Market equilibration process and supply-demand principles for business managers

Market Equilibration

The process of achieving a market equilibrium relies on some basic principles. The principle of demand holds that, all other things being equal, the higher the price of a good the less people will demand of that good (Investopedia, 2012). There are exceptions to this law, for example goods with inverse price elasticity of demand, but in general the law of demand holds for all goods, even those with very low price elasticity of demand.

The law of supply is the inverse. It holds that all other things being equal the higher the price of a good, the more suppliers will want to provide. Thus, as prices rise, the supply of a good will rise because the profit associated with the production of that good will increase, but the lower the demand will be, because the buyers' marginal utility will decrease.

Those other things that must be equal, however, are the determinants of demand and supply, and price is not the only determinant. Among the determinants of demand are the price elasticity of demand, the availability of substitutes, the propensity of buyers to substitute and cross-price elasticity of demand. Buyer utility plays into the elasticity of demand, as does the nature of the good (whether the good is discretionary or mandatory). Supply is affected by opportunity cost as well, since producers often face production constraints. Those include capacity, the marginal cost of increased capacity, exit barriers, time, availability of key inputs and producer price control over new inputs.

Efficient markets theory holds that the price and supply of goods in a free market will trend towards an equilibrium point. It is unlikely that this point would ever be reached, because there is a time lag in the feedback, but the process works by way of a series of adjustments. Given that populations are not stable, it is likely that the demand side will change first, if we assume a product currently in equilibrium. If demand increases, initially the supply will remain constant, because producers cannot easily change supply. This will drive the price higher. At this point, one of two things will happen. Either the higher price will reduce demand, and D. will fall back to the equilibrium point at some buyers either reduce consumption or substitute other products. The other option is that demand will remain constant. The new price P, and demand D, will remain. Suppliers will respond to that by increasing production, because they can earn more profit on the product. This increased supply will then reduce the price. A new equilibrium point will be set as a result, at new price and demand levels. In the real world, this process is perpetual, such that P, D and S. never reach and hold equilibrium but always trend around the equilibrium point, sometimes in a very narrow range.