How Market forces determine equilibrium Price and Quantity in a product market (Essay Sample)

HOW MARKET FORCES DETERMINE EQUILIBRIUM PRICE AND QUANTITY IN A PRODUCT MARKET
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To have a deeper understanding on how the market forces determine the equilibrium price and quantity in a product market, the Keynesian Cross Model is put into use. In the product market, the respective economic agents in place usually consume the amount of output that is produced, for instance, the output in this economy could be the demand for a car. It is in this product market that we have the National Income identity defined by the following equation,
Y = C + I + G
According to Keynes, he proposes that an economy's total income in the goods market in the short-run is to a greater extend determined by the desire by households, firms and the government at large to spend on goods and services. Therefore, the more the number of people who want to spend on goods and services, the more the quantity of goods and service firms will produce and sell. In the product market, two important concepts arise; these are actual expenditure, which is the amount of income that households, firms and the government spend on goods and services and the other one is the planned expenditure, which is the amount of income that households, firms and government would like to spend on goods and services (Davidson and Smolensky 1964).
Assuming that a closed economy's planned expenditure is the sum of its planned consumption, planned investment spending and its planned government purchases, that is,
Planned expenditure (E) = C + I + G
But Consumption C = C(Y-T) = Disposable income
While
I = I0
G = G0
T = T0
Substituting the equation, we get
E = C(Y-T) + T0 + G0
With the knowledge about actual expenditure and planned expenditure, it becomes easier to comprehend how market forces determine the equilibrium price and quantity. Starting form a lower level, the demand curve for a given commodity for instance a car shows the willingness, readiness and the capability of a consumer to purchase the respective car in question. The general idea behind the demand curve is that people tend to demand more of a product as the price of the respective product reduces and vice versa (Muth 1964). However, in the case for supply curve, it slopes upwards with a positive gradient because as the prices of goods and services increase, the higher the quantity of products producers are willing to supply in order to take advantage of the higher prices (Davidson and Smolensky 1964).
S
Price level P
P1
D
Q1
Quantity Q
In determining the equilibrium price and quantity in the goods market, it is best understood by the Aggregate Demand Curve. As opposed to the demand curve, the aggregate demand curve shows the overall relationship in an economy exhibited between the price levels of a given commodity for instance cars and the respective total amount of the commodities produced (Barro 1994). To be more precise, the aggregate demand curve normally represents the real GDP, which shows the level of total income and total output met in a given economy. Just like the demand curve, the aggregate demand curve slopes downwards resulting into a negative gradient hence the negative relationship that emanates between the price level and quantity level with the demand curve drawn to illustrate the market situation for a single good (Barro 1994). However, the reason as to why the aggregate demand curve slopes downwards is a different scenario. For instance, there are very many cases where individuals in an economy will consume less quantity of a given product when the price of this respective product increases because these people have an incentive that they will otherwise substitute to another commodity that has become less costly because of the other substitute becoming more costly (Davidson and Smolensky 1964). Unlike the aggregate demand curve, the aggregate supply curve slopes upwards in the short-run. This is as a result of some market imperfections that usually cause the level of output of the economy in the goods market to deviate (Barro 1994). The relationship between the AS-AD models is shown below.
Long-run Aggregate Supply
Short-run Aggregate Supply
Price level
Aggregate Demand
Output
From the graph above, the point of intersection of the short-run aggregate supply curve, the long-run aggregate supply curve and the aggregate demand curve represents the equilibrium price level and the respective equilibrium level of output in the goods market. Aggregate demand is simply the primary cause of the shifts in the product market. In this view, the expansionary policy normally shifts the aggregate demand curve to the right while the contractionary policy shifts it to the left. This is in the long run because in the aggregate supply level is fixed by the respective production factors (Barro 1994). In this case, the short-term aggregate supply does shift to the left so that the only significant effect on the aggregate demand level is the change in the exhibited price level (Davidson and Smolensky 1964). This is shown in the graph below.
Graph of an expansionary shift in the AS-AD model.
Long run Aggregate Supply
Short run Aggregate Supply1
Short run Aggregate Supply2
Price LevelC
B
A
Aggregate Demand1
Aggregate Demand2
Output
As a result of the shifts, the intersection point has also shifted from point A to B. At point B, both the level of output and price have increased. Therefore, point B marks the long run equilibrium (Barro 1994).
Additionally, it is important to note that cases of shifts of the aggregate supply curve in the short run occur rarely as compared to the shifts in the aggregate demand curve. Mostly, when the short run aggregate supply shifts, it is usually as a resultant effect or response to the shifts in the aggregate demand curve (Ball and Mankiw 1995). However, there are cases where the aggregate supply curve c...