How Do Impersonal Forces of Demand & Supply Determine Prices?
Neoclassical economics incorporates theory from classical economics, such as the belief that competition is the driving force for an efficient distribution of resources to meet demand in the marketplace. These economists believe in the impersonal forces of supply and demand to determine prices, and that government intervention is unnecessary to achieve market equilibrium.
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Demand
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Market demand varies with the price of goods. If a product has strong demand at its current price, and then vendors raise its price, demand will drop as the product becomes more expensive. Inversely, if a product is selling poorly and vendors lower the price, marketplace demand will increase as it becomes more affordable. Local and national events influence demand. For example, when news stories occur about impending winter storms, such as a major blizzard, stores sell out of food and supplies within hours. The local event created an instant demand for food and supplies.
Supply
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Manufacturers examine sales trends when deciding production quantity. They increase production when demand is high and decrease it as demand withers. If they want to continue producing the same amount of product, then they must lower the price to stimulate demand. Many products are seasonal in nature, such as selling air conditioners in Northern climates. They are readily available during the summer months, but stores do not keep them in inventory after Labor Day. Manufacturers consider this trend when deciding how many units to produce during different times of the year. The health of the company suffers if they produce too many, and they lose potential profits if they produce too few.
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Market Equilibrium
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Market equilibrium occurs when vendor pricing reflects what the market is willing to pay in relation to the current level of demand. As supply and demand vary, so does the price of goods. Government intervention, in the form of rationing or price controls, interferes with true market equilibrium. Rationing tends to increase prices and create a black market for the product. Price controls may lower the available supply if the product is no longer profitable to manufacture.
Exceptions
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Sometimes government intervention is necessary, such as when a foreign competitor is intentionally under-pricing products to destroy domestic competitors. A government may respond by imposing tariffs to raise the foreign product to the same price as the domestically produced one. The government may also decide to limit the quantity of product the foreign company can export to the domestic market, thereby reducing or eliminating its negative effect on the marketplace.
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