The Price Theory Complete by Kongnso Rene 674729925

PRICE THEORY PREPARED BY KONGNSO RENE, TEL 674729925
PRICE THEORY
1. Price
It refers what we pay in order to obtain a unit of a good or service. Price can be absolute or relative.
Absolute price is the amount we pay in monetary terms in order to obtain a unit of a good or service while
relative price is the price of a good or service in terms of another good or service.
2. Value
It is the economic worth of a good or service or the total satisfaction (utility) a good/service can yield to its
owner. There are two types of values;
(a) Value in exchange.
It is the rate at which a good/service can exchange for another or the money value/economic worth of a good.
(b) Value in use.
It is the total satisfaction a good/service can render to its owner and it is subjective because it changes from
one person to another. Since value in use is subjective, economists are more interested in value in exchange.
3. Paradox of value
It is the clear contradiction where `essential goods to life like water and air are less expensive and even
sold at zero prices while non-essential goods like gold and diamond are expensive.
This is because essential goods like water and air are abundant/plentiful thus giving them a high Total
utility (TU) and a low Marginal Utility (MU). Since it is the MU that determines the price, they are bound to
sell at very low and even zero prices. On the other hand, non-essential goods like gold and diamond are limited
in stock (scarce) thus giving them a low TU and a high MU. Since their MU is high, they sell at high prices.
Therefore, essential goods to life have a high value in use and a low value in exchange while non-
essential goods have a low value in use and high value in exchange.
THE THEORIES OF DEMAND AND SUPPLY
A. The Theory of Demand
Demand refers to the quantity of a good/service consumers are willing and able to buy at different
prices over a given period of time.
Demand Schedule
It is table which shows the quantity of a good which will be bought at different prices over a given period
of time. There are two types of demand schedules: individual demand schedule and market demand schedule.
1. Individual demand schedule
It is a table which shows the different quantities of a good which a consumer will buy at different prices
over a given period of time
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Price (FCFA) Quantity demanded (kg)

