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The role of the price mechanism

How the market, left to its own devices, can overcome any shock in demand/supply without government intervention.
by

Danai Mic

on 27 October 2012

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Transcript of The role of the price mechanism

Ever wondered why goods' prices rise when there is more demand for them? I know I did!
As a matter of fact, as a kid I used to think it was because of the producers' insatiable greed for money! But it's a bit more complicated than that... So let's investigate this further with an example! Assume the market for greek frozen yogurt where:
at price P1, Qs=Qd and thus the market is at peace P in $ per scoop Q in scoops S D P1 Q1 Now, assume that summer has arrived(!) causing an increase in demand for fro-yo:
this would result in a shift to the right of the initial demand curve. P in $ per scoop Q in scoops S D P1 Q1 D' But what happens to the price? P in $ per scoop Q in scoops S D P1 Q1 D' P1 is no good anymore since we have excess demand ED Excess demand leads to a tendency for the price to increase P in $ per scoop Q in scoops S D P1 Q1 D' ED P2 Q2 This price increase conveys information:
it signals to producers that there is ED, giving them incentive to produce MORE At the same time, it signals to consumers that the good is now more expensive, giving them incentive to CUT BACK in consumption or WITHDRAW from the market A B C Supply will therefore extend from point A to C whilst demand will contract from point B to C Point C is therefore the new equilibrium point where:
Qd'=Qs and
there is 0 excess demand The importance of the role of the price mechanism is its SIGNALING power:
consumers and producers around the world reach a consensus merely by RESPONDING to changes in relative prices and ADJUSTING their behavior while KEEPING their own self-interest in mind!
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