Overview – Demand, Supply and Prices

Have you ever wondered how things function in our economic system? Let’s take the city of Johannesburg as an example:

Apart from the millions that live there, thousands travel to and from this metropolitan beehive of activity every day. All these people must be able to buy food, obtain transport, find accommodation and have access to hundreds of other services on a daily basis in order to survive. How is it possible that the residents of greater Johannesburg can sleep peacefully without fearing some breakdown in the economic services on which their lives depend? Who makes such a massive but efficient organisation possible? Who is the master organiser behind all this?

The answer to the above questions is simply that nobody is responsible.

Yes, the answer to all these questions is that no single authority or organisation is responsible for the smooth functioning of the economic system. What in fact happens is that all the millions of actions by consumers, producers and businesses are directed and coordinated by a system of markets and the prices that are established on them. The coordination occurs invisibly in the sense that nobody is consciously aware of the coordinating process. By pursuing their own interests, every player in the economic process ensures the wellbeing of the community at large.

The process may be summed up in the following way:

A market economy is an elaborate mechanism for the unconscious coordination of people, activities and businesses through a system of prices and markets. It is a communication device for pooling the knowledge and actions of millions of diverse individuals. Without central intelligence or computation, it solves a problem that the largest super-computer could not solve today, involving millions of unknown variables and relations. Nobody designed the market; yet it functions remarkably well.

The two crucial words in the above are market and prices. In this unit, we will start building an economic model of a market in which the price of a good or service is determined by the forces of demand and supply.

In our circular flow model, it is in the goods market that households (consumers) buy their goods and services and the producers supply their goods and services. Two active participants in this market are households, as the demanders of goods and services, and firms, as the suppliers of goods and services. It is through the interaction between the demanders and suppliers of a good or service that the price is determined. In this unit, we take a closer look at what lies behind demand, supply and the determination of a price in a market.

Every good, service or factor of production which can be traded has a market. A market is any situation where potential buyers and sellers come into contact with one another in order to establish the price and quantity of a good or service that will be bought and sold. When a person speaks of a market, most people assume it to be a visible concrete market such as a specific building, for example the municipal fresh produce market in Pretoria. The market is not necessarily a specific place or building; it may also be invisible or abstract as in the case of the black market or the labour market. Furthermore, a market does not have to be local, because all potential buyers and sellers throughout the world can communicate by post, telephone, fax or the internet, as in the case of foreign exchange markets, as well as the markets for gold, diamonds and certain raw materials. In these cases, we can speak of world markets.

Watch the following video clips for an introduction on why we study this model and what it is about.