If economists were good at business, they would be rich men instead of advisers to rich men.
In order to better understand the market’s forces, we need to handle three concepts which are very simple but also very powerful. You may want to go back to our little supply and demand post before moving on. If you know it already, let’s then move on.
When supply equals demand, we say that the market is in equilibrium. This means that all the goods and services produced are accommodated at a given price and no demand is left unattended. This is also called a clear market.
Equilibrium is a characteristic of free markets. When market imperfections exist, the market may take some time to clear. An example: when guarantee prices for commodities exist. Let’s say wheat’s producers are guaranteed a minimun price for metric ton. If the wheat demand goes down, the price of wheat won’t, because the price that they receive is guaranteed, the farmers are encouraged to keep their previous levels of production. The result is excess demand:
Pg is the guaranteed price, which produces Q1. When the demand curve moves downwards, Q2 becomes the new quantity which the market demands, thus the new price should be Pr, but because producers are still receiving Pg, they continue to produce Q1. The market only accommodates Q2, so the difference is now an excess.
In the agricultural sector, the excess is often bough by the government and then either sold with a loss, or pour into the ocean. Haven’t seen those Braziliean cargo ships pouring coffee into the Atlantic?
In the labour market, this would be manifested throught unemployment. Salaries can’t go down, and the market can only accommodate Q1 at the current wages, so, the excess is people either fired or not being able to find a job.
Price flexibility is crucial for continuous equilibrium in markets. If prices are flexible they adjust quickly to changes in supply or demand, so market equilibrium is restored. When a price takes to long to adjust downwards, is called a sticky price. Sticky prices have a considerable practical significance. At the onset of a economic recession, a slowdown in growth triggers cuts in production and drop in demand for goods and services. Unemployment rises; both labour income and business profits fall. The negative effect is worse if prices cannot adjust fast enough.
The most perfect market, the one that clears fastest, is the Capital Market. The price of money is the interest rate; the slightest adjust and capitals fly all over the world. The sticker price is labour, which due to regulations usually never moves downwards directly.
These apparent boring subjects will be very useful when we’ll examine Fair Trade price scheme. As reward for bearing with me during all this economic jargon, which I know may be pretty hard, here is THE funniest video: