alevel economics unit 2

Micro Economics
Price Determination
(Unit 2)
 Law of Demand
 Law of Supply
 Market price determination
 Changes in Market Price
 Government role in price determination
(An Insight to Economics)

Azar Anjum Riaz
Price Determination
In a free market economy, prices are determined by the market forces of demand and supply and it is
assumed that there is no government intervention in this process.
 Demand represents consumers’ willingness and ability

 Supply represents producers’ willingness and ability
Demand: It is a quantity of a good or service that consumers are willing and able to buy at a given price
in a given time period. Demand in economics must be effective which means that only when a consumers'
desire to buy a product is backed up by an ability to pay for it does demand actually have an effect on the
market. Consumers must have sufficient purchasing power to have any effect on the allocation of scarce
resources.
Market demand: Market demand is the sum of the individual demand for a product from each consumer
in the market. If more people enter the market and they have the ability to pay for items on sale, then
demand at each price level will rise.
The rational consumer
Economists assume that in deciding what to buy, consumers will tend to act rationally in their own self-
interest. This means that they will choose between different goods and services so as to maximize total
satisfaction.
Clearly they will take into consideration

 How much satisfaction they get from buying and consuming an extra unit of a good or
service
 The market price that they have to pay to make this purchase
The Law of Demand
Other factors remaining constant (ceteris paribus) there is an inverse relationship between the price of a
good and demand. As prices fall, we see an expansion of demand. If price rises, there will be a
contraction of demand.
Understanding ceteris paribus is the key to understanding much of microeconomics. Many factors can be
said to affect demand. Economists assume all factors are held constant (ie do not change) except one – the
price of the product itself. A change in a factor being held constant invalidates the ceteris paribus
assumption
Price QD
(Apples $) (Apples Kgs)
10 500
20 400
30 300
40 200
50 100
An insight to Economics 1
AZAR ANJUM RIAZ (0321-4455386)
The Demand Curve: A demand curve shows the relationship between the price of an item and the
quantity demanded over a period of time. There are two reasons why more is demanded as price falls:
The Income Effect: There is an income effect when the price of a good falls because the consumer can
maintain current consumption for less expenditure. Provided that the good is normal, some of the
resulting increase in real income is used by consumers to buy more of this product.
The Substitution Effect: There is also a substitution effect when the price of a good falls because the
product is now relatively cheaper than an alternative item and so some consumers switch their spending
from the good in competitive demand to this product.
Changes in demand due to change in price:
Increase in QD due to decrease in price of that product (extension).
Decrease in QD due to increase in price of that product (contraction).
A change in the price of a good or service causes a movement along the demand curve. A fall in the price
of a good causes an expansion of demand; a rise in price causes a contraction of demand. Many other
factors can affect total demand - when these change, the demand curve can shift.
Shifts in the Demand Curve Caused by Changes in the Conditions of Demand
There are two possibilities: either the demand curve shifts to the right or it shifts to the left.
D1 – D3 would be an example of an outward shift of the demand curve (or an increase in demand). When
this happens, more is demanded at each price.
A movement from D1 – D2 would be termed an inward shift of the demand curve (or decrease in
demand). When this happens, less is demanded at each price.
Changing prices of a substitute good: Substitutes are goods in competitive demand and act as
replacements for another product. For example, a rise in the price of Pepsi should cause a substitution
effect away from Pepsi towards competing brands. A fall in the monthly rental charges of cable companies
or mobile phones might cause a decrease in the demand for PTCL services. Consumers will tend over time
to switch to the cheaper brand or service provider. When it is easy and cheap to switch, then consumer
demand will be sensitive to price changes.
Changing price of a complement: Two complements are said to be in joint demand. Examples include
fish and chips, DVD players and DVDs, iron ore and steel. A rise in the price of a complement to Good X
should cause a fall in demand for Y. For example, an increase in the price of bread would cause a decrease
in the demand for butter. A fall in the price of a complement to Good Y should cause an increase in
demand for Good X. For example, a reduction in the market price of computers should lead to an increase
in the demand for printers, scanners and software applications.
Change in the income of consumers: Most of the things we buy are normal goods. When an
individual’s income goes up, their ability to purchase goods and services increases, and this causes an
outward shift in the demand curve. When incomes fall there will be a decrease in the demand for most
goods.
Change in tastes and preferences: Changing tastes and preferences can have a huge effect on demand.
Persuasive advertising is designed to cause a change in tastes and preferences and thereby create an
outward shift in demand. A good example of this is the recent surge in sales of bottled water and tetra
pack milk.
Discretionary income: Discretionary income is disposable income less essential payments like electricity
& gas and, especially, mortgage repayments. An increase in interest rates often means an increase in
monthly mortgage payments reducing demand.
Interest rates and demand: Many products are bought on credit using borrowed money, thus the demand
for them may be sensitive to the rate of interest charged by the lender. Therefore if the central bank
decides to raise interest rates – the demand for many goods and services may fall. Examples of “interest
sensitive” products include household appliances, electronic goods, new furniture and motor vehicles. The
demand for housing is affected by changes in mortgage interest rates. On the other hand, with high interest
rate people tend to save more so there will be a decrease in over all consumption.
Income & Demand - Normal and Inferior Goods
For normal products, more is demanded as income rises, and less as income falls. Most products are like
this but there are exceptions called inferior products. They are cheaper poorer quality substitutes for
some other good. Examples include black-and-white television sets, white bread, and several other basic
foods. With higher income a consumer can switch from the cheaper, but poorer quality substitute to the
more expensive, but preferred alternative. As a result, less of the inferior product is demanded at higher
levels of income.
Exceptions to the law of demand
Demand for a product is not always inversely related to the price. There are two possible reasons why
more might be demanded even when the price of a good or service is increasing.
(a) Ostentatious consumption: Some goods are luxurious items where satisfaction comes from
knowing both the price of the good and being able to present the consumption proudly to other
people! The demand for the product is a direct function of its price. Higher price may also be
regarded as a reflection of product quality and some consumers are prepared to pay this for the
“snob value effect”.
Examples might include perfumes, designer clothes, and top of the range cars. Consider the case of VI
