Market clearing

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In economics, market clearing is the process by which, in an economic market, the supply of whatever is traded is equated to the demand, so that there is no leftover supply or demand. The new classical economics assumes that, in any given market, prices always adjust up or down to ensure market clearing.

Mechanism and examples

A market-clearing price is the price of a good or service at which quantity supplied is equal to quantity demanded, also called the equilibrium price. The theory claims that markets tend to move toward this price.

For a one-time sale of goods, supply is fixed, so the market-clearing price is simply the price at which all items can be sold, but no lower. (Demand can be adjusted by setting the price appropriately, perhaps through an auction mechanism.) In this case, the marketplace is literally cleared of all goods.

For a market where goods are produced and sold on an ongoing basis, the theory predicts that the market will move toward a price where the quantity supplied in a broad time period will equal the quantity demanded. This might be measured over a period like a week, month or year, to smooth out irregularities caused by manufacturing in batches, and delivery schedules; sellers often have a buffer of inventory, so that products are always available for retail sale.

If the sale price is higher than the market-clearing price, then supply will exceed demand, and a surplus inventory will build up over the long run. If the sale price is lower than the market-clearing price, then demand will exceed supply, and in the long run shortages will result, where buyers sometimes find no products for sale at any price.

The first version of market-clearing theory assumes that the price adjustment 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.

History and non-ideal behavior

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 inviolable, 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).

See also