CONTENT

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.

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

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

EVALUATION

1. What is equilibrium position?
2. Describe the condition for equilibrium.

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”

“Prices are determined by the forces of demand and supply”. Explain and illustrate with a diagram.