Problem on free market economy

Question

A) Using appropriate tables and diagrams explain how price and quantity is determined in a free market economy.

B) Briefly explain using the diagrams in 4.1 the followings two scenarios

C) When price is set below the equilibrium price and

D) When price is set above the equilibrium price.

Answer 1

The law of demand and supply illustrates how a free market economy functions. The law of demand states that an increase in prices will decrease the quantity demanded in a free market economy and the law of supply states that an increase in prices will increase the quantity supplied in a free market economy. The price at which the quantity supplied and the quantity demanded is equal is the market equilibrium price. The quantity represents the market equilibrium quantity. A free market economy is one system, which tries to solve the basic economic problems through minimum governmental regulation and control. Hence in a free market economy, the prices and quantities tend to move towards the market equilibrium levels and keep the market stable in such a way. This can be illustrated by the following quantity demanded, supplier and prices of gasoline, for example:

From the above values, a graph can be plotted for the demand and supply curve as below.

In order to determine the price and quantity of gasoline in the market, it is necessary to determine the price point where the demand equals the amount that suppliers are ready to supply. In the above example, at $1.25 per liter, demand exceeds supply and hence there will be a shortage of gasoline. Shortage most likely will drive up the prices since consumers compete to buy the product. When the price increases, demand decreases, since consumers go for substitutes. In such a case, supply will exceed demand and result in a surplus of gasoline, thus leading to a decrease in price levels. Finally, the market reaches its equilibrium point where the quantity supplied is equal to quantity demanded and the market will stabilize at this point. We can hence determine the equilibrium point by plotting a graph between quantity in the x-axis and price in the y-axis. Both the demand and supply curves must be drawn and the point of intersection of the demand and supply curve is the equilibrium point. In the above case, the equilibrium price is $1.5 per liter and the equilibrium quantity is 75 liters.

When price is set at $1 per liter (below equilibrium price), the shortage will drive up the price until it reaches $1.5 per liter. In this scenario, the demand will be high since consumers’ competition increase.

When price is set at $2 per liter (above equilibrium price), the surplus will drive down the price until it reaches $1.5 per liter. In this scenario, supply will be higher than demand since there will be more production but no consumption.