600 200
500 400
400 600
300 800
200 1000
100 1200
From the table above, when price increases from 300 – 400 FCFA, quantity demanded falls from 800 – 600kg
but when price falls from 200 – 100FCFA, quantity demanded increases from 1000 -1200kg. We therefore
notice that price and quantity demanded have an inverse (negative, indirect) relationship that is, price and
quantity demanded move in opposite directions. Thus, the higher the price, the lower the quantity demanded
and vice versa. This confirms the first law of demand and supply which states that, the higher the price, the
lower the quantity demanded and vice versa.
The individual demand schedule can be obtained from an individual demand function. An individual
demand function shows the relationship between price and quantity demanded of a good by a consumer
within a given period of time.
Example:
The demand function for mangoes in a market is given as; Qd=1200 – P. We can derive the demand schedule
for mangoes for a price range of 100 – 500FCFA assuming that price is changing by 100FCFA.
Solution
Qd=1200 – P, when
P= 100, Qd=1200 – 100= 1100
P= 200, Qd=1200 – 200= 1000
P= 300, Qd=1200 – 300= 900
P=400, Qd=1200 – 400= 800
P=500, Qd=1200 – 500= 700
Price (FCFA) Quantity demanded (units)
100 1100
200 1000
300 900
400 800
500 700
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Exercises
1. Assume that the individual demand function for Ndop rice (kg) is given by Qd=600 – 2P. Draw a demand
schedule for Ndop rice for prices ranging from 10 – 50FCFA assuming that price is changing by 10FCFA.
2. The individual demand function for garri (kg) is given by Qd=500. Draw a demand schedule for garri for
prices ranging from 100 – 500FCFA assuming that price is changing by 100FCFA.
2. Market Demand Schedule
It is a table which shows the total quantities of a good which all consumers of that good are willing and able
to buy at different prices over a given period of time. It is obtained by summing all the quantities bought at
each price by all the consumers.
Quantity Demanded (kg) Market Demand
Price (FCFA) Paul Mary John (Aggregate Demand)
20 30 25 40 95
30 25 20 35 80
40 20 15 30 65
50 15 10 25 50
60 10 5 20 35
The table still shows an inverse relationship between price and quantity demanded.
A market demand schedule can be obtained from a market demand function. A market demand
function shows the relationship between price and quantity demanded of a good by all the buyers at given
period of time or it is the sum of all the individual demand functions in the market for a good.
Example:
A market has three consumers with the following demand functions:
Qd1=10 – P
Qd2=18 – 3P
Qd3=5 – P
The market demand function will be obtained by summing up all the three individual demand functions that
is:
Market demand function= Qd1 + Qd2 + Qd3
= 10 – P + 18 – 3P + 5 – P
= 33 – 5P
NB: If we have prices, we then substitute in the place of P and obtain the corresponding quantities for each
price.
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Exercises
1. Suppose a market is dominated by four giant buyers, w, x, y and z.
Qdw=20
Qdx=20 – 2P
Qdy=80 – 3P
Qdz=140– 10P
Derive the market demand function.
2. The market for fish has 10 buyers each having a demand function given as, Qd= 600 – 2P. Determine the
market demand function for fish in this market.
3. The daily demand function for buyers of yams in the market is given by the demand function,
Qd=5 – 1/40P, where P is the price and Qd is the quantity demanded. Assuming that there are 200 buyers,
a) Find the market demand function.
b) On a table, show the quantity of yams (in units) as the price increases in the order, 10FCFA,
20FCFA - - - 50FCFA.
A Demand Curve
It is a diagram which shows the relationship that exists between the price and quantity demanded of a good a
particular time or it is a graphical representation of a demand schedule. A normal demand curve is negatively
sloped or it slopes downward from the left to the right as shown below.
Price
D
300 -----------------------
-----------------------------------------------
200 -------------------------------------
----------------------------------
100 ----------------------------------------------------
---------------------
20 40 60 Quantity
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The above curve shows an inverse (negative or indirect) relationship between price and quantity demanded.
When the price is 200FCFA, the quantity demanded is 40 units. When the price increases from 200 –
300FCFA, quantity demanded falls from 40 – 20 units and when price falls from 200 – 100FCFA, quantity
demanded increases from 40 – 60 units. This confirms the first law of demand and supply which states that
the lower price, the higher quantity demanded and vice versa. That is why a normal demand curve slopes
down from the left to the right or North West to South East.
Reasons Why a Normal Demand Curve is Negatively Sloped
A normal demand curve slopes downward from the left to the right indicating that more is bought at lower
prices than at higher prices.
Price
D
300 -----------------------
-----------------------------------------------
200 -------------------------------------
----------------------------------
100 ----------------------------------------------------
---------------------
20 40 60 Quantity
The negatively sloped nature of a normal demand curve is explained by the following economic concepts.
1. The Law of Diminishing Marginal Utility (DMU)
The law of DMU states that, as more units of a good are consumed, the Marginal Utility (MU) keeps falling.
MU is the satisfaction obtained from the consumption of an additional unit of a good. The price a consumer
pays for a product is determined by the MU obtained from its consumption. Therefore, the lower the MU, the
lower the price the consumer will be willing to pay. Since the additional satisfaction (MU) keeps falling as
more units of a good are consumed, the consumer will only be encouraged to buy more if the price is reduced.
That is why, a fall in price from 200 – 100FCFA leads to an increase in quantity demanded from 40 – 60 units
and an increase in price from 200 – 300FCF, leads to a fall in quantity demanded falls from 40 – 20units. That
is why a normal demand curve is negatively sloped.
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2. The Substitution Effect

It refers to the change in quantity demanded of a good as result of a change in price of the good in relation
to the price of a close substitute. Goods are close substitutes when one can be consumed in the place of the
other and they are within the same price range eg meat and fish, MTN and ORANGE networks etc.
When the price of a good falls from 200 – 100FCFA, with the price of the substitute remaining constant, the
good becomes cheap and more attractive to consumers. Consumers will switch from the good whose price
has remained unchanged to the one whose price has fallen and again the low price will attract those who were
not initially consuming the good. That’s why a fall in price from 200 – 100FCFA leads to an increase in
quantity demanded from 40 – 60 units.
When the price of the good rises from 200 – 300FCFA, with the price of the substitute remaining constant,
the good becomes expensive and unattractive to consumers. Consumers will switch from this good whose
price has risen to the substitute and the high price drive those who cannot buy at that price out of the market.
This will cause a fall in quantity demanded. That is why when price rises from 200 – 300FCF, quantity
demanded falls from 40 – 20units
3. The Income Effect
It refers to the effect of a change in price of a good on consumers’ real income which will equally cause a
change in the quantity demanded of a good everything being equal. When the price of a good changes, real
income changes. Real income is the amount of goods and services which money income or income can buy.
When the price of a good falls from 200 – 100FCFA, real income increases because, the same amount of
income can now buy more of the good than before and those who could not initially pay the high price are
now able to buy at lower prices thus the quantity bought at lower prices increases causing the normal demand
curve to be negatively sloped downward. That is why when price falls from 200 – 100FCF, quantity demanded
rises from 40 – 60units.
When the price of the good increases from 200 – 300FCFA, real income falls because, the amount of income
can only buy a smaller quantity of the good and some consumers will not able to pay the high prices and thus
move out of the market. This will reduce the quantity bought causing the normal demand curve to be
negatively sloped upward. That is why when price rises from 200 – 300FCF, quantity demanded falls from
40 – 20units.
Abnormal or Exceptional Demand Curves
These are demand curves which do not respect/obey the first law of demand and supply. They instead slope
upward from the left to the right (positively sloped) indicating that more is bought at higher prices than at
lower prices. There are two types:
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1. Regressive at the top.

With this situation, more is bought when the price of the good increases.
Price
D
300 --------------------------------
----------------------------------------------
200 -------------
------------------------------
40 60 Quantity
Up to the price of 200FCFA, the demand curve is normal after the price of 200FCFA, the demand curve
becomes abnormal. The above can be explained by two reasons:
a) Goods of Ostentation (Veblen goods, or Luxurious goods, or goods with a Snob Appeal)
These are goods which consumers buy for the sake of prestige and to show-off their wealth. Consumers buy
them not because of the satisfaction obtained from its consumption but because of the appreciation the society
has for them. The prestige of such goods is attached to their prices. Therefore, the higher the price, the higher
the prestige and social status. That is why when the price of such goods increases from 200 – 300FCFA,
quantity demanded equally increases from 40 – 60 units causing the demand curve to slope upwards from the
left to the right.
b) Expectation of future increase in price
A rise in the price of a good can create an expectation in the minds of consumers about further increases in
price. Thus, when they expect that the price of the good will increase in the future, they keep buying more
now even if the price is high because they are afraid of buying at even higher prices in future. That is why
when price increases from 200 – 300FCFA, quantity demanded equally increases from 40 – 60 units causing
the demand curve to slope upwards from the left to the right.
2. Regressive at the bottom
With this situation, less is bought when the price of the good falls.
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Price
300 -----------------------------------
---------------------------------
200 ---------------------
-------------------
40 60 Quantity
Up to the price of 300FCFA, the demand curve is abnormal and above 300FCFA, the curve is normal. The
above can be explained by two reasons.
a) Giffen goods.
With such goods, a fall in their prices increases the consumer’s real income and instead of using the increase
in real income to buy more of the same good, the consumer instead buys better quality substitutes which he
could not buy because of limited income. That is why the price of the good falls from 300 – 200FCFA,
quantity demanded instead falls from 60 – 40 units.
b) Expectation of future fall in price
When the price of good falls, consumers may expect further price falls. Thus, when they expect that the price
of a good will fall, they keep buying less now waiting for prices to fall sufficiently so that they can benefit
from the low prices. That is why the price of the good falls from 300 – 200FCFA, quantity demanded instead
falls from 60 – 40 units.
A CHANGE IN QUANTITY DEMANDED AND A CHANGE IN DEMAND

