What determines the price of a good or service in the market?
In a free market, we combine the forces of demand and supply in order to determine the market price of a good or service.
P is known as the market clearing price — the price at which supply exactly meets demand. If the price is too high, then supply > demand, and we have excess supply, or a surplus or glut. To get rid of the excess supply, producers will have to lower the price, and so the market clearing price will eventually be reached. If the price is too low, then demand > supply, and we have excess demand or a shortage. To get rid of the excess demand, the price will rise towards the market clearing price, causing consumers to leave the market as the good becomes more expensive than the price they are willing to pay.
The Functions of Prices
Rationing: because resources are scarce and finite, not everyone is able to buy everything they want; when demand is greater than supply, then prices are bid up so that the good/service is rationed out to those who can afford to pay.
Incentive: when prices are high, then this attracts producers to the market because it can enable higher profits to be earned.
Signalling: prices help to determine where and how resources should be allocated; if prices increase, this signals to producers that demand is probably high and that they should increase
Consumer and Producer Surplus
Consumer surplus: the difference between the amount that a consumer is willing to pay and the price that they actually pay; shown by the difference between the demand curve (the amount they
are willing to pay) and the market equilibrium price (the amount they actually pay) — the darker
shaded area on the diagram.
Producer surplus: the difference between the amount a producer is willing to sell a good for, and the price they actually receive; shown by the difference between the supply curve and the market
equilibrium price — the lighter shaded area on the diagram.
Obviously, the level of consumer and producer surplus will change if there is a shift in the demand or supply curve.