 Markets are dynamic, evolving, adapting and changing all around us every day. And whatever the product or service, the market is the space where buyers and sellers come together and interact. Now this interaction can be personal, face-to-face, over the telephone, fax of the internet, through advertisements and through many other means of communication. The purpose of this interaction is to determine prices and exchange goods and services. We've looked at demand and then supply separately in order to understand their function. But of course, in the real world, buyers can't determine prices on their own and neither can sellers. They come together and negotiate in the market. We're now going to look at the market model, which will give us a more realistic understanding of how the economy works. The market model takes the two parties we've looked at so far, the buyers represented by the demand curve and the sellers represented by the supply curve, and puts them together. This model will show us how the interaction of the forces of supply and demand determine the equilibrium price of a product and the equilibrium quantity. So we have another tool to help us understand how economies work, and this one will eventually be able to show us how those key economic questions, what to produce, how to produce, and for whom are answered by markets. To illustrate how prices are determined in a market, we'll take our good old fried chicken example and compare the market demand and market supply. In the first column, we have the different prices for fried chicken. In the second column, the quantity demanded at those different prices. And in the third column, the quantity supplied. Now somewhere in this table, we'll find our dream position, a point where the quantity demanded is equal to the quantity supplied. It's clearly not at a price of seven rand. There, the market demand is 1,200 pieces, but the quantity supplied is 4,800. It's also not at two rand, where demand is 4,200 pieces and the quantity supplied only 1,800. But at a price of four rand, the quantity demanded is 3,000 pieces and the quantity supplied is also 3,000 pieces. Yes, at a price of four rands, the quantity demanded is equal to the quantity supplied and this position is known as market equilibrium. In this case, the equilibrium price is four rand and the equilibrium quantity demanded and supplied is 3,000. This market equilibrium position indicates that no market participant has any reason to change his or her behaviour. Buyers and sellers are happy to trade at that price and there are no further pressures on prices and quantities in the market to change. The plans of the buyers exactly match the plans of the sellers. At any other price, the market is in disequilibrium, meaning that some of the market participants are frustrated in their plans and will change their behaviour. Pressure on the market to change exists when it is out of equilibrium. Apart from the equilibrium at a price of four rand, see if you can work out what's happening at some of the other prices. Who will be the frustrated market participant in each case? The buyer or seller? If we take the market at six rand, the quantity supplied is 4,200 pieces but buyers only want 1,800 pieces so there's more than is needed to meet their needs. They're not bothered but the producers who hope to sell all 4,200 pieces are in a spot because the market is only taking 1,800. We have what's called an excess supply in the market. The excess supply is the difference between what they plan to sell and what consumers actually bought. In this case, 2,400 pieces of fried chicken. The last thing we want to do is throw away the 2,400 pieces of chicken. So what can we do as suppliers to cut our losses and sell more chicken? Well, the first and most obvious course of action is to lower the price, to try and lure buyers back to consume more. As all the suppliers in the market are in the same boat, sooner or later they'll all do the same thing or suffer further losses. A drop in price will cause an increase in the quantity demanded. Customers will want more. Now, what's happening in the market is that downward pressure is being exerted on the price. Suppliers are competing with one another to sell more fried chicken and they do that most often by lowering their prices. And this downward pressure will continue until market equilibrium is reached at a price of four round and at an equilibrium quantity of 3,000 pieces. At this point, the plans of buyers exactly match the plans of sellers. At one round the quantity demanded is 4,800 but the quantity supplied is only 1,200 pieces so the buyers are frustrated. They'd like to buy 4,800 pieces but the suppliers are only prepared to produce 1,200 pieces at that price. This is what economists call excess demand and it's equal to the difference between the quantity demanded and the quantity supplied. So 4,800 minus 1,200 is equal to 3,600 so an excess demand of 3,600 pieces of fried chicken exists in the market. In this case, it is the buyers who now compete with one another trying to get hold of more chicken. The upward pressure continues to drive prices up until market equilibrium is reached at a price of four round where demand and supply are equal. From our discussion so far, we can conclude that at a price higher than the equilibrium price an excess supply exists in the market and this will sooner or later put in motion forces that exert a downward pressure on prices. But at a price lower than the equilibrium price demand exists and this will start an upward pressure on prices in the market. We can see that there are forces that will always push this market towards equilibrium and when that is reached, the pressure relaxes. The market naturally seeks its own equilibrium. As we've done before, we can now use this table to analyse the behaviour of the market demand and supply curves. The demand curve shows how the quantity demanded changes if the price changes. If the price drops from five round to three round quantity demanded jumps from 2,400 to 3,600. Our supply curve, also based on the information in the table shows how the quantity supplied changes if the price changes. This price drop from five to three round causes the quantity supplied to fall from 3,600 to 2,400. Putting the two curves together, we get a picture of the state of the market. The demand curve reflects the behaviour of consumers and the supply curve the behaviour of suppliers. We can see that market equilibrium takes place at the point where the two curves intersect at the price of four round where the quantity demanded matches the quantity supplied 3,000 pieces of fried chicken. At this point, the plans of consumers exactly match the plans of suppliers. Note that in this market there is only one possible equilibrium position also known as the market clearing position where everything that's produced is consumed and both buyers and sellers are satisfied. At a price of six round an excess supply exists and this excess supply causes downward pressure on the price and as the price declines the quantity demanded increases and the quantity supplied decreases. This process continues until equilibrium is reached. At a price of two round an excess demand exists. Now this excess demand causes upward pressure on the price and as the price increases the quantity demanded decreases and the quantity supplied increases. This process continues until equilibrium is reached. To summarise that an excess supply forces sellers to compete more aggressively putting downward pressure on prices which declines until market equilibrium is reached. An excess demand in the market means buyers will compete with one another to get hold of the product and this forces prices to rise until market equilibrium is reached again. So that's the market model. We're slowly getting better equipped to understand the inner workings of the markets and our economy. In the next episode we're going to use these tools again. We'll try to find out what lies behind the often erratic and turbulent changes in demand and supply.