d. How a market allocates resources

We have shown how supply and demand combine to give a single stable price and output - the equilibrium. But what happens when something comes along and upsets this equilibrium?

Economists call anything which moves a market out of equilibrium a shock. Shocks could come from shifts in demand caused by such things as changes in income or from shifts in supply caused by such things as a change in costs. In each case the shock upsets the market equilibrium. How will the market respond?

How the market responds to a shock

Let's analyse the reaction by looking at a demand shock caused by a rise in people's incomes. How will the osteopathy market react? The graph below, Figure A, shows the initial supply and demand curves - SS and DD. The initial market equilibrium (see Figure B) is at a price P' and quantity Q'.

 Figure A Figure B

Now imagine that there is an increase in people's income. The demand curve will shift outwards (see Figure C) to D'D' because people (see Figure D) are willing to buy more osteopathy treatments at the same price (osteopathy is a normal good). This shift in demand throws the market out of equilibrium. Now people want to buy Q"' treatments at price P' but the osteopaths are still only prepared to sell Q' at that price. The result is excess demand (see Figure E) and unsatisfied buyers who react by 'bidding up' (see Figure F) the price. The rise in price simultaneously reduces the demand (see Figure G) and increases the supply until the market regains equilibrium (see Figure H) at a new price and quantity.

 Figure C Figure D Figure E Figure F Figure G Figure H

The rise in people's incomes has led to a new equilibrium at a higher price P" (see Figure I) and a higher quantity Q" than before.

 Figure I

 
This process will occur whenever there is shock leading to either a shift in demand or supply. The market will move out of equilibrium with either excess demand or excess supply appearing. The price will then adjust until equilibrium is regained.

The 'invisible hand'

We have just demonstrated that our free market will automatically produce an equilibrium price and quantity. It is this which makes it a very powerful allocation system. (See Unit 1). This is what Adam Smith (the founding father of economics) referred to as the "invisible hand".

Who decides how much osteopathy is to be produced? The answer in a free market is consumers. They go out and buy osteopathy treatments and the price they are prepared to pay sends signals to the osteopaths. The osteopaths respond by producing either more or less treatment. The market not only allocates resources automatically, it does so efficiently. Providing certain conditions are met, the free market will achieve a Pareto efficient allocation. (See Unit 1).

From price mechanism to a Pareto efficient allocation

For the consumer, the price they are willing to pay measures the benefit or utility that the consumers expect to receive from consuming the last unit. To be precise, the demand curve reflects the marginal utility (extra benefit) that consumers receive from consuming the last unit. Consumers only buy something if it is worth as much as or more than the other things that the same money could buy. So if the price of something is greater than the benefit they get from consuming it, they will not buy it.

For the producer or seller, the price they are willing to accept measures the cost of the resources involved in the production including the supplier's own time and effort. Again to be precise, the supply curve reflects the seller's marginal costs (the cost of producing an extra unit). Thus when a market is in equilibrium, marginal benefit equals marginal cost equals price. The benefit received from the last unit consumed will exactly equal the resource cost of producing that unit. This fulfils the condition for allocative efficiency. Competing producers chasing maximum profits will always choose the least cost combination of factors to produce a given output. Consequently, the free market will also be productively efficient.