What is the Use of Price-Mechanism Tools in Economical Analysis?

It may be defined as ‘a system of exchange through which price of a product is determined through the interaction of the market forces of demand and supply’. Price so determined is called the market clearing price, or simply, the market price. Figure 1.1 below demonstrates the functioning of the price mechanism.

Demand refers to the quantity of product demanded by people at a given price, other things remaining unchanged. Demand equation refers to the algebraic relationship of quantity demanded with the price of the product when all other factors remain unchanged.

The relationship portrays the ‘Law of Demand’ which states that, ‘other things remaining the same (ceteris paribus), more of a product is demanded at a lower price and less of it at a higher price’. Quantity demanded expressed as a function of price, while other things remain unchanged, called ‘demand function’.

Supply refers to the quantity offered by sellers at a given price, while other things remain unchanged (ceteris paribus).

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Supply equation refers to the algebraic relationship between the quantity of a product supplied and its price offered by the market, ‘other things remaining unchanged. It portrays the ‘Law of Supply’ which states that, other things remaining unchanged (ceteris paribus), more of a product is supplied at a higher price and less of it at a lower price.’ The supply curve portrays the supply equation or the ‘supply function’.

A demand curve for normal goods slopes downwards, while a supply curve for such goods slopes upwards.

Illustration 1.1:

Quantity demanded of a product, Q^D, is given as a function of price, P as below:

Q^D = 150,000 – 3P

While its supply, Q^S, as

Q^S =7 P

Determine the market clearing price and the quantity demanded and supplied in equilibrium.

Solution:

The demand curve resulting from the demand equation, when plotted on the graph, with price represented on the vertical axis and quantity on the horizontal axis, is a downward sloping curve, DD, as shown in Figure 1.1 (drawn not to scale. The reader should draw the curves to scale on graph paper for practice).

Likewise, the supply curve is an upward sloping curve, SS, as shown in the figure (again not to scale). The point of intersection of the two, point E, is the point of equilibrium, coordinates of which can be read directly from the graph drawn to scale or can be found by solving the two equations simultaneously as Q^D = Q^S at the point of equilibrium.

Thus,

150, 00 – 3P = 7P

=> 10P = 150,000

=> P = 15,000

Substituting in either of the two equations, we have

Q^D =Q^S

= 105,000

Thus, the market clearing price is 15,000 and the quantity transacted is 105,000 units of the product.