THE PRICE SYSTEM

Meaning of demand – Demand refers to the quantities of a product that purchasers are willing and
able to buy at various prices per period of time, all other things being equal.
Effective demand – Effective demand means demand for goods which is backed by purchasing
power also.
Price and demand relationship – Price and demand have negative relationship (because if price
increases demand Price and demand relationship decreases and when price decreases demand
increases)

The Demand curve

The above demand curve shows the law of demand which states that other things remain the same
when price goes up, there is a decrease in quantity demanded and when price goes down, there is an
increase in quantity demanded. This happens which price changes from P a to Pb and demand
changes from Qa to Qb.

SHIFT IN THE DEMAND CURVE

A shift in demand means at the same price, consumers wish to buy more. This happens due to following reasons:

1. The good become more popular(i.e. change in fashion or taste and preferences)
2. The price of a substitute goods increased.
3. The price of a complementary goods decreased.
4. A rise in incomes ( Assuming the good as normal good, with positive YED)
5. Seasonal factors
Types of shift in
demand are as
follows –
1. Increase in
demand –
when at a
same price more quantity demanded it is known as increase in demand. (rightward shift of the demand
curve)
2. Decrease in demand – When at a same price less quantity demanded it is known as decrease in demand.
(Leftward shift of the demand curve)

Movement along the demand curve

A change in price cause a movement along the demand curve. There are two types of movement along the
demand curve which are as follows –
1. Extension of demand - when due to fall in price demand increases it is known as extension of demand.

2. Contraction in demand
– When due to rise in price of the goods demand for goods decreases it is known as contraction in
demand.
Substitute goods – These are alternatives that satisfy essentially the same wants or needs.The range of
substitutability can be fairly narrow, e.g in terms of different products brands. For example different brands
like Nike and Adidas in shoes, Dell and Acer in computers and so on.The range of substitutability can also
be broad e.g in terms of product groups, such as different types of transport- rail, buses taxi etc, different
types of soft drinks- coca cola, pepsi, leman tea etc.

Complementary goods – These are goods that enhance the satisfaction we derive from another product.
Common examples are toothbrushes and toothpaste, tennis balls and racquets, laptops and dongles.In some
cases, without the complement the main product would be useless. Examples are includes car and fuel,
mobile phone and top up cards etc. Change in price or attractiveness of one of these products will have an
impact on the demand for the complementary good. In such cases this is known as joint demand.

OTHER DEMAND-INFLUENCING FACTORS

Other then price of a product there are some other factors which influence the demand of a
product let see them one by one.
1. Taste and preference - when a consumer likes the good more he or she buys it more and the
demand increases.
2. Price of Related Goods or Services: when the price of substitute good (e.g. banana)
increases, a consumer normally gives up at least some of its consumption and as a result the
demand (e.g. for pinapple) increases.
3. prices of complementary goods: when the price of complementary good (e.g. coffee)
increases, a consumer normally gives up at least some of its consumption and as a result the
demand (e.g. for sugar) decreases.
4. consumers´ future expectations: when consumers expect higher prices in the future, they
buy more goods in order to avoid higher prices and as a result the demand increases.
5. Income of the consumer - when consumer`s income increases, he or she usually buys more
goods which increases the demand.

Elasticity of demand

Meaning – It is defined as a numerical measure of responsiveness of one variable following a

change in another variable, other things being equal.

1. Perfectly Elastic Demand:

When a small change in price of a product causes a major change in its demand, it is said to be perfectly
elastic demand. In perfectly elastic demand, a small rise in price results in fall in demand to zero, while a
small fall in price causes increase in demand to infinity. In such a case, the demand is perfectly elastic or
ep = 00.
In perfectly elastic demand, the demand curve is represented as a horizontal straight line

it can be interpreted that at price OP, demand is infinite; however, a slight rise in price would result in fall in
demand to zero. It can also be interpreted from Figure that at price P consumers are ready to buy as much
quantity of the product as they want. However, a small rise in price would resist consumers to buy the
product.
 2. Perfectly Inelastic Demand:
A perfectly inelastic demand is one when there is no change in the demand of a product with change in its
price. The numerical value for perfectly inelastic demand is zero (ep=0).

It can be interpreted from Figure-3 that the movement in price from OP1 to OP2 and OP2 to OP3 does not
show any change in the demand of a product (OQ). The demand remains constant for any value of price.
Perfectly inelastic demand is a theoretical concept and cannot be applied in a practical situation. However,
in case of essential goods, such as salt, the demand does not change with change in price. Therefore, the
demand for essential goods is perfectly inelastic.

3. Relatively Elastic Demand:

Relatively elastic demand refers to the demand when the proportionate change produced in demand is
greater than the proportionate change in price of a product. The numerical value of relatively elastic demand
ranges between one to infinity.
Mathematically, relatively elastic demand is known as more than unit elastic demand (ep>1). For example,
if the price of a product increases by 20% and the demand of the product decreases by 25%, then the
demand would be relatively elastic. E >1
4. Relatively Inelastic Demand:
Relatively inelastic demand is one when the percentage change produced in demand is less than the
percentage change in the price of a product. For example, if the price of a product increases by 30% and the
demand for the product decreases only by 10%, then the demand would be called relatively inelastic.
Here (ep<1). 
 Types of elasticity with numerical values

Cross elasticity of demand – XED is a numerical measure of the responsiveness of demand for one product
following a change in price of another related product alone.
XED = % change in quantity demanded of product A
% change in the price of product B

Products that are substitutes for each other(e.g different types of laptops computer) will have positive values
for the XED.If the price of B falls, then consumers will start to buy B instead of A.Products that are
complements (e.g computers and printers or software) will have negative values of XED. If the price of B
goes up, the quantity demanded of B will drop and so will the complementary demand for A.
 Income elasticity of demand – YED is defined as a numerical measure of the responsiveness of demand
following a change in income alone. The formula used in this case is

YED = % change in quantity demanded

% change in income

Supply

Supply refers to the quantities of a

product that suppliers are
willing and able to sell at various prices per period of time, other thigs remain same

Suppliers – These are the sellers of the product and are often referred to as producers, although they may
not necessarily be manufacturers of the product but again may simply be an intermediary in the production-
consumption chain or they may be selling services.

Supply curve – It is diagrammatically presentation of supply

Price and supply relationship – Price and supply have positive relationship (because if price increases supply
increases and when price decreases supply decreases)
Law of supply - The law of supply is the microeconomic theory stating that other things being equal, as the
price of a good or service increases, the number of goods or services offered will also increase and at decrease
in the price the number of goods or services offered will also decrease. The law of supply states that as the price
of an item goes up, and thus profit increases, suppliers will attempt to make more profits by increasing the
amount produced. Existing suppliers will produce more or new suppliers will enter the market.
Factors affecting supply – Following are the factors affecting supply of a commodity
Technology: when there is a technological progress in the production methods, producers become more
productive and can produce more under the same quantity of factors, as a result the supply increases.
producers` future expectations: when producers expect higher prices in the future, they may increase their
production to earn higher profits in the future and as a result the supply increases (naturally, they could also cut
down production in order to wait higher prices in the future, in this case the supply decreases) 
Number of producers: when the number of producers increases, there are more suppliers in the market and the
supply increases
The influence of government - Government may be influential in promoting or discouraging certain goods. An
increase in the tax placed upon cigarettes may discourage the production of cigarettes as demand is reduced.

The objectives of the producer- Many producers are not, surprisingly enough, interested in making the
maximum profit. They may prefer to make a satisfactory profit. This simply may be sufficient profit to give a
reasonable return on the money invested and provide the producer a reasonable living without incurring the
risks associated with expanding the business. In such a case even a price rise might not be sufficient to
encourage the business to expand its production

Monday 20 July 2020

MARKET SUPPLY
A market supply curve is the summation of individual firms' supply curves. An important principle for market
supply curves is that the market has to be perfectly competitive. This means that there is a large number of
players (firms producing the same product) in the market and there is no dominant player that can manipulate
prices.
To get total or market supply, we have to add the supplies of all the producers of a product. Suppose there are
two producers of carrots in an area, viz., A and B. Both of them supply carrots at the same point of time.
We show the supply schedule and the supply curve of the first producer, i.e., A,
Price per Kg $ Quantity supplied
0.50 0
1 300
1.50 600
2 900
2.50 1200
3 1500
3.50 2000

supply schedule and the supply curve of the second producer, i.e., B,
Price per Kg $ Quantity supplied
0.50 0
1 0
1.50 150
2 300
2.50 450
3 600
3.50 750

Market supply schedule

Price per Kg $ Quantity supplied A Quantity supplied B Market supply A + B

0.50 0 0 0
1 300 0 300
1.50 600 150 750
2 900 300 1200
2.50 1200 450 1650
3 1500 600 2100
3.50 2000 750 2750
The market supply curve is derived simply by adding the quantities supplied at each price by the two
producers.

Price elasticity of supply

Price elasticity of supply – PES is a numerical measure of the responsiveness of supply to a change in the
price of the product alone. The supply could be that of an individual firm or group of firms, it could, of
course, refers to the supply of the overall industry. It is expressed as:
 PES = % change in quantity supplied
%change in price
Different PES values
When Pes > 1, then supply is Relatively elastic
When Pes < 1, then supply is Relatively inelastic
When Pes = 0, supply is perfectly inelastic
When Pes = infinity, supply is perfectly elastic
When Pes = 1, supply is unitary elastic

Putting supply and demand all together – market in equilibrium and disequilibrium
The equilibrium price is the only price where the plans of consumers and the plans of producers agree—that
is, where the amount consumers want to buy of the product, quantity demanded, is equal to the amount
producers want to sell, quantity supplied. This common quantity is called the equilibrium quantity. At any
other price, the quantity demanded does not equal the quantity supplied, so the market is not in equilibrium
at that price.
The word equilibrium means balance. If a market is at its equilibrium price and quantity, then it has no
reason to move away from that point. However, if a market is not at equilibrium, then economic pressures
arise to move the market toward the equilibrium price and the equilibrium quantity.

Price of a laptop Quantity supplied per month Quantity demanded per month
$ 800 1000 7000
$1000 2000 6000
$ 1200 3000 5000
$1400 4000 4000
 $1600 5000 3000
$1800 6000 2000
$2000 7000 1000

S1

1400

D1
4000

The market equilibrium is at a price of $1400 with 4000 units bought and sold. These are referred to as
equilibrium price and equilibrium quantity. Total consumer expenditure will be $5600000 per month. If in
case companies thought that consumers were prepared to pay $1600 and supplied 5000 units to the market.
In this case the market would be in disequilibrium.At a price of $1600 consumers are only ready to buy
3000 units.As such companies will build up excess stock at the rate of 2000 laptops per month. There is
disequilibrium due to excess supply.
Companies could cut prices, they would also probably start to reduce the quantity they supply to the
market. Of course as they cut prices some consumers who would not have been prepared to pay the higher
price are now attracted back into the market- the disequilibrium starts to narrow. Provided there is no
change to any of the conditions of supply or demand and nothing prevented companies adjusting in this way
then eventually perhaps through expert decision making or simply trial and error, the market price and
quantity should move back to equilibrium.
What would happen if the price was set at $ 1000 Again we have disequilibrium- this time excess demand.

21/07/2020
CHANGE IN EQUILIBRIUM PRICE
 Change in demand – If the market is in equilibrium, that is the demand and supply of the commodity
meets each other at a certain point.
Now for an equilibrium market, if the demand of the commodity changes, the the following impacts
would be seen in the market.
1. INCREASE IN DEMAND
The above diagram represents
 The demand curve DD which slopes downward from left to right
 A supply curve SS Slopes upward from left to right.
 When demand and supply of the commodity are equal, the firm finds its equilibrium i.e at point E with
equilibrium price OP and equilibrium quantity OQ.

Now if the demand for the goods increases , then

 The demand curve will shift parallel to the right (DD to D’ D)
 The supply curve will remains as same as earlier (SS)
 The equilibrium price will increase from OP to OP’
 The equilibrium quantity will increase from OQ to OQ’
 The equilibrium point will also changes from E to E’
2. Decrease in demand

The above diagram represents

 The Demand curve DD which slopes downward from left to right
 A supply Curve SS slopes upward from left to right.
 When demand and supply of the commodity are equal, the firm finds its equilibrium i.e at point E with
equilibrium price OP and equilibrium quantity OQ

Now if the demand for the goods decreases, then

 The demand curve will shift parallel towards left (DD to D’ D)
 The supply curve will remains as same as earlier (SS)
 The equilibrium price will decrease from OP to OP’
 The equilibrium quantity will decrease from OQ to OQ’
 The equilibrium point will also change from E to E’

 CHANGE IN SUPPLY
1. Increase in supply –
 The below diagram represent the demand curve DD which slopes downwards from left to right
 A supply curve SS slopes upwards from left to right.
 When demand and supply of the commodity are equal, the firm finds its equilibrium i.e at point E with
equilibrium price OP and equilibrium quantity OQ
Now if the supply for the good increased, then
 The supply curve will shift parallel towards right (SS to S’ S)
 The demand curve will remain as same as earlier (DD)
 The equilibrium price will decrease from OP to OP’
 The equilibrium quantity will increase from OQ to OQ’
 The equilibrium point will also changes from E to E’

2. DECREASE IN SUPPLY
 The diagram represents the demand curve DD which slopes downwards from left to right
 A supply curve SS slopes upwards from left to right.
 When demand and supply of the commodity are equal, the firm finds its equilibrium i.e at point E with
equilibrium price OP and equilibrium quantity OQ.

Now if the supply for the goods increases, then

 The supply curve will shift parallel towards left (SS to S’ S’)
 The demand curve will remain as same as earlier (DD)
 The equilibrium price will increase from OP to OP’
 The equilibrium quantity will decrease from OQ to OQ’
 The equilibrium point will also changes from E to E’
SIMULTANEOUSLY INCREASE IN DEMAND AND SUPPLY

LET SEE THE EFFECT IN THE MARKET IF BOTH DEMAND AND SUPPY OF THE COMMODITY CHANGES AT THE SAME TIME.
(SIMULTANEOUS CHANGE).

1. INCREASE IN DEMAND > INCREASE IN SUPPLY

 The demand curve DD which slopes downward from left to right
 A supply curve SS slopes upward from left to right.
 When demand and supply of the commodity are equal, the firm finds its equilibrium i.e at point
E with equilibrium price OP and equilibrium quantity OQ.

Now if there exist simultaneous increase in both demand and supply of the commodity, but the increase in demand is
greater than the increase in supply. Then the following changes will appear in the market.

 The supply curve will shift parallel towards right (SS to S’S)
 The demand curve will also shift parallel towards right (DD to D’D’)
(But the change in demand is greater than that of change in supply)
 The equilibrium price will increase from OP to OP.
 The equilibrium quantity will also increase from OQ to OQ’
 The equilibrium point will also changes from E to E’
 CONSUMER SURPLUS

Meaning - Consumer surplus is the difference between the total amount that consumers are willing and able to pay for
the goods and services(shown by the demand curve) and the total amount that they actually pay( I.e. Market price).

Consumer surplus is indicated by the area under the demand curve and above the market price.

Consumer surplus = Area ABC

A C

Demand

Q1
For any good or service, though, there are always some people who are prepared to pay above the given
price to obtain it.Some of the best examples where this happens are in cases of tickets to world cup football
matches or any popular rock concerts where all tickets are sold out.The stated price of the tickets may well
be $ 50 but there will always be some people who are willing to pay over $50 to obtain a ticket.
Consumer Surplus And Change In Market Prices
The level of consumer surplus rises or falls as the market price for a good or service changes
Example no – 1

B
E S2 S1
D
A C

Higher supply costs leads to a rise in market price and a fall in consumer surplus from ABC to DBE.

Example no – 2
An increase in market demand cause consumer surplus to rise from area ABC to area GHI

H S1
B
G I

A C D2

Demand
Q1 Q2
When demand is Inelastic (PES<1) there is a greater consumer surplus because there are some buyers
willing to pay a very high price to continue consuming the product.
Elastic demand means relatively low consumer surplus

When demand for a product is perfectly elastic (When the percentage change in quantity demanded is
infinite even if the percentage change in price is zero), the level of consumer surplus is zero since the price
that people pay matches precisely the price, they are willing to pay. There must be perfect substitutes in the
market for this to be the case.
When demand is perfectly inelastic (When the percentage change in quantity demanded is zero no matter
how price is changed,) the amount of consumer surplus is infinite. Demand is invariant to a price change.
Whatever the price, the quantity demanded remains the same.

NOTE – Both the above situations (in case of perfectly elastic and perfectly inelastic) are highly unlikely to
exist – the vast majority of demand curves for goods and services are downwards sloping.

Self-Assessment Task
Q – 1 Explain how an equilibrium price for a product is established in the market and how it may change.
Q – 2 Suppose the Uk government wishes to reduce the demand for air travel for environmental reasons.
Comment on how it might use the price elasticity of demand estimates to achieve this objectives.
Q – 3 What is the market equilibrium price and quantity?
Q – 4 What might happen to supply if all firms decide to try and increase the amount of profit they make on
each unit they sell?
Q – 5 Explain Income and Demand relationship both in case of normal goods and inferior goods.