A. A Change in Quantity Demanded
It refers to the movement along the same demand curve caused by changes in the price of the good only.
Changes in price can lead to contractions and extensions in demand as shown below. It should be noted that
A change in price affects quantity demanded not demand.
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Price
D
300 -----------------------
-----------------------------------------------
200 -------------------------------------
----------------------------------
100 ----------------------------------------------------
---------------------
D
20 40 60 Quantity
When the price of the good increases from 200 – 300FCFA, quantity demanded falls from 40 – 20 units. This
is a contraction in demand. A contraction in demand refers to a fall in quantity demanded caused by an
increase in the price of the good only.
When the price of the falls from 200 – 100FCFA, quantity demanded increases from 40 – 60 units. This is an
extension in demand. An extension in demand refers to an increase in quantity demanded caused by a fall in
the price of the good only.
NB: A contraction and an extension in demand can be presented on two separate diagrams.
B. A change in demand
It is a complete shift of the demand curve to the left or to the right caused all other factors except the price of
the good eg advertisement, income, population etc.
Price D0 D2
D1
200 -------------------------------------
----------------------------
----------------------------
----------------------------
D2
D0
D1
20 40 60 Quantity
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The movement from DoDo to D1D1 is movement to the left which a decrease in demand. A decrease in demand
refers to the complete shift of the demand curve to left caused by unfavourable factors affecting demand like
unsuccessful advertisement, fall in income, and fall in population etc. At the same price of 200FCFA, a fall
in demand from DoDo to D1D1 leads to a fall in quantity demanded from 40 – 20 units.
The movement from DoDo to D2D2 is movement to the right which an increase in demand. An increase in
demand refers to the complete shift of the demand curve to right caused by favourable factors affecting
demand like successful advertisement, increase in income, and increase in population etc. At the same price
of 200FCFA, an increase in demand from DoDo to D2D2 leads to an increase in quantity demanded from 40 –
60 units.
NB: An increase in demand and a decrease in demand can presented on two separate diagrams.
DETERMINANTS (CAUSES) OF CHANGES IN DEMAND OR FACTORS THAT AFFECT

DEMAND
A number of factors can cause the whole demand curve to move to the right or to the left. Some of these
factors include:
1. The level of income
When the income of consumers increases, the demand for goods and services will equally increase because
an increase in income increases the purchasing power of consumers. A fall in income will lead to a fall in the
demand for goods and services.
2. Advertisement
A good and successful advertisement will lead to an increase in the demand for a good because it will give
consumers the impression/feeling that the good is superior to others. This will attract new consumers and
motivate old ones to buy more. But when advertisement is bad and unsuccessful, it will lead to a fall in
demand. Advertisement can be informative or persuasive.
3. Population
An increase in population will lead to an increase in the demand for goods and services because it increases
the number of buyers. A fall in population reduces the demand for goods and services.
4. Taste and fashion
The demand for some goods is very sensitive to changes in taste and fashion eg clothing, furniture, food
industry etc. When fashion changes in favour of a good, the demand for that good will increase because many
consumers will want to be in the latest mode. When there is unfavourable change in taste and fashion for a
good, the demand for that good will fall.
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5. The price of other goods

