Monday, February 21, 2011

Demand and Supply Discussion - 2

In the earlier blog on Supply and Demand, we noted the relation between price that he buyer intends to pay and the quantity available at that price. Now we take the next leap and see what happens when the buyer and supplier meets - that is, how the market price of a good gets fixed.

Consider the following situation, I go to the market intending buy some lemons. The last time I went to the market the price of each lemon was Rs 2 each and since I was carrying Rs 10/- I expected to have 5 lemons by the time I return. When I get to the only vendor who was selling lemons on that day, I realize he had put up Rs 4 per lemon. At this rate I would probably get only 2 lemons (given half a lemon is not sold). Given my earlier price peg, I wasn’t willing to pay Rs 4, so I begin negotiating with the vendor and finally we settle at Rs 3/- per lemon and had 3 lemons at Rs 10/-.

This price that both agreed for is the equilibrium price. I began with an expectation that at Rs 10/- I would get 5 lemons, while the vendor wanted to keep it to just 2 lemons for Rs 10/-. I reduced my expectation was happy when I got 3 lemons (and a rupee to take back home) for Rs 10/- and the Vendor didn’t mind giving away 3 instead of 2 lemons. So we “both struck the deal” and agreed at Rs 3/- per lemon. This price, which we both agreed on, is the equilibrium price that is essential for a business transaction to take place between us.

In the next section, we shall look in detail both the consumer (me) and the vendor made the choice - giving us more clarity of why the price got fixed at this equilibrium price.
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