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The Market Mechanism

April 21, 2022
Paul Roux
Finance

Demand and Supply lie at the very core of economics. It is often referred to as the “market mechanism”, which studies the relationship between buyers and sellers in a market. This article investigates the dynamics of the market mechanism and how it achieves a balance that satisfies both consumers and producers.

Demand

Demand is the quantity of a good or service that consumers are willing and able to purchase at various prices. If a consumer is willing, but not able to purchase a product, they do not have a demand for that specific product: Sam is willing to buy a Ferrari, but he is not able to and therefore he is not included in the market demand for Ferrari’s.

The law of demand is a fundamental principle that states that there is an inverse relationship between price and quantity demanded: As prices increase, consumers are willing and able to buy less, and as prices decrease, consumers are willing and able to buy more. If the average price of cappuccinos decreases from R35 to R25, people will be willing and able to buy more, there by increasing the quantity of cappuccinos demanded in the economy.

When plotting the demand curve on a graph, we see a clear downward trend, re-establishing the inverse relationship between the two variables: price and quantity demanded. In economics, price is always plotted on the Y-axes and quantity on the X-axes. In this fictitious example, we plot the demand for Wimpy cappuccinos.

Supply

Supply is the quantity of a good or service that producers are willing and able to provide at various prices. Resources are scarce, which means that suppliers might not be willing or able to sell their products below certain price levels.

The law of supply isa fundamental principle that states that there is a direct relationship between price and quantity supplied: As prices increase, producers are willing and able to sell more, and as prices decrease, producers are willing and able to sell less. Proceeding with the example above - If the average price of cappuccinos decreases from R35 to R25, Wimpy would be willing to sell fewer cappuccinos because they make lower profits at lower prices. They would rather sell more of other products with higher prices and profit margins, like tea or sodas.

When plotting the supply curve on a graph, we see a clear upward trend, re-establishing the direct relationship between price and quantity supplied.

Equilibrium

The objective of the market mechanism is to determine the price and quantity of goods and services traded in the market. When the supply and demand curves intersect, the market is in equilibrium. In our example, the equilibrium point indicates that 6 cappuccinos will be traded at R20 per cappuccino.

Closing remarks

The market mechanism plays an integral role in how economies operate. In this article, we investigated the interaction between price and quantity. In the next article, we will discuss the factors, other than price, that influence demand and supply and how they affect the equilibrium position.