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Economics Notes

Price Determination in A Free Market Economy

CONTENTS

i.          Free market economy

ii.         Determination of price in a free market

iii         Equilibrium point, equilibrium price and equilibrium quantity.

iv.        Derivation of equilibrium price and quantity from demand and supply functions.

v.         Effects of changes in demand and supply on equilibrium price and quantity

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. 

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

Effects of Decrease in Supply

a.         Increase in the equilibrium price from P1 to P2

b.         Decrease in the equilibrium quantity from Q1to Q2

EVALUATION QUESTION

  1. What is the equilibrium quantity?
  2. Illustrate with a diagrammatic sketch the market situation at a price lower than the equilibrium price
  3. Explain the term “market forces”
  4. “Prices are determined by the forces of demand and supply”. Explain and illustrate with a diagram.
  5. Explain with the aid of diagrams how the market equilibrium price is affected by the combined effects of
  6. Increase in demand and increase in supply

b.       Decrease in demand and decrease in supply

  1. Increase in demand and decrease in supply

READING ASSIGNMENT

  1. Comprehensive Economic by J.U Anyaele page 132-136
  2. Fundamentals of Economics by Anyawuocha page 166-168

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. If the government fixes a price of a commodity above the equilibrium price, the quantity supplied will be (a) les that the quantity demanded (b) Equal to the quantity demanded (c) Greater than the quantity   demanded (d) Equal to zero
  3. 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
  4. The gap between demand and supply curves below the equilibrium price indicates (a) Excess demand (b) Excess supply (c) Equilibrium quantity (d) Equilibrium price
  5. 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

THEORY

Given the demand and supply function for a crate of eggs as follows:

Qd = 12 –2p;      Q = 3+1p

Determine the equilibrium price and quantity What is the excess supply at the price of N3.50? 

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