Price determination in a free market

In a free market, price is set by the interaction of demand and supply. Buyers and sellers effectively “agree” a price through trading: if buyers won’t pay a price, they buy less; if firms can’t sell enough, they change what they charge. Over time, these choices push the market toward a stable outcome.

A market is any system that brings buyers and sellers together, either in person or online.

Market equilibrium

Equilibrium is when quantity demanded equals quantity supplied. The price at this point is the equilibrium price,Pe (also called the market-clearing price) because there is no shortage and no surplus.

• If price is above equilibrium, there is a surplus (excess supply).

• If price is below equilibrium, there is a shortage (excess demand).
  

How markets move back to equilibrium

Markets don’t stay perfectly balanced. Any change in demand or supply creates disequilibrium, which leads to price changes that move the market back toward equilibrium.

Shortage (excess demand)

A shortage exists when Qd > Qs, as we can see on the diagram at price P1 quantity demanded is at Q2 ( remember go from the price of P1 and to work out quantity demanded look at where the price intersects the demand curve) . However quantity supplied at the same price of P1 is only at Q1 , this therefore means there is a shortage in the market represented by the distance between Q1 and Q2

How This shortage is solved ? .

• Consumers compete for the limited supply, and firms see stock selling out rapidly. This signals to firms that demand is greater than supply at the current price.

• As firms are profit maximisers , they have an incentive to raise prices.

• A higher price causes a contraction in demand (Qd falls) as higher prices ration consumers demand . 

•  And an extension in supply (Qs rises) as at higher prices producers are more incentivised to supply

• The shortage shrinks until a new equilibrium is reached.
  

Surplus (excess supply)

A surplus exists when Qs > Qd, as we can see on the diagram at the price of P1 quantity demanded is at Q1. However quantity supplied at the same price of P1 is at Q2 , this therefore means there is a surplus in the market represented by the distance between Q1 and Q2

How This surplus is solved ? .

• Firms struggle to sell stock, so this signals for firm to cut prices.

• As firms are profit maximisers, they have an incentive to lower prices.

• A lower price causes an extension in demand (Qd rises) as goods become more affordable, and a contraction in supply (Qs falls) as lower prices reduce firms’ incentive to supply.

• The surplus shrinks until a new equilibrium is reached.
  

Shifts in demand and supply 

Real world application: changes to demand that increase price

In 2025 due to social media trends the demand for crocs increased . This led to an increase in demand from D to D1 . This means at the original market price of Pe excess demand exists and the demand for crocs is higher than the supply . Suppliers raise their prices in response ,leading to a contraction of demand (higher prices rations consumers) and an extension of supply (more incentive at higher prices for producers) leading to new equilibrium being established at price P1 and Quantity Q1.