Supply, Demand, and the Market Process

Because people want more of scarce goods than Nature has made freely available, a rationing mechanism is necessary. Competition is the natural outgrowth of the necessity for rationing scarce goods A change in the rationing mechanism used will alter the form of competition but it  will not eliminate competitive tactics. 

The law of demand holds that there is an inverse relationship between  price and the amount of a good purchased. A rise in price will cause consumers to purchase less because they now have a greater incentive to use substitutes. On the other hand, a reduction in price will induce consumers to buy more, since they will substitute the cheaper good for other commodities.

The law of supply states that there is a direct relationship between the price of a product and the amount supplied. Other things constant, an increase in the price of a product will induce established firms to expand their output and new firms to enter the market. The quantity supplied will expand.

Market prices will bring the conflicting forces of supply and demand into balance. If the quantity supplied to the market by producers exceeds the quantity demanded by consumers, price will decline until the surplus is eliminated. On the other hand, if the quantity demanded by consumers exceeds the quantity supplied by producers, price will rise until the shortage is eliminated.

When a market is in long-run equilibrium, supply and demand will be in balance and the producer's opportunity cost will equal the market price. If the opportunity cost of supplying the good is less than the market price, profits will accrue. The profits will attract additional suppliers, cause lower prices, and push the market toward an equilibrium. On the other hand, if the opportunity cost of producing a good exceeds the market price, suppliers will experience losses. The losses will induce producers to leave the market, causing price to rise until   equilibrium is restored.

Changes in consumer income, prices of closely related goods, preferences, and expectations as to future prices will cause the entire demand curve to shift. An increase (decrease) in demand will cause prices to rise (fall) and quantity supplied to increase (decline).

Changes in input prices, technology, and other factors that influence the producer's cost of production will cause the entire supply curve to shift. An increase (decrease) in supply will cause prices to fall (rise) and quantity demanded to expand (decline).

The constraint of time temporarily limits the ability of consumers to adjust to changes in prices. With the passage of time, a price increase will usually elicit a larger reduction in quantity demanded. Similarly, the market supply curve shows more responsiveness to a change in price in the long-run than during the short-term time period.

When a price is fixed below the market equilibrium, buyers will want to purchase more than sellers are willing to supply. A shortage will result. Nonprice factors such as waiting lines, quality deterioration, and illegal transactions will play a more important role in the rationing process

When a price is fixed above the market equilibrium level, sellers will want to supply a larger amount than buyers are willing to purchase at the current price. A surplus will result.

The pricing system answers the three basic allocation questions in the following manner.

(a) What goods will be produced? Additional units of goods will be produced only if consumers value them more highly than the opportunity cost of the resources necessary to produce them.

(b) How will goods be produced? The methods that result in the lowest opportunity cost will be chosen. Since lower costs mean larger profits, markets reward producers who discover and utilize efficient (low-cost) production methods.

(c) To whom will the goods be distributed? Goods will be distributed to individuals according to the quantity and price of the productive resources they supplied in the marketplace. A great number of  goods will be allocated to persons who are able to sell a large quantity of highly valued productive resources; few goods will be allocated to persons who supply only a small quantity of low-valued resources.

Market prices communicate information, coordinate the actions of buyers and sellers, and provide the incentive structure that motivates decision-makers to act. The information provided by prices instructs entrepreneurs as to (a) how to use scarce resources and (b) which products are intensely desired (relative to their opportunity cost) by consumers. Market prices establish a reward-penalty system, which induces individuals to cooperate with each other and motivates them to work efficiently, invest for the future, supply intensely desired goods, economize on the use of scarce resources, and use efficient production methods. Even though decentralized individual planning is a characteristic of the market system, there is a harmony between personal self interest and the general welfare, as Adam Smith noted long ago. The efficiency of the system is dependent on (a) competitive market conditions and (b) securely defined private property rights.