Market Clearing - On Market Clearing

On Market Clearing

A market clearing price is the price of goods or a service at which quantity supplied is equal to quantity demanded, also called the equilibrium price. Another market clearing price may be a price below equilibrium price to stimulate demand.

In simple terms, this means that markets tend to move towards prices which balance the quantity supplied and the quantity demanded, such that the market will eventually be cleared of all surpluses and shortages (excess supply and demand). The first version assumes that this process occurs instantaneously.

If, for example, a community is subject to a terrorist attack, its members might become more anxious and insecure, leading to an increased demand for means of protection (such as weapons). The market will be temporarily out of equilibrium, suffering from an excess demand (shortage). But if markets are free to operate (i.e., if prices are free to change), and given enough time, prices will increase causing (1) manufacturers to produce more weapons in the short run and (2) new companies to enter the market in the longer run. This increase in production brings supply into balance with the new demand. The adjustment mechanism has cleared the shortage from the market and established a new equilibrium. A similar mechanism is believed to operate when there is a market surplus (glut), where prices fall to end the excess supply.

For 150 years (from approximately 1785 to 1935), the vast majority of economists took the smooth operation of this market-clearing mechanism as inevitable and inviolate, based largely on belief in Say's law. But the Great Depression of the 1930s caused many economists, including John Maynard Keynes, to doubt their classical faith. If markets were supposed to clear, how could ruinously high rates of unemployment persist for so many painful years? Was the market mechanism not supposed to eliminate such surpluses? In one interpretation, Keynes identified imperfections in the adjustment mechanism that, if present, could introduce rigidities and make prices sticky. In another interpretation, price adjustment could make matters worse, causing what Irving Fisher called "debt deflation". Not all economists accept these theories. They attribute what appears to be imperfect clearing to factors like labor unions or government policy, thereby exonerating the clearing mechanism.

Most economists see the assumption of continuous market clearing as not very realistic. However, many see the assumption of flexible prices as useful in long-run analysis, since prices are not stuck forever: market-clearing models describe the equilibrium towards which the economy gravitates. Therefore, many macroeconomists feel that price flexibility is a good assumption for studying long-run issues, such as growth in real GDP. Other economists argue that price adjustment may take so much time that the process of equilibration may change the underlying conditions that determine long-run equilibrium. That is, there may be path dependence, as when a long depression changes the nature of the "full employment" period that follows.

In the short run (and possibly in the long run), markets may find a temporary equilibrium at a price and quantity that does not correspond with the long term market clearing equilibrium. For example, in the theory of "efficiency wages," a labor market can be in equilibrium above the market-clearing wage, since each employer has the incentive to pay wages above market-clearing to motivate their employees on the job. In this case, equilibrium wages (where there is no endogenous tendency for wages to change) would not be the same as market-clearing wages (where there is no classical unemployment).