Price is dependent on the interaction between demand and supply components of a market. Demand and supply represent the willingness of consumers and producers to engage in buying and selling. An exchange of a product takes place when buyers and sellers can agree upon a price.
At any price below P, the quantity demanded is greater than the quantity supplied. In such a situation, consumers would clamour for a product that producers would not be willing to supply; a shortage would exist. In this event, consumers would choose to pay a higher price in order to get the product they want, while producers would be encouraged by a higher price to bring more of the product onto the market. The result is a rise in price, to P, where supply and demand are in balance. Similarly, if a price above P were chosen arbitrarily, the market would be in surplus with too much supply relative to demand. If that were to happen, producers would be willing to take a lower price in order to sell, and consumers would be induced by lower prices to increase their purchases. Only when the price falls would balance be restored.
A market price is not necessarily a fair price, it is merely an outcome. It does not guarantee total satisfaction on the part of buyer and seller. Typically, some assumptions about the behaviour of buyers and sellers are made, which add a sense of reason to a market price. For example, buyers are expected to be self-interested and, although they may not have perfect knowledge, at least they will try to look out for their own interests. Meanwhile, sellers are profit maximisers. This assumption limits their willingness to sell to within a price range, high to low, where they can stay in business.
Let us take a few examples to explain my point:
Example 1. When a bumper crop develops, supply shifts outward and downward, more product is available over the full range of prices. With no immediate change in consumers' willingness to buy crops, there is a movement along the demand curve to a new equilibrium. Consumers will buy more but only at a lower price. How much the price must fall to induce consumers to purchase the greater supply depends upon the elasticity of demand.
Example 2. A decline in the preference for beef is one of the factors that could shift the demand curve inward or to the left. With no immediate change in supply, the effect on price comes from a movement along the supply curve. An inward shift of demand causes price to fall and the quantity exchanged to fall. The amount of change in price and quantity, from one equilibrium to another, is dependent upon the elasticity of supply.
Two forces contribute to the size of a price change: the amount of the shift and the elasticity of demand or supply. For example, a large shift of the supply curve can have a relatively small effect on price if the corresponding demand curve is elastic. That would show up in Example 1 above if the demand curve is drawn flatter (more elastic). In fact, the elasticity of demand and supply for many agricultural products are relatively small when compared with those of many industrial products. This inelasticity of demand has led to problems of price instability in agriculture when either supply or demand shifts in the short-term.
Thus, price determines how a marketplace operates and price is in turn controlled by elasticity of demand first and then supply.
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