even obvious, and so in a sense it is. Yetit took many years for the mechanism of price determination to be fully understood.Much effort was spent by the classical economists of the nineteenth century trying to link price to the cost of production. The cost of a product was assumed to be closely related to the amount of labour required to produce it.

Hence, a moral as well as an economic case could be made for the superiority of

the free market system. With hindsight, we see that cost of production is just one

side of the picture. Simple demand and supply analysis also enables us to provide

a definitive answer to questions such as: Is price high because a good is expensive

to make? Or is it high because people prize it greatly? Or does one go to a lot of

expense to make it because its price is high? The answer to all three questions is

yes. In a celebrated passage, the eminent economist Alfred Marshall used the

analogy of a pair of scissors to explain how demand and supply jointly determine

price. Which blade of a pair of scissors cuts the page? One cannot say: both blades

together do the cutting.

While prices are determined by supply and demand, they also act as incentives

and as sources of information. They play an active as well as a passive role in the

market system. Changes in price bring about equilibrium between demand and

supply. When a gap threatens to appear between demand and supply, prices act

as a signalling mechanism to bring them closer together. These signalling and

incentive functions of price play a vital role in making the market system work.