Market clearing

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, assuming that all buyers and sellers have access to information and that there is not "friction" impeding price changes, prices always adjust up or down to ensure market clearing.

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 an earthquake which destroys all of the houses and apartments, its members will have a sudden increased demand for new housing. Immediately after the disaster, the market for housing in the community will be temporarily out of equilibrium, suffering from an excess demand for houses and apartments (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) construction companies to build new houses in the short run and (2) new companies to enter the house and apartment-construction 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 until all the excess supply is sold off. An example of excess supply is Christmas decorations that are still in stores several days after Christmas; the stores that still have boxes of decorations view these products as "excess supply", so the prices are discounted until shoppers buy all the decorations (to keep them until next Christmas).

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