Ch.

2 The price system and the microeconomy

What is price mechanism?

 It is the means through which scare resources (factors of

production) are allocated in a market economy.

Functions of price mechanism

1. Signalling – prices act as a signal to both producers and consumers.

Ex. if there is excess demand for a product due to a fall in
quantity, this indicates to the producer that they must supply
more of the product in the market. In turn, if consumers withhold
their demand, it signals to the producers that they must lower
price and in turn produce less.
2. Rationing – if a producer wants to retain exclusivity for their
product, they may limit the supply of the product in the market,
thereby driving its price up and in turn restricting its demand.
3. Transmission of preferences – this means that if consumers do not
buy a particular product because they don’t like it, or it is not
priced to their liking, then this message is transmitted back to the
producer.

Demand

 It is the quantity consumers are willing to and able to buy at

different prices, ceteris paribus
 Notional demand – willingness to buy a product, which is not
backed up by the ability
 Effective demand – both willingness and ability to buy a product
 Individual demand is the demand of one person/one household
 Market demand is the demand of the entire economy for a
particular product
Law of demand

 The higher the price of a good, the less people will demand that
good. In other words, the higher the price, the lower the quantity
demanded. The amount of a good that buyers purchase at a higher
price is less because as the price of a good goes up, so does the
opportunity cost of buying that good.
 Exception - luxury items also known as Veblen goods, such as
diamonds. If the price of a diamond goes up then it will hold more
value and will make it demanded buy more no. of people.
 Another example is speculative demand a rise in the price of a
share creates an impression among buyers that its price will rise
further.

Price

This is a demand curve. It is

downwards sloping as it depicts the
P inverse relation between demand
and price. When price rises, demand
P1
falls and vice versa. In the figure, as
price fell from P-P1, quantity

D demanded rose from Q-Q1.

0 Q1
Q Quantity
demanded

 There is a linear and continuous relationship between demand and

price. It is time based and is made on the assumption of ceteris
paribus.
Movements in the demand curve

Price ($) The figure shows a demand curve. As price

25 falls, demand rises. At price $15, 60 units

of a good is demanded. But, when this
price falls to $13, 115 units of the same
15
good are demanded as more people are
willing and able to buy it. This shows
13
demand has increased. This is known as
EXTENTION in demand.

0 Quantity demanded
60 115 250 Quantity demanded

The figure shows a demand curve. As price

Price ($) rises, demand falls. At price $13, 115 units
of a good are demanded. But, as price rises
25
to $15, demand falls to 60 units the same

15 good as people are less willing to spend more

money for the same good. This shows
13 demand has fallen. this is known as
CONTRACTION in demand.

60 115 250 Quantity demanded

 A change in demand, due to factors other than price causes a SHIFT

in the demand curve.
 A rise in demand, due to factors other than a fall in price causes a
shift to the right.
 A fall in demand, due to other factors than a rise in price causes a
shift to the left.
Price

The figure shows a right shift in the demand

curve. This shows a rise in demand, due to
factors other than a fall in price. This is
shown by a shift from D-D1.
D1

D
0
Quantity
demanded

Price

The figure shows a left shift in

the demand curve. This shows a
fall in demand, due to factors
other than a rise in price. This is
shown by a shift from D-D1.
D

D1
0 Quantity
demanded

Factors affecting demand

1. Disposable income –
 Increase in income, increases purchasing power causing
demand to rise and a right shift in the demand curve.
 Decrease in income, decreases purchasing power causing
demand to fall and a left shift in demand curve.
  Normal goods – these are goods whose demand rises as
income rises and falls as income falls
 Inferior goods – these are goods whose demand falls as
income rises and rises as income falls.
2. Changes in prices of related goods –
 Substitutes – these are products or services which can be
replaced with one another.
 Complements – these are goods which are used together.
They have joint demand.
 A rise in prices of substitutes causes a rise in demand for your
good as consumers will switch from your competitors to your
products causing a right shift in the demand curve.
 A fall in prices of substitutes causes a fall in demand for your
good as consumers will switch to your competitors, causing a
left shift in demand curve.
 A rise in price of complements will cause a fall in demand for
your good as people won’t have enough money to spend on
both and both goods need to be consumed together. This will
cause a left shift in the demand curve.
 A fall in price of complements will cause a rise in demand for
your good as consumers will find it easier to buy the
complement causing a rise in demand for your good, leading
to a right shift in demand curve.
3. Changes in age and population structure –
 Demand for certain goods and services depends on size,
gender and age composition of the country
4. Fashion, tastes and attitudes –
 These are a matter of individual behaviour
 It depends on culture, personal taste, etc.
 Sometimes it is influenced through advertising
 5. Expectation of future prices –
 If a person believes price of a product will rise in the future,
they will buy more of the good now causing a shift to the
right. (speculation)