which is considered to be the most exclusive perfume in the world. Only 475 bottles have been produced
and bottles have been selling for £47,500 each.
Goods of ostentatious consumption are known as Veblen Goods and they have a high-income elasticity of
demand. That is, demand rises more than proportionately to an increase in income.
(b) Speculative Demand: The demand for a product can also be affected by speculative demand.
Here, potential buyers are interested not just in the satisfaction they may get from consuming the
product, but also the potential rise in market price leading to a capital gain or profit. When prices are
rising, speculative demand may grow, adding to the upward pressure on prices. The speculative
demand for housing and for shares might come into this category and we have seen, in the last few
years, strong speculative demand for many of the world’s essential commodities (oil and gold are
perfect examples).
Supply
It is the quantity of a product that a producer is willing and able to supply onto the market at a given price
in a given time period. The basic law of supply is that as the price of a commodity rises, so producers
expand their supply onto the market. A supply curve shows a relationship between price and quantity a
firm is willing and able to sell.
There are three main reasons why supply curves for most products are drawn as sloping upwards from left
to right giving a positive relationship between the market price and quantity supplied:
The profit motive: When the market price rises (for example after an increase in consumer demand), it
becomes more profitable for businesses to increase their output. Higher prices send signals to firms that
they can increase their profits by satisfying demand in the market.
Production and costs: When output expands, a firm’s production costs rise, therefore a higher price is
needed to justify the extra output and cover these extra costs of production.
New entrants coming into the market: Higher prices may create an incentive for other businesses to
enter the market leading to an increase in supply.
Price in rupees QS
(Apples) (Apples)
10 100
20 200
30 300
40 400
50 500
A supply curve is drawn assuming ceteris paribus - ie that all factors influencing supply are being held
constant except price. If the price of the good varies, we move along a supply curve. In the diagram above,
as the price rises from P1 to P2 there is an expansion of supply. If the market price falls from P1 to P3
there would be a contraction of supply in the market. Businesses are responding to price signals when
making their output decisions.
The supply curve shows a relationship between the price of a good or service and the quantity a producer
is willing and able to sell in the market.
Shift in supply curve
The supply curve can shift position. If the supply curve shifts to the right (from S1 to S2) this is an
increase in supply; more is provided for sale at each price. If the supply curve moves inwards from S1 to
S3, there is a decrease in supply meaning that less will be supplied at each price.
Non price determinants of supply (causes of shift in supply curve)
Costs of production (negative relation with supply) : A fall in the costs of production leads to an increase
in the supply of a good because the supply curve shifts downwards and to the right. Lower costs mean
that a business can supply more at each price because profits will increase. For example a firm might
benefit from a reduction in the cost of imported raw materials. If production costs increase, a business
will not be able to supply as much at the same price as profits will decrease - this will cause an inward
shift of the supply curve. An example of this would be an inward shift of supply due to an increase in
wage costs.
Changes in production technology (positive relation with supply): Technology can change very quickly
and in industries where the pace of technological change is rapid we expect to see increases in supply
because improvement in technology decreases the cost of production by making the production process
efficient. There will be less wastage of material, time and other resources.
Government taxes and subsidies (taxes have negative & subsidies positive relation): Government
intervention in a market can have a major effect on supply. A tax on producers causes an increase in
costs and will cause the supply curve to shift left wards. Less will be supplied after the tax is introduced.
A subsidy has the opposite effect as a tax cut. A subsidy will increase supply because a guaranteed
payment from the Government reduces a firm's costs allowing them to produce more output at a given
price. The supply curve shifts downwards and to the right depending on the size of the subsidy.
Climatic conditions : For agricultural commodities such as coffee, fruit and wheat the climate can exert a
great influence on supply. Favorable weather will produce a bumper harvest and will increase supply.
Unfavorable weather conditions such as a drought will lead to a poor harvest and decrease supply. These
unpredictable changes in climate can have a dramatic effect on market prices for many agricultural goods.
The number of producers in the market : The number of sellers in a market will affect total market
supply. When new firms enter a market, supply increases and causes downward pressure on the market
price. Sometimes producers may decide to deliberately limit supply by controlling production through the
use of quotas. This is designed to reduce market supply and force the price upwards. The entry of new
firms into a market causes an increase in market supply and normally leads to a fall in the market price
paid by consumers. More firms increase market supply and expand the range of choice available.
Market Equilibrium Price
Equilibrium means a state of equality between demand and supply. Without a shift in demand and/or
supply there will be no change in market price. In free market prices are determine by the market forces
of demand and supply. Demand represents the willingness and ability of consumer and supply represents
the willingness and ability of producers of produce and sell.
Market price is price at which consumers are willing and able to buy and producers are willing and
able to produce and sell. At this price there will be no surplus or shortage so it is also known as
clearing price. Equilibrium means a state of equality between demand and supply. Without a shift in
demand and/or supply there will be no change in market price.
Price in rupees QS QD
(Apples) (Apples) (Apples)
10 100 500
20 200 400
30 300 300 QD=QS
40 400 200
50 500 100
In the diagram below, the quantity demanded and supplied at price P* are equal.
At any price above P*, supply exceeds demand and at a price below P*, demand exceeds supply. In other
words, prices where demand and supply are out of balance are termed points of disequilibrium. Changes
in the conditions of demand or supply will shift the demand or supply curves. This will cause changes in
the equilibrium price and quantity in the market.
Changes in Market Price
Changes in the conditions of demand or supply will shift the demand or supply curves. This will cause
changes in the equilibrium price and quantity in the market.
A change in fashion causes the demand for T-shirts to rise by 4,000 at each price. The next row of the
table shows the higher level of demand. Assuming that the supply schedule remains unchanged, the new
equilibrium price is £6 per tee shirt with an equilibrium quantity of 14,000 units. The entry of new
producers into the market causes a rise in supply of 8,000 T-shirts at each price. The new equilibrium
price becomes £4 with 18,000 units bought and sold
Changes in Market Demand and Equilibrium Price
The demand curve may shift to the right (increase) for several reasons:
 A rise in the price of a substitute or a fall in the price of a complement

