In economics

Economics

Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...

, market clearing refers to either

1. a simplifying assumption made by the new classical school that market
   Market
   A market is one of many varieties of systems, institutions, procedures, social relations and infrastructures whereby parties engage in exchange. While parties may exchange goods and services by barter, most markets rely on sellers offering their goods or services in exchange for money from buyers...
   
   s always go to where the quantity supplied equals the quantity demanded; or
2. the process of getting there via price adjustment.

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

Say's law

Say's law, or the law of market, is an economic principle of classical economics named after the French businessman and economist Jean-Baptiste Say , who stated that "products are paid for with products" and "a glut can take place only when there are too many means of production applied to one kind...

. But the Great Depression

Great Depression

The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...

 of the 1930s caused many economists, including John Maynard Keynes

John Maynard Keynes

John Maynard Keynes, Baron Keynes of Tilton, CB FBA , was a British economist whose ideas have profoundly affected the theory and practice of modern macroeconomics, as well as the economic policies of governments...

, to doubt their classical faith. If markets were supposed to clear, how could ruinously high rates of unemployment

Unemployment

Unemployment , as defined by the International Labour Organization, occurs when people are without jobs and they have actively sought work within the past four weeks...

 persist for so many painful years? Was the market mechanism not supposed to eliminate such surpluses? In one interpretation

New Keynesian economics

New Keynesian economics is a school of contemporary macroeconomics that strives to provide microeconomic foundations for Keynesian economics. It developed partly as a response to criticisms of Keynesian macroeconomics by adherents of New Classical macroeconomics.Two main assumptions define the New...

, 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

Irving Fisher

Irving Fisher was an American economist, inventor, and health campaigner, and one of the earliest American neoclassical economists, though his later work on debt deflation often regarded as belonging instead to the Post-Keynesian school.Fisher made important contributions to utility theory and...

 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

Economic growth

In economics, economic growth is defined as the increasing capacity of the economy to satisfy the wants of goods and services of the members of society. Economic growth is enabled by increases in productivity, which lowers the inputs for a given amount of output. Lowered costs increase demand...

 in real GDP

Gross domestic product

Gross domestic product refers to the market value of all final goods and services produced within a country in a given period. GDP per capita is often considered an indicator of a country's standard of living....

. 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

Path dependence

Path dependence explains how the set of decisions one faces for any given circumstance is limited by the decisions one has made in the past, even though past circumstances may no longer be relevant....

, as when a long depression changes the nature of the "full employment

Full employment

In macroeconomics, full employment is a condition of the national economy, where all or nearly all persons willing and able to work at the prevailing wages and working conditions are able to do so....

" 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

Endogenous

Endogenous substances are those that originate from within an organism, tissue, or cell. Endogenous retroviruses are caused by ancient infections of germ cells in humans, mammals and other vertebrates...

 tendency for wages to change) would not be the same as market-clearing wages (where there is no classical unemployment).