In market economies (capitalism) – prices are signals that guide the allocation of resources. The retail price indicates clearly to suppliers when consumers want more/less of a product. For example – Nintendo 64 or Sega Dreamcast.
The implications of market forces for business are very important. Rising prices may indicate increasing demand. If demand is increasing, which way does the demand curve go? If there is increasing demand, producers have the opportunity to increase supply and also raise their prices, thus increasing their profits substantially.
On the other hand, demand maybe falling and orders diminishing. The producer would need to cut output before it starts to make significant losses. To stay alive, it may need to launch a new and more popular product (e.g. iphone 5!).
Businesses that can come up with new products or devise a way to reduce production costs will be able to cut costs and therefore prices. As law of demand states, as retail prices decrease, demand increases. The result is that the business dominates the market more, with a larger share of it.
Can you remember back to ‘business objectives’? Success to some people may mean expansion and growth. But other businesses are happy to survive – and just cover their costs. Either way, a successful business is sensitive to changes in market forces and their likely implications. An excellent business will be proactive and not reactive. Consider supermarkets and how they change their prices almost daily!
Operation of market forces to eliminate excess demand and excess supply
At any price above the equilibrium level, quantity supplied exceeds quantity demanded (remember the producer’s objective- to get as high a price as possible, whilst consumer’s don’t want this!) and there will be excess supply to the market. How can we eliminate excess supply? A sudden ‘sale’ would be one way of selling surplus stock and restore equilibrium to a market.
At a price below equilibrium, there is excess demand as consumers want more than firms will supply (remember the consumer’s objective – to get as low a price as possible, whilst businesses don’t want this!). How we eliminate excess demand? Raising the price will cause consumers to buy less and restore equilibrium to a market.
Only at the equilibrium price will there be market clearing, where demand will meet supply and both producer and consumer are happy. In a competitive market, excess supply and excess demand (which cause a disequilibrium) will usually not last for long. Market forces will act and will lead to a change in price.
Prices in a dynamic economic
Whenever a price has changed, it is usually a change in demand and supply or both that has caused it. Where prices stay unchanged over a long period of time, this is often the result of suppliers choosing stability and absorb any cost changes and living with reduced profit margins.
Technology allows suppliers such as holiday companies and supermarkets to adjust prices frequently in response to market conditions. For example – if a holiday company has block booked aeroplane seats and hotel rooms, subsequently noticing an increase in demand for that location, they may then bump up their prices. Although as the departure date draws near, they may then reduce the price if that will help to fill the remaining capacity.
Flaws in the model
Our D&S model simplifies reality though, making unrealistic assumptions and simply only looking at one variable at a time. We rely on ‘ceteris paribus’ (remember Y8 Latin!? It means ‘other things being equal’) assumption which means that we ASSUME everything stays unchanged except the one thing that we are focussing on. Is this true in reality!?
We also assume that supplying businesses are motivated simply by profit and that competition forces them to react to changing conditions in predictable ways. An example is the very recent slump in global oil prices in Autumn 2014. This slump was caused by a fall in demand from China/The Eurozone and an increase in supply from the American invention of ‘fracking’. As a result the crude oil price fell from over $100US per barrel to less than $50US. This was passed onto the consumer by cheaper prices at the pumps and, eventually after some gov pressure, cheaper utility bills. The delay in passing the saving onto the consumer was that wholesale energy prices are often fixed for some time by ‘future’ contracts and adds a real life complexity to what should be, in theory, a simple shift to the right in supply and a shift to the left in demand – resulting in a drop in price. Put simply – is the D&S model too simplistic.
Although it is simplified, our D & S model (aka model on price determination) does capture some important basic factors and provides a foundation on which much of economics is built.
In summary the disadvantages of the D&S model are:
- Simplifies complex situations to aid understanding
- Only one variable at a time examined
- Model is analysed under conditions of ‘ceteris paribus’ (assumes other variables remain constant)
- Representation of one particular moment in time, things are likely to change
- At what point on the demand and supply curve does market equilibrium occur?
The Profit Signalling Mechanism
When the equilibrium price changes because demand has changed, this can trigger the profit signalling mechanism. A price increase, when demand rises, is likely to increase profits and thus attract new producers and encourage existing firms to increase output. In the short run, this will bring a movement along the supply curve (change in price). In the long run, new entrants will increase supply to the market and shift the curve to the right and offset any price hike due to a rise in demand. Put simply – profits act like a ‘carrot’ and will attract firms to enter the market. Losses lead to firms closing down or reduced production.