 An increase in consumers’ income or their wealth
 Changing consumer tastes and preferences in favour of the product
 A fall in interest rates (i.e. borrowing rates on bank loans or mortgage interest rates)
 A general rise in consumer confidence and optimism
 Decrease in direct taxes by the govt, increased the PDI
The outward shift in the demand curve causes a movement (expansion) along the supply curve and a rise
in the equilibrium price and quantity. Firms in the market will sell more at a higher price and therefore
receive more in total revenue.
The reverse effects will occur when there is an inward shift of demand. A shift in the demand curve does
not cause a shift in the supply curve! Demand and supply factors are assumed independent of each other
although some economists claim this assumption is no longer valid
Changes in Market Supply and Equilibrium Price
The supply curve may shift outwards if there is
 A fall in the costs of production (e.g. a fall in labour or raw material costs)
 A government subsidy to producers that reduces their costs for each unit supplied
 Favourable climatic conditions causing higher than expected yields for agricultural commodities
 A fall in the price of a substitute in production
 An improvement in production technology leading to higher productivity and efficiency in the
production process and lower costs for businesses
 The entry of new suppliers (firms) into the market which leads to an increase in total market
supply available to consumers
The outward shift of the supply curve increases the supply available in the market at each price and with a
given demand curve, there is a fall in the market equilibrium price from P1 to P3 and a rise in the quantity
of output bought and sold from Q1 to Q3. The shift in supply causes an expansion along the demand
curve.
The equilibrium price and quantity in a market will change when there shifts in both market supply and
demand. Two examples of this are shown in the next diagram:
In the left-hand diagram above, we see an inward shift of supply (caused perhaps by rising costs or a
decision by producers to cut back on output at each price level) together with a fall (inward shift) in
demand (perhaps the result of a decline in consumer confidence and incomes). Both factors lead to a fall
in quantity traded, but the rise in costs forces up the market price.
The second example on the right shows a rise in demand from D1 to D3 but a much bigger increase in
supply from S1 to S2. The net result is a fall in equilibrium price (from P1 to P3) and an increase in the
equilibrium quantity traded in the market.
Price Elasticity of Demand
Elasticity of demand (Ped) = % change in demand of good X / % change in price of good X
If the PED is greater than one, the good is price elastic. Demand is responsive to a change in price. If for
example a 33% increase in price leads to a 50% decrease in quantity demanded, the price elasticity = 2.0
If the PED is less than one, the good is inelastic. Demand is not very responsive to changes in price. If for
example a 20% increase in price leads to a 5% fall in quantity demanded, the price elasticity = 0.25
SPECIAL CASES OF ELASTICITY
 Demand is infinitely inelastic if the value of elasticity is zero (zero divided by any number). Any
change in price would have no effect on the quantity demanded. If the PED is equal to zero, the
good is perfectly inelastic.
 Demand has unitary elasticity if the value of elasticity is exactly 1. This means that a percentage
change in the price of a good will lead to an exact and opposite change in the quantity demanded.
For example a good would have unitary elasticity if a 10% increase led to a 10% fall in the
quantity demanded. If the PED is equal to one, the good has unit elasticity.
 Demand is infinitely elastic if the value of elasticity is infinity (any number divided by zero). A
fall in price would lead to an infinite increase in quantity demanded (i.e. increasing from zero),
whilst an increase in price would lead to the quantity demanded falling to zero. If the PED is
infinity, the good is perfectly elastic
Determinants of Price Elasticity of Demand
The number of close substitutes for a good / uniqueness of the product – the more close substitutes in
the market, the more elastic is the demand for a product because consumers can more easily switch their
demand if the price of one product changes relative to others in the market. The huge range of package
holiday tours and destinations make this a highly competitive market in terms of pricing – many
holidaymakers are price sensitive
The cost of switching between different products – there may be significant transactions costs involved
in switching between different goods and services. In this case, demand tends to be relatively inelastic. For
example, mobile phone service providers may include penalty clauses in contracts or insist on 12-month
contracts being taken out.
The degree of necessity or whether the good is a luxury – goods and services deemed by consumers to
be necessities tend to have an inelastic demand whereas luxuries will tend to have a more elastic demand
because consumers can make do without luxuries when their budgets are stretched. I.e. in an economic
recession we can cut back on discretionary items of spending
The % of a consumer’s income allocated to spending on the good – goods and services that take up a
high proportion of a household’s income will tend to have a more elastic demand than products where
large price changes makes little or no difference to someone’s ability to purchase the product.
The time period allowed following a price change – demand tends to be more price elastic, the longer
that we allow consumers to respond to a price change by varying their purchasing decisions. In the short
run, the demand may be inelastic, because it takes time for consumers both to notice and then to respond
to price fluctuations.
Whether the good is subject to habitual consumption – when this occurs, the consumer becomes much
less sensitive to the price of the good in question. Examples such as cigarettes and alcohol and other drugs
come into this category.
Peak and off-peak demand - demand tends to be price inelastic at peak times – a feature that suppliers
can take advantage of when setting higher prices. Demand is more elastic at off-peak times, leading to
lower prices for consumers. Consider for example the charges made by car rental firms during the course
of a week, or the cheaper deals available at hotels at weekends and away from the high season. Train fares
are also higher on Fridays (a peak day for travelling between cities) and also at peak times during the day
Uses of PED
 If the business is producing on the price elastic section of the demand curve, a large percentage
change in price leads to a large percentage change in quantity demanded. Lowering the price will
have the effect of increasing total revenue and raising the price will decrease total revenue.
 If the business is producing on the price inelastic section of the demand curve, a small percentage
change in price leads to a small percentage change in quantity demanded. This will have the effect
of decreasing total revenue when the price is decreased and increasing total revenue when the price
rises.

