Preliminary Economics Practise extended response

Define the economic concept of market equilibrium. With the aid of a diagram, explain how market forces determine equilibrium price and quantity. Discuss the reasons for, and methods of, government intervention in markets.

Market equilibrium is the situation where at a certain price, the quantity supplied and the quantity demanded are equal. Markets always tend towards equilibrium and, if excess demand or excess supply exists, the market will bid the price up or down until the equilibrium price is reached. The price mechanism determines the equilibrium in the market and consists of the relationship of supply and demand.

Market equilibrium occurs when the demand and supply curves intersect with each other. This is when the quantity demanded is exactly the quantity supplied.

Above is a situation of excess demand, where the current price is below the equilibrium. Figure 1 shows at price 0P1, the quantity demanded (0Q2) exceeds the quantity supplied (0Q1). This creates competition among the buyers and bid for higher prices. The increase in prices results in an expansion of supply but a contraction in demand. This will keep happening as long as there is excess supply; however, eventually it will reach the intersection of the demand and supply curves resulting in equilibrium (demand and supply is equal).

Preliminary Economics Practise extended response

Below, the quantity supplied at 0P1 exceeds the quantity demanded (0Q2). Therefore there is an excess of supply. To remove the excess supply, the sellers will sell for a lower price. This creates an expansion in demand but a contraction in supply. This will keep happening as long as there is excess supply, until it intersects with demand and the market is cleared (Qe, Pe).

The equilibrium will also be changed when the demand and supply curves shift. The change is not always caused by price. For example, an increase in demand means that more of a good will be demanded at the same price. Factors that may cause an increase in demand include rise in the price of substitute goods and a fall in the price of complementary goods; higher prices expected in the future, goods becoming fashionable and rising consumer incomes. Because the demand curve shifts to the right, the quantity demanded exceeds the quantity supplied. Competition among buyers will begin to force the limited quantity of the good in question up, causing an expansion in supply and a contraction in demand. This will continue until the market “clears” again at a new equilibrium point – both the equilibrium price and quantity have increased. Similarly, a decrease in demand will lower both the equilibrium price and quantity.

The Government intervenes in many ways to either change the market or make it behave in a way which is more desirable and beneficial for both the government and the public/economy. Ways of intervention include price ceilings, price floors, merit goods, demerit goods, public goods and taxes.

Although markets can sort issues of what and how much to produce, this is not the end of the story. When it operates by itself, the market can create poor outcomes. When this occurs, governments may intervene in the market. For instance, the government may feel that the market price of some commodities (for instance the cost of train travel) is too high, or that the market-determined price of some items (such as

unskilled labour, for example) is too low. The government uses a price ceiling or a price floor in order to achieve economic results.

Preliminary Economics Practise extended response

A ceiling price (maximum price for a good or service) may be introduced to make a good or service more accessible to the public and a price floor (minimum price for a good or service) might be introduced to make a good less accessible or guarantee a minimum price to the producers. However these methods can limit the supply or expand the supply compared to normal market operation.

A government may also intervene by introducing merit, demerit and public goods. Merit goods are introduced to maximise consumption of that particular service or good. This is opposed to private firms providing this specific good or service in which the social benefits and social costs are not considered (i.e. not everyone being able to afford it). An example of a merit good is education and Medicare. If the private sector was operating this then the public would not be encouraged to consume it due to limited education or lack of funds. This is why the government sector provides and encourages its use for positive externalities (impact on a party not involved in the transaction). Demerit goods however are introduced to minimise consumption due to their adverse effects on society e.g. alcohol, cigarettes and drugs. Without these the private sectors could take complete control over the distribution while not seeking social benefits.

Some goods and services will not be provided by individual/private firms at all because the good/service they supply might be excludable to people who are unable to pay for it. These are called public goods. Obvious examples include air and water. These things are needed by each and every person, and if one were not able to afford it, the firms would exclude the individual. Another example is national security, roads and cleaning up which the government provides in order to clear all rivalry and make it non-excludable.

Lastly the government collects taxes to build up its revenue which in turn helps the funding towards the country. The government sets a certain amount and type of tax for specific goods and services. The tax is applied on the individual and/or the firm producing the good or service. Government intervenes in a market and introduces higher tax to minimise negative externalities – which will help improve society and economy (i.e. tax on tobacco). It increases the cost of production and reduces demand.

The market force is an important and unavoidable natural phenomenon in an economy. Equilibrium is always achieved even if changed as the market force will slowly create a new point to suit the excess demand and supply. In some case the market fails to achieve the best for economy and society which is when the government must intervene to correct a market failure, to improve performance in the economy and create an equitable distribution of income and wealth along with the general interest of the public.