Price determination - Business Environment

The market is the place where buyers and sellers meet and where demand and supply are brought together. The information on demand and supply is combined in Table and presented graphically in Figure.
The equilibrium price
At a price of £1.20, the quantity demanded is the same as the quantity supplied at 48 000 pints per week. At this price the amount that consumers wish to buy is the same as the amount that producers wish to sell. This price is called the equilibrium price and the quantity being bought and sold is called the equilibrium quantity.The point of equilibrium can be seen on the diagram at the point where the demand and supply curves cross.At price levels above £1.20 the quantity that producers wish to supply is greater than the quantity consumers wish to buy. There is excess supply and the market is a‘buyers’ market’. At prices less than £1.20 consumers wish to buy more than producers wish to supply. There is excess demand and the market is a ‘sellers’ market’.

In competitive markets, situations of excess demand or supply should not exist for long as forces are put into motion to move the market towards equilibrium. For example, if the price level is £1.30 per pint, there is excess supply and producers will be forced to reduce the price in order to sell their beer. Consumers may be aware that they are in a buyers’ market and offer lower prices, which firms might accept. For one or both of these reasons, there will be a tendency for prices to be pushed back towards the equilibrium price. The opposite occurs at prices below equilibrium and price is pushed upwards towards equilibrium.

Shifts in demand and supply
So long as the demand and supply curves in any market remain stationary, the equilibrium price should be maintained. However, there are numerous factors that could shift either or both of these curves. If this were to happen, then the old equilibrium would be destroyed and the market should work to a new equilibrium.How does this happen?In Figure the original equilibrium price for Real Brew draught beer is P1.
Assume that the demand curve moves from D1 to D2. This increase in demand could be due to a variety of factors already mentioned. For example, the price of a rival drink may have increased; disposable income could have risen; or sales may have benefited from a successful advertising campaign. In any event, at the old equilibrium price there now exists an excess of demand over supply of Q1Q3. It is likely that price will be bid upwards in order to ration the shortage in supply. As price rises, demand is choked off and supply exhausted. Eventually, there is a movement to a new equilibrium of P2. At this new price both supply and demand at Q2 are higher than they were at the previous equilibrium. If, alternatively, the demand curve had shifted to the left, then the process would have been reversed and the new equilibrium would have been at a level of demand and supply less than Q1, with a price below P1. Illustrate this process diagrammatically for yourself.In Figure there is a shift in the supply curve from S1 to S2. Refer back in this chapter to envisage specific reasons for such a shift. At the original equilibrium price of P1 there would now be an excess supply over demand of Q1Q3. Price would therefore fall in a free market. As it does, demand will be encouraged and supply diminished. Eventually there will be a new equilibrium at P2 with a higher quantity demanded and supplied than at the previous equilibrium. If the supply curve had instead shifted to the left, then market forces would have resulted in a lower quantity supplied and demanded than before. Once again, illustrate this diagrammatically for yourself. The analysis so far has been relatively straight forward; it has been assumed that either the demand or the supply curve moves alone. However, it is likely that in any given time period both curves could move in any direction and perhaps even more than once.

Given the many factors that may shift both the demand and the supply curves, it is easy to imagine that markets can be in a constant state of flux. Just as the market is moving towards a new equilibrium, some other factor may change, necessitating an adjustment in an opposite direction. Given that such adjustment is not immediate, and that market conditions are constantly changing, it may be the case that equilibrium is never actually attained. It is even possible that the very process of market adjustment can be destabilising. The constant movement of price implied by the analysis may also be detrimental to business. The firm might prefer to keep price constant in the face of minor changes in demand and supply.