When demand is inelastic – a rise in price leads to a rise in total revenue – for example a 20% rise in price
might cause demand to contract by only 5% (Ped = -0.25)
When demand is elastic – a fall in price leads to a rise in total revenue - for example a 10% fall in price
might cause demand to expand by only 25% (Ped = +2.5)
 If the business is producing on the unitary price elasticity section of the demand curve, small
changes in price do not change total revenue as a percentage change in price will be exactly offset
by an inverse change in quantity.
It is important to note that the revenue maximising level of production occurs when elasticity is unitary,
but this isn't necessarily the level where profit is maximised. We don't know the firm's costs at different
levels of output. Furthermore elasticities are notoriously difficult to calculate and errors in the elasticity
figures could lead to incorrect pricing decisions.
Conclusion
Income Elasticity of Demand
Income elasticity of demand measures the relationship between a change in quantity demanded for good
X and a change in real income.
The formula for calculating income elasticity: % change in demand divided by the % change in income
Normal Goods: normal: normal goods are those which consumers prefer to buy and use if there is no
budget constraint. Normal goods have a positive income elasticity of demand so as consumers’ income
rises, so more is demanded at each price level i.e. there is an outward shift of the demand curve.
YED for normal goods is going to be positive because if there is increase in income of consumer,
consumer will prefer to buy normal goods which he/she was not able to buy previously.
Normal necessities have an income elasticity of demand of between 0 and +1 for example, if income
increases by 10% and the demand for fresh fruit increases by 4% then the income elasticity is +0.4.
Demand is rising less than proportionately to income.
Luxuries have an income elasticity of demand > +1 i.e. the demand rises more than proportionate to a
change in income – for example a 8% increase in income might lead to a 16% rise in the demand for
restaurant meals. The income elasticity of demand in this example is +2.0. Demand is highly sensitive to
(increases or decreases in) income.
Inferior Goods: inferior goods are those which consumers do not prefer but buy as cheaper substitutes.
Inferior goods have a negative income elasticity of demand. Demand falls as income rises. Typically,
inferior goods or services tend to be products where there are superior goods available if the consumer has
the money to be able to buy it. Examples include the demand for cigarettes, low-priced own label foods in
supermarkets.
 The income elasticity of demand is usually strongly positive for high quality chocolates and luxury
holidays overseas. Consumer durables - audio-visual equipment, 5G mobile phones, designer
kitchens, Sports and leisure facilities (including gym membership and sports clubs)
 In contrast, income elasticity of demand is lower for Staple food products such as bread,
vegetables and frozen foods, Mass transport (bus and rail) and takeaway pizza.

