How prices are set
The price of a good or service in a competitive market is determined by the interaction of demand and supply. The equilibrium price (or market‑clearing price) is the price at which the quantity demanded equals the quantity supplied. At this price there is no tendency for change: there is neither excess demand nor excess supply. If the market price is above equilibrium, a surplus exists and producers reduce price to sell their excess stock. If the price is below equilibrium, a shortage arises and producers raise price to ration demand.
Changes in equilibrium
When demand or supply changes, the equilibrium price and quantity adjust accordingly. An increase in demand, ceteris paribus, raises both equilibrium price and quantity. A decrease in demand lowers both. Conversely, an increase in supply lowers price but raises quantity; a decrease in supply raises price but lowers quantity. Understanding these relationships helps explain how markets respond to events such as changes in income, production costs and government policies.
| Scenario | Effect on equilibrium price (Pe) | Effect on equilibrium quantity (Qe) |
|---|---|---|
| Demand increases (supply constant) | Price rises | Quantity rises |
| Demand decreases (supply constant) | Price falls | Quantity falls |
| Supply increases (demand constant) | Price falls | Quantity rises |
| Supply decreases (demand constant) | Price rises | Quantity falls |
Sometimes governments intervene in markets by setting price ceilings (maximum prices) or price floors (minimum prices). Such controls can cause persistent shortages or surpluses and may lead to black markets or waste. Economists often prefer to allow prices to adjust freely unless there is a clear case of market failure.