Supply

 Supply is the willingness and ability of a firm to sell/produce a

product.
 Supply of one firm– INDIVIDUAL SUPPLY
 Supply of the entire market/economy – MARKET SUPPLY
 As price rises, firms will be more willing and able to produce and
sell goods/services, showing a positive relation between price and
supply.
 As price rises supply rises.
 As price falls supply also falls.
 A change in price (increase/decrease) causes a MOVEMENT along
the supply curve
 An increase in price causes an EXTENTION in supply, upward
movement
 A decrease in price causes a CONTRACTION in supply, downward
movement

Price
Supply
This figure shows the positive relation
between supply and price. As price rises,
supply also rises, indicated in the upward
sloping supply curve.

0
Quantity supplied
 The figure shows a supply curve. As price
Price
Supply rises, supply also rises. At price $18, 85

30 units of a good is supplied. But, when this

0 price rises to $30, 120 units of the same
18 good are supplied. This shows supply has
increased. This is known as EXTENTION in
supply.

0 Quantity supplied
85 120

The figure shows a supply curve. As

price falls, supply also falls. At price
Price
Supply $30, 120 units of a good is supplied.
30 But, when this price falls to $18, 85
units of the same good are supplied.
18
This shows supply has decreased. This
8
is known CONTRACTION as in
supply.
0 85 120 Quantity supplied

 A change in supply, due to factors other than price causes a SHIFT in

the supply curve.
 A rise in supply, due to factors other than a rise in price causes a shift
to the right.
 A fall in supply, due to other factors than a fall in price causes a shift
to the left.
Price

S The figure shows a right shift in the

supply curve. This shows a rise in
S1
supply, due to factors other than a
rise in price. This is shown by a
shift from S-S1.

0 Quantity
supplied

Price

S1

S The figure shows a left shift in the

supply curve. This shows a fall in supply,
due to factors other than a fall in price.
This is shown by a shift from S-S1.

0 Quantity
supplied

Factors affecting supply

1. Costs –
 Change in price of factors of production
 Factors of production become cheaper causing a
fall in average costs, increasing supply
 Factors of production become expensive, increasing
unit costs leading to lower supply
 Change in productivity of factors of production
  High productivity, lower wastage, lower
average costs, increase supply
 Low productivity, higher inefficiency, higher
costs, lower supply
2. Government policies –
 Taxes -
 Tax is a payment made to the government
 Lower taxes reduce costs for producers, increasing supply
 Higher taxes lead to higher costs for producers, lowering
supply
 Subsidies –
 A form of payment by the government to encourage
production of a product
 Higher subsidies to the producer, lower costs, increased
supply
 Lower subsidies to the producer, higher costs, decreased
supply
3. Weather conditions –
 Affects mostly agricultural products
 Good weather, better production, higher supply
 Bad weather, poor production, low supply
4. Size and nature of industry –
 Expanding market, higher supply
5. Actions of competitors –
 If competitors lower supply, you will be able to supply
more as demand will rise
6. Changes in prices of other products –
 Joint supply – when 2 items are produced together
 A rise in supply of one will automatically lead to a rise in
supply of another
 Equilibrium price
 It is the price level where demand = supply
 There is no shortage (demand higher than supply) or surplus
(supply higher than demand)
 Disequilibrium is when demand is not equal to supply (there’s
either a surplus or shortage)

The figure shows the equilibrium

Price price and demand. At $20, people
Supply
are demanding 100 units of a good
and producers are also supplying
only 100 units. This shows,
20 Equilibrium everything that is produced is sold,
no shortage or surplus. Therefore,
$20 is known as the equilibrium
price level and 100 in known as the

Demand equilibrium quantity demand and

supply.
0 100
Quantity

Price
The figure shows a disequilibrium
Supply
with a surplus. At price $33,

33 producers are willing to supply

125 units of a good but demand is
25 only 75. Therefore, producers’
lower prices, which causes supply
to CONTRACT and demand to
EXTEND and reach an equilibrium
Demand of $25 with 100 units demanded
and supplied.
0 75 100 125 Quantity
Price
Supply The figure shows a disequilibrium with a
shortage. At price $15, producers are
willing to supply only 60 units of a good
but demand is 130. Therefore, producers’
30
increase prices, which causes supply to
EXTEND and demand to CONTRACT and

15 reach an equilibrium of $30 with 85 units

Demand demanded and supplied.