When two goods are substitutes, that is when one can be consumed in the place of the other and they have the
same price range, like meat and fish, MTN and Orange etc, a fall in the price of one reduces the demand for
the other and vice versa.
When two goods are compliments, that is they must be used together in order to obtain full satisfaction, eg
bush lamp and kerosene, car and petrol, a mobile phone and sim card etc, a fall in the price of one increases
the demand for the other and vice versa.
6. Expectation/speculation of future change in price
When consumers expect/speculate that the price of a good will increase in the near future, the demand for the
good will increase now because consumers want to avoid buying at higher prices in near future. But when
they expect that the price of the good will fall in the near future, the demand will fall now because consumers
will want to wait for such price fall and benefit the price fall.
7. Income distribution about households
When income is equitably distributed in the society, the demand for necessity goods will increase because the
poor have a greater propensity to consume than the rich. But income is inequitably distributed, the demand
for necessity goods will fall because the rich have a low propensity to consume. They instead have a high
propensity to save.
8. The availability and terms of credit facilities
The demand for goods and services increases when credit facilities like hire purchase, trade credit, personal
loans etc are available on soft. The terms can be softened with a fall in interest rate, extension in payment
period, and reduction in the initial deposit. But when credit facilities are not available or when the terms are
very hard, the demand for goods and services will fall.
9. Seasonal and weather changes
The demand for some goods changes with seasons. Therefore, when weather changes in favour of a particular
good, its demand will increase and when the weather change is unfavourable, the demand for the for the good
will fall. The demand for umbrellas, rain coats, rain boots, increase in the rainy season but fall in the dry
season. The demand for ice screams and sundry blocks increases in the dry season and fall in the rainy season.
10. Periods of festivities
The demand for goods and services increases when the periods of festivities increase and vice versa.
Exercise
1. What do you understand by the paradox of value?
2. What factors account for an increase in the demand of goods and services?
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3. What factors affect the demand for goods and services?

4. What factors affect the demand for housing in major towns in Cameroon?
5. What are the determinants of changes in the demand for carina 2 cars in Cameroon?
6. What exceptions exist to a normal demand curve?
7. Using the substitution and income effects, explain the shape of a normal demand curve.
8. Why is more demanded at lower prices than at higher price.
9. With the aid of diagrams, distinguish between an increase in demand and an extension in demand.
10. With the aid of diagrams, distinguish between a decrease in demand and a decrease in demand.
B. The Supply Theory

Supply refers to the quantity of a good/service which a producer is willing and able to sell at different prices
over a given period of time.
Supply schedule
It is table which shows the different quantities of a good which a producer is willing and able to offer for sale
at different prices over a given period of time. There are two types;
1. Individual Supply Schedule
It is a table which shows the different quantities of a good which a producer is willing and able to offer for
sale at different prices over a given period of time.
Price (FCFA) Quantity supplied (units)
1200 100
1000 90
8000 80
6000 60
4000 40
2000 20
When price reduces from 1200 – 1000FCFA, quantity supplied falls from 100 – 90 units and when price
increases from 6000 – 8000FCFA, quantity supplied increases from 60 – 80 units. Therefore, there is a
positive (direct) relationship between price and quantity supplied that is, an increase in price leads to an
increase in quantity supplied and vice versa. This confirms the second law of demand and supply which states
that, more is supplied at higher prices than at lower prices.
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The individual supply schedule can be obtained from the individual supply function. An individual supply
function shows the relationship between price and quantity supplied by a seller or a producer for a given
period of time.
Example:
The supply function of good is given as Qs= 200 + 4P, where Qs is the quantity supplied and P is the price.
Draw a supply schedule if prices increase in the order; 100FCFA, 200FCFA ….500FCFA.
Solution
Qs= 200 + 4P,
We will substitute the various values of price (P) in the function and obtain,
When P= 100FCFA, Qs=200 + 4(100) = 200 + 400= 600
When P= 200FCFA, Qs=200 + 4(200) = 200 + 800= 1000
When P= 300FCFA, Qs=200 + 4(300) = 200 + 1200= 1400
When P= 400FCFA, Qs=200 + 4(400) = 200 + 1600= 1800
When P= 500FCFA, Qs=200 + 4(500) = 200 + 2000= 2200
PRICE (FCFA) QUANTITY SUPPLIED (units)