Income elasticity of demand is negative (inferior) for cigarettes and public transport services.
Long-term changes: There is a general downward trend in the income elasticity of demand for many
products, particularly foodstuffs. One reason for this is that as a society becomes richer, there are changes
in consumer perceptions about different goods and services together with changes in consumer tastes and
preferences. What might have been considered a luxury good several years ago might now be regarded as
a necessity (with a lower income elasticity of demand).
Uses of income elasticity of demand
 Knowledge of income elasticity of demand for different products helps firms predict the effect of
a business cycle on sales. All countries experience a business cycle where actual GDP moves up
and down in a regular pattern causing booms and slowdowns or perhaps a recession. The business
cycle means incomes rise and fall.
 Luxury products with high-income elasticity see greater sales volatility over the business cycle
than necessities where demand from consumers is less sensitive to changes in the economic cycle
 Over time, we expect to see our real incomes rise (due to persistent economic growth) and as we
become better off, we can afford to increase our spending on different goods and services. Clearly,
what is happening to the relative prices of these products will play a key role in shaping our
consumption decisions.
 However, the income elasticity of demand will also affect the pattern of demand over time. For
normal luxury goods, whose income elasticity of demand exceeds +1, as incomes rise, the
proportion of a consumer’s income spent on that product will go up. For normal necessities
(income elasticity of demand is positive but less than 1) and for inferior goods (where the income
elasticity of demand is negative) – then as income rises, the share or proportion of their budget on
these products will fall.
Cross Price Elasticity of Demand
Cross price elasticity (XPed) measures the responsiveness of demand for good X following a change in
the price of good Y (a related good). We are mainly concerned here with the effect that changes in relative
prices within a market have on the pattern of demand.
Xped = % change in QD x / % change in price y
**It refers to degree of change in QD of one product due to change in price of another product
With cross price elasticity we make an important distinction between substitute products and
complementary goods and services.
Substitutes: With substitute goods such as brands of cereal or washing powder, an increase in the price of
one good will lead to an increase in demand for the rival product. Cross price elasticity for two substitutes
will be positive. For example, in recent years, the prices of new cars have been either falling or relatively
flat. *** XPED of substitutes is always +, showing a direct relationship between substitutes
Complements: With goods that are in complementary demand, such as the demand for DVD players and
DVD videos, when there is a fall in the price of DVD players we expect to see more DVD players bought,
leading to an expansion in market demand for DVD videos. The cross price elasticity of demand for two
complements is negative. *** XPED for complements is always - , showing inverse relationship
The stronger the relationship between two products, the higher is the cross-price elasticity of
demand. For example with two close substitutes, the cross-price elasticity will be strongly positive.
Likewise, when there is a strong complementary relationship between two products, the cross-price
elasticity will be highly negative. Unrelated products have a zero cross elasticity.
Uses of the concept of cross price elasticity of demand
Pricing strategies for substitutes: If a competitor cuts the price of a rival product, firms use estimates of
cross-price elasticity to predict the effect on the quantity demanded and total revenue of their own product.
For example, two or more airlines competing with each other on a given route will have to consider how
one airline might react to its competitor’s price change.
Consider for example the cross-price effect that has occurred with the rapid expansion of low-cost airlines
in the European airline industry. This has been a major challenge to the existing and well-established
national air carriers, many of whom have adjusted their business model and pricing strategies to cope with
the increased competition.
Pricing strategies for complementary goods: For example, popcorn, soft drinks and cinema tickets have
a high negative value for cross elasticity– they are strong complements. Popcorn has a high mark up i.e.
pop corn costs pennies to make but sells for more than a hundred rupee. If firms have a reliable estimate
for Xped, they can estimate the effect of a two-for-one cinema ticket offer on the demand for popcorn.
The additional profit from extra popcorn sales may more than compensate for the lower cost of entry into
the cinema.
Advertising and marketing: In highly competitive markets where brand names carry substantial value,
many businesses spend huge amounts of money every year on persuasive advertising and marketing.
There are many aims behind this, including attempting to shift out the demand curve for a product (or
product range) and build consumer loyalty to a brand. When consumers become habitual purchasers of a
product, the cross price elasticity of demand against rival products will decrease. This reduces the size of
the substitution effect following a price change and makes demand less sensitive to price. The result is that
firms may be able to charge a higher price, increase their total revenue and turn consumer surplus into
higher profit.
Price Elasticity of Supply
Price elasticity of supply measures the relationship between change in quantity supplied and a change in
price.If supply is elastic, producers can increase output without a rise in cost or a time delay
If supply is inelastic, firms find it hard to change production in a given time period.
The formula for price elasticity of supply is:
(Percentage change in quantity supplied divided by the percentage change in price)
Supply curves with different price elasticity of supply
Factors that Affect Price Elasticity of Supply
Spare production capacity: If there is plenty of spare capacity then a business should be able to increase
its output without a rise in costs and therefore supply will be elastic in response to a change in demand.
The supply of goods and services is often most elastic in a recession, when there is plenty of spare labour
and capital resources available to step up output as the economy recovers.
An empty restaurant – plenty of spare capacity to meet any rise in demand
Stocks of finished products and components: If stocks of raw materials and finished products are at a
high level then a firm is able to respond to a change in demand quickly by supplying these stocks onto the
market - supply will be elastic. Conversely, when stocks are low, dwindling supplies force prices higher
and unless stocks can be replenished, supply will be inelastic in response to a change in demand.
The ease and cost of factor substitution: If both capital and labour resources are occupationally mobile
then the elasticity of supply for a product is higher than if capital and labour cannot easily and quickly be
switched
Time period involved in the production process: Supply is more price elastic the longer the time period
that a firm is allowed to adjust its production levels. In some agricultural markets for example, the
momentary supply is fixed and is determined mainly by planting decisions made months before, and
climatic conditions, which affect the overall production yield.
Applications of price elasticity of demand and supply
The elasticity will affect the ways in which price and output will change in a market and elasticity is also
significant in determining some of the effects of changes in government policy when the state chooses to
intervene in the price mechanism.
Some relevant issues that directly use elasticity of demand and supply include:
Taxation: The effects of indirect taxes and subsidies on the level of demand and output in a market e.g.
the effectiveness of the congestion charge in reducing road congestion; or the impact of higher duties on
cigarettes on the demand for tobacco and associated externality effects
Changes in the exchange rate: The impact of changes in the exchange rate on the demand for exports
and imports
Exploiting monopoly power in a market: The extent to which a firm or firms with monopoly power can
raise prices in markets to extract consumer surplus and turn it into extra profit (producer surplus)
Government intervention in the market: The effects of the government introducing a minimum price
(price floor) or maximum price (price ceiling) into a market
Elasticity of demand and supply also affects the operation of the price mechanism as a means of rationing
scarce goods and services among competing uses and in determining how producers respond to the
incentive of a higher market price.
Consumer Surplus
Consumer surplus is a measure of the welfare that people gain from the consumption of goods and
services, or a measure of the benefits they derive from the exchange of goods. Consumer surplus is the
difference between the total amount that consumers are willing and able to pay for a good or service
(indicated by the demand curve) and the total amount that they actually do pay (i.e. the market price for
the product).
Consumer surplus and price elasticity of demand: When the demand for a good or service is perfectly
elastic, consumer surplus is zero because the price that people pay matches precisely the price they are
willing to pay. This is most likely to happen in highly competitive markets where each individual firm is
assumed to be a ‘price taker’ in their chosen market and must sell as much as it can at the ruling market
price.
On the other hand when demand is perfectly inelastic, consumer surplus is infinite. Demand is invariant to
a price change. Whatever the price, the quantity demanded remains the same.
The majority of demand curves are downward sloping. When demand is inelastic, there is a greater
potential consumer surplus because there are some buyers willing to pay a high price to continue
consuming the product. This is shown in the diagram below:
Changes in demand and consumer surplus
When there is a shift in the demand curve leading to a change in the equilibrium market price and
quantity, then the level of consumer surplus will alter. This is shown in the diagrams above. In the left
hand diagram, following an increase in demand from D1 to D2, the equilibrium market price rises to from
P1 to P2 and the quantity traded expands. There is a higher level of consumer surplus because more is
being bought at a higher price than before.
In the diagram on the right we see the effects of a cost reducing innovation which causes an outward shift
of market supply, a lower price and an increase in the quantity traded in the market. As a result, there is an
increase in consumer welfare shown by a rise in consumer surplus.
Consumer surplus can be used frequently when analysing the impact of government intervention in any
market – for example the effects of indirect taxation on cigarettes consumers or the introducing of road
pricing schemes such as the London congestion charge.
Producer Surplus
Producer surplus is a measure of producer welfare. It is measured as the difference between what
producers are willing and able to supply a good for and the price they actually receive. The level of
producer surplus is shown by the area above the supply curve and below the market price and is illustrated
in this diagram.
Producer surplus and changes in demand and supply
We first consider the effects of a change in market supply – for example caused by an improvement in
production technology or a fall in the cost of raw materials and components used in the production of a
good or service.
The effects on producer surplus of a rise in market demand:
Price Mechanism ( conclusions)
The invisible hand – the workings of the price mechanism:

Adam Smith one of the Founding Fathers of economics famously wrote of the “invisible hand of the price
mechanism”. He described how the invisible or hidden hand of the market operated in a competitive market
through the pursuit of self-interest to allocate resources in society’s best interest. This remains the central
view of all free-market economists, i.e. those who believe in the virtues of a free-market economy with
minimal government intervention.
The price mechanism is a term used to describe the means by which the many millions of decisions taken
each day by consumers and businesses interact to determine the allocation of scarce resources between
competing uses. This is the essence of economics!
The price mechanism plays three important functions in any market-based economic system:
1-The signalling function: Firstly, prices perform a signalling function. This means that market prices
will adjust to demonstrate where resources are required, and where they are not. Prices rise and fall to
reflect scarcities and surpluses. So, for example, if market prices are rising because of high and rising
demand from consumers, this is a signal to suppliers to expand their production to meet the higher
demand.
Consider the left hand diagram on the next page. The demand for computer games increases and as a
result, producers stand to earn higher revenues and profits from selling more games at a higher price per
unit. So an outward shift of demand ought to lead to an expansion along the market supply curve.
In the second example on the right, an increase in market supply causes a fall in the relative prices of
digital cameras and prompts an expansion along the market demand curve. Conversely, a rise in the costs
of production will induce suppliers to decrease supply, while consumers will react to the resulting higher
price by reducing demand for the good or services.
2-The transmission of preferences: Through the signalling function, consumers are able through their
expression of preferences to send important information to producers about the changing nature of our
needs and wants. When demand is strong, higher market prices act as an incentive to raise output
(production) because the supplier stands to make a higher profit. When demand is weak, then the market
supply contracts. We are assuming here that producers do actually respond to these price signals.
One of the features of a free market economy is that decision-making in the market is decentralised in
other words, the market responds to the individual decisions of millions of consumers and producers, i.e.
there is no single body responsible for deciding what is to be produced and in what quantities. This is a
remarkable feature of an organic market system.
3-The rationing function: Prices serve to ration scarce resources when demand in a market outstrips
supply. When there is a shortage of a product, the price is bid up – leaving only those with sufficient
willingness and ability to pay with the effective demand necessary to purchase the product.
The prices for using the motorway are a good example of the rationing function of the price mechanism. A
toll road can exclude those drivers and vehicles that are not willing or able to pay the current toll charge.
In this sense, motorists and road haulage businesses and other road users are paying for the right to use the
road, road space has a market price instead of being regarded as something of a free good.
The price mechanism is the only allocative mechanism solving the economic problem in a free market
economy. However, most modern economies are mixed economies, comprising not only a market sector,
but also a non-market sector, where the government (or state) uses the planning mechanism to provide
public goods and services such as police, roads and merit goods such as education, libraries and health.
In a command economy, the price mechanism plays little or no active role in the allocation of resources.
Instead government planning directs resources to where the state thinks there is greatest need. The reality
is that state planning has more or less failed as a means of deciding what to produce, how much to
produce, how to produce and for whom.
Prices and incentives
Market failure occurs when the signalling and incentive function of the price mechanism fails to operate
optimally leading to a loss of economic and social welfare. For example, the market may fail to take into
account the external costs and benefits arising from production and consumption. Consumer preferences
for goods and services may be based on imperfect information on the costs and benefits of a particular
decision to buy and consume a product. Our individual preferences may also be distorted and shaped by
the effects of persuasive advertising and marketing to create artificial wants and needs.
ELASTICITY
ELASTICITY
(Responsiveness of one variable e.g. Qd or Qs to the change in another variable e.g. own price or the price of related product or income of consumers)
Types of elasticity: 1.P.E.D 2.P.E.S 3.Y.E.D 4. X.E.D
PRICE ELASTICITY OF DEMAND (P.E.D)
Elastic Demand Inelastic Demand Unitary Elastic Demand Perfectly Elastic Demand Perfectly Inelastic
Demand
Value P.E.D > 1 P.E.D < 1 P.E.D = 1 P.E.D = Infinity P.E.D = Zero
Definition Small %∆P→ Large %∆Qd Large %∆P→ Small %∆Qd Equal %∆P→ Equal %∆Qd Small %∆P→ Infinity %∆Qd Large %∆P→ Zero %∆Qd
Example Luxury good with many substitutes Necessities - - -
Curve
Relation- Total Revenue of seller or Total Total Revenue of seller or Total Total Revenue of seller or Total Total Revenue of seller or Total Total Revenue of seller or Total
-ship With consumer expenditure increases with consumer expenditure increases with consumer expenditure remains consumer expenditure increases with consumer expenditure increases with
TR or TE a decrease in price and vice versa. an increase in price and vice versa. constant with any change price. an equal proportion of quantity an equal proportion of price
increase. increase.
PRICE ELASTICITY OF SUPPLY (P.E.S)
Elastic Supply Inelastic Supply Unitary Elastic Supply Perfectly Elastic Supply Perfectly Inelastic Supply
Value P.E.S > 1 P.E.S < 1 P.E.S = 1 P.E.S = Infinity P.E.S = Zero
Definition Small %∆P→ Large %∆Qs Large %∆P→ Small %∆Qs Equal %∆P→ Equal %∆Qs Small %∆P→ Infinity %∆Qs Large %∆P→ Zero %∆Qs
Example Manufactured goods Agricultural goods -- -- Number of seats in stadium
Curve
Shape Originate from y-axis Originate from x-axis Starts from origin Horizontal Vertical