0 60 85 130 Quantity

Price elasticity of demand (PED)

 It is a numerical measure of responsiveness of demand, to a change

in price.

Percentage change in quantity demanded

PED =
Percentage change in price

Types of elasticity

1. Elastic demand –
 Percentage change in demand is greater than percentage
change in price.
 A small rise in price causes a greater fall in demand. A small
fall in price causes a greater rise in demand.
 PED = greater than 1 (>1)
 Price
The figure shows an elastic
demand curve as a small fall
P1 in price (P1-P2) caused a
P2
larger rise in quantity
Demand
demand (Q1-Q2). This is
shown by a shallow demand
curve as in the figure.

Q2 Quantity
0 Q1

2. Inelastic demand –
 Percentage change in demand is smaller than percentage
change in price.
 A large rise in price causes a small fall in demand. A large fall
in demand will cause a small rise in demand.
 PED = less than 1 but greater than 0 (<0, >1)

Price The figure shows an inelastic

demand curve as a large fall in
P price (P-P1) only caused a
small rise in quantity demanded
P1 (Q-Q1). This is shown by a
steep demand curve as in the
figure.
Demand
0
Q Q1 Quantity

3. Unit elastic demand –

 Percentage change in demand equals percentage change in
price.
  A 10% rise in price will cause a 10% fall in demand. A 10%
fall in price will cause a 10% rise in demand.
 PED = 1
Price

P1
The figure shows a unit elastic
demand curve as the change
in price (P-P1) is equal to the
P2
change in demand (Q-Q1). It
Demand
is a rectangular hyperbola.

0 Q1 Q2 Quantity

4. Perfectly elastic demand –

 A small change causes a complete change in demand.
 A 5% increase in price caused demand to fall to 0. Even, a
2% rise in price caused demand to fall to 0.
 PED = infinity
Price
The figure shows a perfectly
elastic demand curve. It shows
that at price P, the firm can

P sell at Q or Q1, but even a

Demand
small change in price will cause
a complete change in demand.
This is shown by a horizontal

0
demand curve as in the figure.
Q Q1 Quantity

5. Perfectly inelastic demand –

 A change in price has no effect on quantity demanded.
  A 5% increase in price causes demand to remain the same
and a fall in price by 5% also causes the demand to remain
the same.
 PED = 0

The figure shows a perfectly

Price
Demand inelastic demand curve. It shows
that a firm can sell at either P or
P1 but the quantity demanded will
remain at Q. it will not change
P1
even, even if price falls or rises. This
is shown by a vertical line as in the
P
figure.

0 Q Quantity

Interpretation of PED

 The negative sign (-) indicates the inverse relation between demand
and price. PED is always negative.
 The size (number) indicates the extent of change.

Factors influencing PED of a product

1. Range and attractiveness of substitutes –

 If a product has substitutes available, the demand for the
product will be elastic as even a small change in price,
consumers will easily be able to shift to different products.
 If a product doesn’t have substitutes, the demand will be
inelastic as consumers won’t have an option but to buy from
the producer suppling it
 The PED also depends on:
 How close the substitutes are?
  The variety of substitutes
 Suitability within and outside groups
 Quality/brand image
 Addictive or not
 Necessity/luxury
 If a product is a luxury, small price changes will change
demand indicating demand is elastic
 If a product is a necessity, small price changes will still
encourage consumers to buy the product, causing demand to
be inelastic
 If a product is addictive, it will have inelastic demand as
consumers will be buying it irrespective of price changes.
2. The relative expense of the product –
 If consumers spend a huge proportion of their income of a
product, even a small change in price will make consumers
change their demand levels, showing elastic demand
 If consumers spend a small proportion of their income, a
small price change won’t have much effect on demand,
causing demand to remain inelastic
3. Time –
 If there is time available before buying the product, demand
will be elastic as consumers will have time to search for
substitutes
 If purchase of a product can be delayed, it will have elastic
demand
 If purchase can’t be delayed it will have inelastic demand as
consumers will have to buy it irrespective of its price.
Price

Perfectly elastic demand PED becomes more elastic as the

price of a product rises as consumers
Elastic demand become more sensitive to price
changes.
Unit elasticity
As price falls, PED becomes more
inelastic
Inelastic demand

Perfectly inelastic demand

0
Quantity demanded

Income elasticity of demand (YED)

 It is a numerical measure of responsiveness of demand to a change

in income.

Percentage change in quantity demanded

YED =
Percentage change in income

 Relationship between income and demand depends on the type of

good.
 An inferior good will have a negative YED value
 A normal good will have a positive YED value.
 YED above 1 is a luxury good
 YED below 1 and above 0 is a necessity
 The sign indicates the type of good, whereas the number shows
how elastic/inelastic it is
Cross price elasticity of demand (XED)

 It is a numerical measure of responsiveness of quantity demanded

of product A following a change in price of product B

Percentage change in quantity demanded for

product A
XED =

Percentage change in price of product B

 This is used to measure the strength of relationship between

substitutes and complements
 XED is not always positive. The sign shows the type of good it is.
 XED for substitutes is positive
 XED for complements is negative
 XED = 0 shows no relation between the 2 goods/services
 The sign indicates nature of relationship between 2 products, and
the value indicates the strength of relationship between 2 products

Price elasticity of supply (PES)

 It is a numerical measure of responsiveness of supply, to a change

in price.

Percentage change in quantity supplied

PES =
Percentage change in price

Interpretation of PES

 The positive sign (+) indicates the positive relation between supply
and price. PES is always positive.
 The size (number) indicates the extent of change.
Factors influencing PES of a product

1. Time factor (how long it takes to produce)-

 Short period – elastic
 Long period - inelastic
2. Nature of commodity –
 Perishable goods – inelastic
 Durable goods – elastic
3. Technique of production –
 Complex technique – inelastic
 Simple technique – elastic
4. Ease with which production can be increased –
 Plenty of spare capacity – elastic
 No spare capacity – inelastic
5. Ease of factor substitution –
 Easy to substitute – elastic
 Difficult to switch – inelastic
6. Stock of goods –
 High stock levels – elastic
 Low stock levels – inelastic

Business relevance of elasticities

1. PED –
 To raise revenue:
 Elastic – lower prices
 Inelastic – increase prices
 Unit – no effect
 It impacts their ability to change prices. They would want to
know the effect of changing price on their own revenue/
consumer expenditure.
 Helps to devise a price discrimination strategy.
  It helps them makes sales forecasts based on price changes.
 Helps to understand the impact of the likely price volatility
when there are changes in supply
 Businesses can make the dd for their goods inelastic by
establishing a brand image or using other effective promotional
techniques to make their products seem like a necessity.
2. YED –
 Knowing the YED of a product will help the business make
informed marketing and production decisions
 It will help the business make future decisions, based on
assumptions of the economy’s state
3. XED –
 Help a business know how change in its competitors’
strategies will impact demand for their product.
 Help the business device marketing and promotional
strategies
4. PES –
 Firms want their supply to be as elastic as possible as it shows
that they are easily able to respond to changes in demand

Government relevance of elasticities

1. PED
 It helps understand devise a taxation policy.
 Goods will inelastic demand can be taxed higher to gain more
tax revenue.
 Govt. can identify merit goods that have elastic demand and
subsidize them so that the demand for these goods increases by
a larger extent.
 2. YED
 Help the government know which producers to subsidise and
which goods production to increase
 Help the government know to what extent will a consumer’s
spending patterns change if there is a change in the income

Limitations of elasticities

 Irrelevant and unreliable data – the data used is from past

observations and may have changed by now. It even depends on the
sample size and how truthful the respondent is.
 Unrealistic assumptions – all calculations are based on ceteris
paribus that is everything else in the economy remains the same
which may not stand corrected.
 Omission of Total Cost – Calculations are not including total cost
while calculating so something that is right for revenue may not be
the same for profits.
 Omission of Production Capacity - PED and XED do not take
production capacity into consideration.

Consumer surplus

 Consumer surplus equals the net happiness

 It is the difference between a consumer’s willingness to pay and
what they actually pay.
 It is below the demand curve and above the equilibrium price
 A rise in equilibrium price reduce consumer surplus and vice versa.
Producer surplus

 The difference between the price a producer is willing to accept

and what is actually paid
 Producer surplus is below equilibrium and above the supply curve
 If equilibrium price rises, producer surplus also rises.
Price
Supply
Consumer
surplus

Producer
P surplus

Demand

0 Q Quantity