100 600
200 1000
300 1400
400 1800
500 2200
Exercise
1. The supply function for tomatoes is given by Qs=100 + P. Draw a supply schedule for tomatoes for prices
ranging from 500 to 1000FCFA assuming that price is changing by 100FCFA.
2. The supply function for beans is given by Qs=P. Draw a supply schedule for beans for prices ranging from
500 to 1000FCFA assuming that price is changing by 100FCFA.
3. The supply function for rice is given by Qs=100. Draw a supply schedule for rice for prices ranging from
500 to 1000FCFA assuming that price is changing by 100FCFA.
4. The supply function for tomatoes is given by Qs=1000 + 10P. Draw a supply schedule for tomatoes for
prices ranging from 5000 to 10000FCFA assuming that price is changing by 1000FCFA.
5. The supply of a good is given by Qs=6P. Draw a supply schedule for tomatoes for prices ranging from
5000 to 10000FCFA assuming that price is changing by 1000FCFA
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2. Market Supply Schedule

It is a table which shows the total quantities of a good which all producers or all sellers are willing and
able to offer for sale at different prices at a particular time.
Price Quantity supplied Market
(FCFA) Mary Remy Joyful supply
12000 100 90 80 270
10000 90 80 70 240
8000 80 70 60 210
6000 70 60 50 180
4000 60 50 40 150
2000 50 40 30 120
NB: To obtain the market supply, we sum the quantities supplied at each price by the various sellers eg at
the price of 12000FCFA, we take 100 + 90 + 80= 270
The market supply schedule can be obtained from the market supply function. The market supply
function is an equation which shows the relationship between price and quantity supplied of a good by all
producers at a particular time. It is obtained by summing up all the individual supply functions.
Example:
A market is dominated by four (4) sellers having the following supply functions:
Qs1= 100 + 3P
Qs2= 200 + P
Qs3= 300 + P
Qs4 = 400
The market supply function will be Qs= Qs1 + Qs2 + Qs3 + Qs4
Qs = 100 + 3P + 200 + P + 300 + P + 400
= 1000 + 5P
Exercises
1. A market is dominated by four (4) sellers having the following supply functions:
Qs1= 3P
Qs2= 200 + P
Qs3= 300 + P
Qs4 = 400
Determine the market supply function.
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2. The supply of pears is dominated by 200 giant sellers having an identical supply function given by Qs=
1000 + 5P. Determine the market supply function.
3. The supply of garri is dominated by 1000 giant sellers having an identical supply function given by
Qs= 5P. Determine the market supply function.
4. The supply of oranges is dominated by 500 giant sellers having an identical supply function given by
Qs= 1000. Determine the market supply function.
THE SUPPLY CURVE

It is a graphical representation of a supply curve or it is a diagram which the relationship between the
price and quantity supplied of a good at a particular time. A normal supply curve is positively sloped or it
slopes upwards from the left to the right implying that, more is supplied at higher prices than at lower
prices.
Price
300------------------------------------------
-------------------------------------
200----------------------------------
-------------------------
100---------------------
----------------
20 Quantity
40 60
When the price increases from 200 – 300FCFA, quantity supplied increases from 40 – 60 units and when
price falls form 200 – 100FCFA, quantity supplied falls from 40 – 20 units. This shows that price and quantity
supplied move in the same direction that is, an increase in price leads to an increase in quantity supplied and
vice versa.
Reasons why a normal supply curve is positively sloped
More is generally supplied at higher prices than at lower prices because:
1. Profit motive
At higher prices, the profit received is higher. This encourages firms to expand their scale of production.
2. Attraction of new firms
When price increases, new firms are attracted into the industry causing quantity supplied to increase.
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3. Good profit margin

