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I've learned what the principle of supply and demand says, and would paraphrase it like this:

The price of a good is at equilibrium when supply and demand are equal.

Or with other words:

The price of a good is dictated by the principle of supply and demand when supply and demand are equal.

My question is:

How does the principle (or even law) of supply and demand work in practice? Which forces force the price to be at equilibrium?

That's what I came up with (a very raw model):

  1. The producer or seller of a product notices that the product sells better than before.
  2. From this he draws the conclusion that there is a bigger need for the product: consumers want to have it more urgently than before.
  3. That means, consumers will probably be willing to pay a higher price for it than the current one.

Now there are different cases:

  1. The producer can produce as much of the good as he could sell. He does so and sells it for the old price (making people happy). Or he takes a higher price (because he can, but not too high).

  2. The producer can not produce as much of the good as he could sell.
    a) He doesn't want to grow, so he produces as much as he can and sells it for the old price ("first come first serve"). Or he takes a higher price (but not too high).
    b) He grows (taking credits) and raises the price to compensate the interests to be paid. Or he raises the price even more (because he can, but not too high).

Which of these scenarios is mainly responsible for rising prices in case a good is demanded more strongly?

And what is responsible for rising prices of goods with no rise of demand? (Is this only a collateral effect?)

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  • $\begingroup$ I believe this is explained in the 'market equilibrium' chapters of intro textbooks. $\endgroup$ – Giskard Jun 5 '19 at 15:06
  • $\begingroup$ "And what is responsible for rising prices of goods with no rise of demand? (Is this only a collateral effect?)" Alas, it depends on why the prices of goods rose. It could be a temporary decrease in supply, it could be that production became more costly, it could be other things. $\endgroup$ – Giskard Jun 5 '19 at 15:07
  • $\begingroup$ @Giskard: Is it (explained in the sense I'm targeting at)? Could you please give me one single reference? $\endgroup$ – Hans-Peter Stricker Jun 5 '19 at 15:09
  • $\begingroup$ @Giskard: The questions arise: Why did the prices of other goods rise? Why and how do temporary decreases in supply rise prices, why and how does production become more costly? $\endgroup$ – Hans-Peter Stricker Jun 5 '19 at 15:12
  • $\begingroup$ 1. A reference: Hal Varian: Intermediate Microeconomics, 8th edition, Chapter 16, page 294. 2. "Why did the prices of other goods rise?" Who says they did? I was quoting you. 3. "why and how does production become more costly" Some input used perhaps became more costly. The union negotiated higher waged, the government taxed fossil fuels, there was bad whether and cocoa crop became more scarce, take your pick. $\endgroup$ – Giskard Jun 5 '19 at 16:57
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You need to take into account the cost of producing a good as well. In most cases, the marginal cost of producing something is increasing. A profit-maximizing producer would want to produce until price is equal to marginal cost. That means that scenario 2 is responsible.

For the case of rising prices with no increase in demand, just think about the basic demand and supply model. What could cause an increase in equilibrium price without the demand's changing? (Hint: a shift in ____). What could cause that shift?

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When the supply fully meets demand, there is no deficit of goods and price depicts Cost+General markup in the market. So the price is equal and fair for all participants of the market.

When supply is greater than demand, there are too many goods, so the price has to go down for you to sell goods and as a supplier you need to sacrifice either cost(quality) or markup. The price is not equal and fair.

In reverse when demand is greater than supply prices will inflate, as it is natural for the businesses trying to reap they rewards. The price is not equal and fair.

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Simple Supply and Demand Figure

Let's assume familiarity with the S&D model's components for now. Imagine a seller comes to the market anticipating price A. (Their anticipation is wrong, the real price is equilibrium, found by the vertical height where S&D meet.)

They pay workers overtime, hire a few extra workers to produce F units, and this drives their costs up. When they arrive at the market, only E units are sold. Customers don't want to pay price A, they are not willing & able to do so. This results in a surplus of size (F-E), aka whatever is leftover.

So the seller will 'learn" that prices of type A (over the equilibrium by any amount) are too high of a price. However that learning takes place is up to you. As you get used to the theory, you will eventually realize the rational agent simply is aware of the appropriate price and charges exactly the correct one, immediately and without error.

Let's make sure we eliminate prices of type B, prices under the equilibrium. If an employer anticipates the product will be sold for price B in the market, they do not hire as many workers for overtime (since the worker's efforts will not be profitable). They arrive at the market and this time, they have E units. Customers observe the price is one they are happy paying, and attempt to buy F units. There is a shortage of (F-E) units, people are clamoring at the the door of the store attempting to buy more of the product. They could have charged more for the product.

Therefore, firms also learn that prices under the equilibrium (like B) are too low. Since above the equilibrium (A) is too high, and (B) is too low, eventually, they stay quite comfortably where S&D meet.

Again, in theory, no exploration is needed, they will simply be aware of the situation and produce at that point.

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