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Question
Explain how prices are determined in a free-market economy.
In a free-market economy prices are determined by the interaction of supply and demand.
Supply is the relationship between the price of a good and the quantity producers are willing to sell in a given time period. The supply relationship can be illustrated with a graph. This graph will show that the higher the price, the more producers are willing to sell.
Demand is the relationship between the price of a good and the quantity people are willing to buy in a given time period. This relationship can also be illustrated with a graph. The graph will show that the higher the price, the less people are willing to buy.
The equilibrium price of a good is the price where the quantity supplied is equal to the quantity demanded. On a graph, it is found where the supply curve intersects the demand curve. The market price of a good tends to move toward this equilibrium price. If the market price is higher than the equilibrium price, quantity supplied will exceed quantity demanded, and this surplus will put downward pressure on price, moving the market toward equilibrium. If the market price is lower than the equilibrium price, the quantity demanded will be greater than the quantity supplied. Thus, a shortage will exist which will put upward pressure on the market price. The upward movement of price will move the market toward equilibrium. Once the equilibrium price is achieved, there is neither a shortage nor a surplus. Thus at the equilibrium price there is no further pressure for price to rise or fall (unless something happens to cause the supply or demand relationships to change).
Answer
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