A market is the interaction of buyers and sellers to exchange goods and services. It can also be defined as a system that is used to allocate scarce resources based on the interaction of forces of demand and supply. Market economies range from free market economies where prices are purely determined by market forces to mixed economies where the state controls the price mechanism[ CITATION Duf06 \l 1033 ].
In perfectly competitive markets, prices are only determined by forces of demand and supply. In these markets, prices adjust downwards and upwards to achieve equilibrium between in-coming goods and services for sale and those that are being requested by purchasers. Supply and demand reacts upon each other until a stable position is achieved where the quantity of goods supplied is equal to the quantity demanded. The resultant equilibrium quantity will then determine the equilibrium price that will be charged in the market. The market prices will keep on changing with variation in supply and demand. In the event that supply exceeds demand the price of the commodity will fall. On the other hand when demand exceeds supply the price of the commodity will rise [ CITATION McE081 \l 1033 ].
The diagram below illustrates market mechanism in perfectly competitive markets.
Figure 1: Price Mechanism
Suppose the demand and supply is defined by the curves in the above diagram. Their intersection at point E determines the equilibrium price (D) and equilibrium quantity (L). Charging any other price will cause disequilibrium in the market that will make the market forces to react upon each other until the market returns back to equilibrium. Charging a higher price, for example A in the above diagram, will cause in an increase in supply from L to M and a decrease in demand from L to K.This will result in excess supply of M to K as shown in the diagram. This will force prices to fall back to D to restore the equilibrium quantity supplied and demanded. On the other hand, if the price falls below the equilibrium price, for example to F,as shown in the above diagram, quantity demanded will increase from L to M and quantity supplied will decrease from L to K. This will result in a shortage of M to K that will force prices to rise back to D to restore the equilibrium quantity supplied and demanded.
In a monopoly, market producers have the sole power of determining the prices of goods and services. Monopoly refers to a market situation where there is only one producer who controls the supply of a commodity that does not have close substitutes. Monopolists normally produce fewer goods than those produced under a perfectly competitive market and charge higher prices therefore earning abnormal profits. Monopolists also practice price discrimination by separating markets or product differentiation. Price discrimination refers to charging different prices for the same good to different markets or people [ CITATION McE081 \l 1033 ].
In mixed economies, government regulates the working of price mechanism rather than allowing it to regulate itself through market forces therefore influencing market prices. There are several methods used by the government to regulate prices which depend on the economic objective it intends to achieve. They include; taxes and subsidies, price ceiling and price floors. Taxes and subsidies affect market demand and market supply therefore influencing prices charged in the market. If a tax is levied per unit of output supplied then there will be an upward shift in the supply curve by an amount equivalent to the unit tax. Since the demand curve slopes upwards, the equilibrium quantity will decrease and equilibrium price will increase. The increase in price will depend on the elasticity of demand. On the other hand, a government subsidy will reduce producers’ cost of production causing a downward shift in the supply curve. This will result in an increase in the equilibrium quantity and equilibrium price will decrease [ CITATION Duf06 \l 1033 ].
Price ceiling refers to situations where the government fixes the price of a commodity below the equilibrium price as determined by forces of demand and supply. The government uses this mechanism if it feels the prices of basic goods and services determined by market mechanism is too high for majority of the citizens and especially the poor and other vulnerable groups. Price ceilings normally results in excess demand and therefore the market is forced to find another mechanism to allocate output other than price. The commonly used mechanisms are rationing and first come first served. However, price ceiling often results in black markets if some people are prepared to pay more than the set prices [ CITATION Wes06 \l 1033 ].
Price floors refer to situations where the government fixes the price of a commodity above the equilibrium price as determined by forces of demand and supply. Price floors are common in the agricultural sector to prevent seasonal price fluctuation and stabilize income of farmers. It results in excess supply because the higher prices motivate producers to produce more than consumers are willing to buy. Another area where price floors are applied is minimum wage. Minimum wage also results in excess supply of labor[ CITATION Wes06 \l 1033 ] .
Duffy, John. Economics. revised. New York: John Wiley and Sons, 2006.
McEachern, William A. Economics: A Contemporary Introduction. 8,illustrated. New York: Cengage Learning, 2008.
Wessels, Walter J. Economics. 4,illustrated. Boston: Barron's Educational Series, 2006.