Preliminary Economics Practise extended response

Define the economic concept of market equilibrium. With the aid of a diagram,
explain how market forces determine equilibrium price and quantity. Discuss the
reasons for, and methods of, government intervention in markets.

Market equilibrium is the situation where at a certain price, the quantity supplied and
the quantity demanded are equal. Markets always tend towards equilibrium and, if
excess demand or excess supply exists, the market will bid the price up or down until
the equilibrium price is reached. The price mechanism determines the equilibrium in
the market and consists of the relationship of supply and demand.

Market equilibrium occurs when the demand and supply curves intersect with each
other. This is when the quantity demanded is exactly the quantity supplied.

Above is a situation of excess demand, where the current price is below the
equilibrium. Figure 1 shows at price 0P1, the quantity demanded (0Q2) exceeds the
quantity supplied (0Q1). This creates competition among the buyers and bid for
higher prices. The increase in prices results in an expansion of supply but a
contraction in demand. This will keep happening as long as there is excess supply;
however, eventually it will reach the intersection of the demand and supply curves
resulting in equilibrium (demand and supply is equal).

Preliminary Economics Practise extended response

Below, the quantity supplied at 0P1 exceeds the quantity demanded (0Q2). Therefore
there is an excess of supply. To remove the excess supply, the sellers will sell for a
lower price. This creates an expansion in demand but a contraction in supply. This
will keep happening as long as there is excess supply, until it intersects with demand
and the market is cleared (Qe, Pe).

The equilibrium will also be changed when the demand and supply curves shift. The
change is not always caused by price. For example, an increase in demand means that
more of a good will be demanded at the same price. Factors that may cause an
increase in demand include rise in the price of substitute goods and a fall in the price
of complementary goods; higher prices expected in the future, goods becoming
fashionable and rising consumer incomes. Because the demand curve shifts to the
right, the quantity demanded exceeds the quantity supplied. Competition among
buyers will begin to force the limited quantity of the good in question up, causing an
expansion in supply and a contraction in demand. This will continue until the market
“clears” again at a new equilibrium point – both the equilibrium price and quantity
have increased. Similarly, a decrease in demand will lower both the equilibrium price
and quantity.

The Government intervenes in many ways to either change the market or make it
behave in a way which is more desirable and beneficial for both the government and
the public/economy. Ways of intervention include price ceilings, price floors, merit
goods, demerit goods, public goods and taxes.

Although markets can sort issues of what and how much to produce, this is not the
end of the story. When it operates by itself, the market can create poor outcomes.
When this occurs, governments may intervene in the market. For instance, the
government may feel that the market price of some commodities (for instance the cost
of train travel) is too high, or that the market-determined price of some items (such as
unskilled labour, for example) is too low. The government uses a price ceiling or a
price floor in order to achieve economic results.
Preliminary Economics Practise extended response
A ceiling price (maximum price for a good or service) may be introduced to make a
good or service more accessible to the public and a price floor (minimum price for a
good or service) might be introduced to make a good less accessible or guarantee a
minimum price to the producers. However these methods can limit the supply or
expand the supply compared to normal market operation.

A government may also intervene by introducing merit, demerit and public goods.
Merit goods are introduced to maximise consumption of that particular service or
good. This is opposed to private firms providing this specific good or service in which
the social benefits and social costs are not considered (i.e. not everyone being able to
afford it). An example of a merit good is education and Medicare. If the private sector
was operating this then the public would not be encouraged to consume it due to
limited education or lack of funds. This is why the government sector provides and
encourages its use for positive externalities (impact on a party not involved in the
transaction). Demerit goods however are introduced to minimise consumption due to
their adverse effects on society e.g. alcohol, cigarettes and drugs. Without these the
private sectors could take complete control over the distribution while not seeking
social benefits.

Some goods and services will not be provided by individual/private firms at all
because the good/service they supply might be excludable to people who are unable to
pay for it. These are called public goods. Obvious examples include air and water.
These things are needed by each and every person, and if one were not able to afford
it, the firms would exclude the individual. Another example is national security, roads
and cleaning up which the government provides in order to clear all rivalry and make
it non-excludable.

Lastly the government collects taxes to build up its revenue which in turn helps the
funding towards the country. The government sets a certain amount and type of tax for
specific goods and services. The tax is applied on the individual and/or the firm
producing the good or service. Government intervenes in a market and introduces
higher tax to minimise negative externalities – which will help improve society and
economy (i.e. tax on tobacco). It increases the cost of production and reduces demand.

The market force is an important and unavoidable natural phenomenon in an

economy. Equilibrium is always achieved even if changed as the market force will
slowly create a new point to suit the excess demand and supply. In some case the
market fails to achieve the best for economy and society which is when the
government must intervene to correct a market failure, to improve performance in the
economy and create an equitable distribution of income and wealth along with the
general interest of the public.