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Micro Economics

(An Insight to Economics)

 Demand represents consumers’ willingness and ability

The rational consumer

Clearly they will take into consideration

The Law of Demand

(Apples $) (Apples Kgs)

Changes in demand due to change in price:

Increase in QD due to decrease in price of that product (extension).

Decrease in QD due to increase in price of that product (contraction).

Income & Demand - Normal and Inferior Goods

Exceptions to the law of demand

Shift in supply curve

(Apples) (Apples) (Apples)

30 300 300 QD=QS

Changes in Market Price

Changes in Market Demand and Equilibrium Price

 A rise in the price of a substitute or a fall in the price of a complement

Changes in Market Supply and Equilibrium Price

The supply curve may shift outwards if there is

Elasticity of demand (Ped) = % change in demand of good X / % change in price of good X

SPECIAL CASES OF ELASTICITY

Income Elasticity of Demand

Uses of income elasticity of demand

Cross Price Elasticity of Demand

Xped = % change in QD x / % change in price y

Uses of the concept of cross price elasticity of demand

The formula for price elasticity of supply is:

(Percentage change in quantity supplied divided by the percentage change in price)

Supply curves with different price elasticity of supply

Factors that Affect Price Elasticity of Supply

The effects on producer surplus of a rise in market demand:

The invisible hand – the workings of the price mechanism:

Prices and incentives

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