At higher prices, marginal firms which could not cover their costs at lower prices find it profitable to undertake
production thus increasing the market supply.
ABNORMAL SUPPLY CURVE
An abnormal supply curve does not obey the second law of demand and supply which states that more is
supplied at higher prices than at lower prices. Such a curve instead shows that more is supplied at lower prices
than at higher prices.
1. Backward Bending Supply Curve
This curve is applied to the individual supply curve of labour which relates the number of hours offered by
an individual at different wage rates. Each individual worker shares his time between work and leisure. This
curve shows that initially, a worker is interested in high wage rate. Therefore, when the wage rate increases,
the supply of labour increases. The worker substitutes work in the place of leisure because the substitution
effect (SE) is greater than the income effect (IE).
Once the target wage or critical point is attained, an increase in wage rate instead causes the worker to reduce
the supply of labour because he devotes more time to leisure than work. This known as the income effect
because the worker substitutes leisure in the place of work. The worker is longer interested in high wages.
Wage
Rate S
4000--------------------------------
----------------------------------------------
Critical point or
3000------------------------------------------------------ Target wage level
----------------------------------
60 Number of hours
40
Up to the wage rate of 3000FCFA, the marginal utility (MU) of work is greater than the MU of leisure. Thus,
the worker is prepared to supply more hours as the wage rate increases because he values work more than
leisure. He substitutes work in the place of leisure. That is why the SE is greater than the IE.
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At any wage rate above 3000FCFA, the MU of leisure is greater than the MU of work. The worker supplies
less hours of work as wage rate increases because he values leisure more than work. He substitutes leisure in
the place of work. That is why when the wage rate increases from 3000 to 4000FCFA, the supply labour falls
from 60 to 40 hours. Therefore, the IE is greater than the IE. Thus, 3000FCFA is the target wage. This curve
only applies to the individual supply curve of labour not to the whole industry.
A CHANGE IN QUANTITY SUPPLIED AND A CHANGE IN SUPPLY
(A) A Change in Quantity Supplied
It is a movement along the same supply curve caused by changes in the price of the good only. A change in
price can lead to an extension or a contraction in supply. It should be noted that A change in price affects
quantity supplied not supply.
Price
S
300-------------------------------------------------
------------------------------------------
200----------------------------------
-------------------------
100-------------
-----------
20 Quantity
40 60
An increase in price from 200 – 300FCFA, leads to an increase in quantity supplied from 40 – 60 units. This
is an extension in supply. An extension in supply is an increase in quantity supplied caused by an increase in
the price of the good only.
A fall in price from 200 – 100FCFA leads to a fall in quantity supplied from 40 – 20 units. This is a contraction
in supply. A contraction is supply is a decrease in quantity supplied of a good caused by a fall in the price of
the good only.
NB: An extension and a contraction in supply can be represented on two separate diagrams.
(B) A Change in Supply
It is complete shift of the supply curve to the right or left caused by factors affecting supply except the price
of the good eg number of producers, cost of production etc.
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Price S1
S0
S2
-------------------------------
200
-----------------------------
-----------------------------
S1
S0
S2
Quantity
20 40 60
The movement from S0S0 to S2S2 is a movement the right which is an increase in supply. With price held
constant at 200FCFA, this increase in supply causes quantity supplied to increase from 40 – 60 units. An
increase in supply is a complete shift of the supply curve to the right caused by favourable factors affecting
supply like an increase in the number of producers, and fall in cost of production.
The movement from S0S0 to S1S1 is a movement the left which is a decrease in supply. With price held
constant at 200FCFA, this decrease in supply causes quantity supplied to fall from 40 – 20 units. A decrease
in supply is a complete shift of the supply curve to the left caused by unfavourable factors affecting supply
like a fall in the number of producers, and an increase in cost of production.
NB: An increase and a decrease in supply can be illustrated on separate diagrams.
Determinants (causes) of changes in supply or factors affecting supply
1. Cost of production
A fall in cost of production maybe due to a fall in cost of inputs leads to an increase in supply because increases
the profits of firms causing them to expand the scale of production and equally attracts new firms into the
industry. An increase in cost of production reduces supply.
2. