PRICE DETERMINATION IN A FREE MARKET ECONOMY

FREE MARKET ECONOMY

A free market is a market in which prices of goods and services are regulated by market forces. This means that prices of commodities in a free market economy are fixed by the interaction (i.e. joint actions) of demand and supply.

DETERMINATION OF PRICES IN A FREE MARKET

It is possible to compare demand with supply by drawing a schedule showing the quantity of goods demanded and supplied.  An example of a combined demand and supply schedule is shown below.

Price N                       Quantity Demanded (Units)             Quantity Supplied (Units)

7                                              100                                                      900

6                                              200                                                      700

5                                              300                                                      650

4                                              400                                                      400

3                                              500                                                      300

2                                              600                                                      250

1                                              700                                                      200

 

The schedule above can be graphically represented by the curve below.

From the table and graph above, it is seen that at N4, 400 units of goods was demanded and 400 units of goods was supplied. N4 is the equilibrium price, while 400 units is the equilibrium quantity and the point of intersection between demand curve and supply curve is called the equilibrium point.

 

EQUILIBRIUM POINT, EQUILIBRIUM PRICE AND EQUILIBRIUM QUANTITY

Given a downward sloping demand curve and an upward sloping supply curve as in the diagram above, there would occur a unique point of intersection indicating a price level at which quantity supplied will be equal to the quantity demanded. Such point of intersection is called an equilibrium point and when such point is traced to the price and quantity axis of the graph, we shall obtain the equilibrium price and equilibrium quantity bought and sold respectively.

From the graph above, the equilibrium point was established at point A and when traced to the price and quantity axis, it showed the market equilibrium price and equilibrium quantity bought and sold of N4 and 400 units respectively.The equilibrium price is the price at which the quantity of goods demanded is equal to the quantity supplied. This price is determined by the interaction of supply and demand

 

At a price lower than the equilibrium price (say N2) demand will be greater than supply. This will lead to shortage of goods in the market that is, excess demand.  On the other hand, at a higher price than the equilibrium price (say N6), producers will supply more than the consumers are willing to buy and this will lead to an excess supply – i.e surplus of goods in the market.

 

Derivation of Equilibrium Price and Quantity from Demand and Supply Functions

Given the Demand and supply functions:

Qd = 42-2p and Qs =12+4p

Determine the equilibrium price and equilibrium quantity

Solution

At equilibrium price

Qd = Qs

i.e. 42- 2p = 12+4p

42-12 = 4p +2p

30 = 6p

P= 30/6 = 5

Equilibrium  price = N5

To obtain the equilibrium quantity

Substitute for p in

Qd = 42 –2p

Qd = 42 – 2 (5)

= 42 –10

= 32

Equilibrium Quantity = 32units

PRICE SYSTEM OR PRICE MECHANISM

MEANING OF A PRICE

A Price- is defined as a monetary unit of measurement or value that helps to facilitate the exchange of goods and services in the market. That is, a price is the rate at which something can be exchanged for another thing. For goods to command a price, it must have the attributes of usefulness (valuable) and relative scarcity.

PRICE SYSTEM OR PRICE MECHANISM

In a free market economy, prices of goods and services affect the behaviour of both the consumer and the producer (supplier).  Price system maybe defined as a system whereby prices of goods and services are determined by the free interaction of the forces of demand and supply in a free market economy. That is, it is a system of resources allocation based on a free movement of prices. It id described as a process by which the monetary value of a commodity, service, or factor of production is determined by the inter-play of the market forces of demand and supply.

 

FUNCTIONS/IMPORTANCE OF THE PRICE SYSTEM

1. The price system operates to allocate scarce resources
2. It regulates the flow of goods and services from producers to the consumer.
3. It determines the extent of demand and supply of goods and services.
4. It is used to encourage or discourage consumption of certain goods and services.
5. It helps to determine how the factors of production will be rewarded.

 

FACTORS THAT DETERMINE PRICE OF COMMODITIES

1. The cost of production of the product
2. The level of profit desired by the seller
3. The level of competition in the market
4. Government policies e.g subsidies, taxation etc.
5. The activities of Trade Unions
6. The cost incurred on advertisement
7. Changes in demand and supply

PRICE FIXING METHODS

The prices of goods and services are often fixed by any of the following methods:

1. Through Bargaining System
2. Through Sales by Auction
3. Through Sales by Price Tags
4. Through Market Forces of Demand and Supply

 

GENERAL EVALUATION QUESTIONS

1. Distinguish between fixed cost and variable cost.
2. Under what condition will a perfectly competitive firm maximize profit.
3. Describe each of the following: (a) abnormal demand (b) effective demand
4. What is a public corporation?
5. Explain the causes of a declining population.
6. What is equilibrium position?
7. Describe the condition for equilibrium.
8. What is the equilibrium quantity?
9. Illustrate with a diagrammatic sketch the market situation at a price lower than the equilibrium price
10. Explain the term “market forces”
11. “Prices are determined by the forces of demand and supply”. Explain and illustrate with a diagram.
12. Define price mechanism.
13. List the  importance of a price mechanism.
14. Explain factors that determine price
15. State three price fixing methods

 

WEEKEND ASSIGNMENT

1. At the equilibrium price, quantity demanded is (a) greater than quantity supplied (b) equal to quantity supplied (c) less than quantity supplied (d) equal to excess supply
2. The market price of a commodity is normally determined by the (a) law of demand (b) Interaction of the forces of demand and supply (c) total number of people in the market (d) total quantity of the commodity in the market
3. The gap between demand and supply curves below the equilibrium price indicates (a) excess demand (b) excess supply (c) equilibrium quantity (d) equilibrium price
4. If prices fall below the equilibrium (a) demand will equal supply (b) demand will be greater than supply (c) supply will be greater than demand (d) quantity supplied will be zero
5. The price system refers to the system by which (a) the government control prices in the economy (b) prices tend to rise to a general level (c) price allocates resources between consumer and producer goods (d) the producers fix the price of their products

 

THEORY

1. Given the demand and supply function for a crate of eggs as follows: Qd = 12 –2p; Q = 3+1p
2. Determine the equilibrium price and quantity
3. What is the excess supply at the price of N3.50?
4. State three factors that determine the price of commodities.

 

See also

SUPPLY: LAW, SCHEDULE, TYPE & FACTORS

DEMAND: DEFINITION, LAW, TYPES & FACTORS

THE MIDDLEMEN

DISTRIBUTIVE TRADE

MERCHANT BANKS & DEVELOPMENT BANKS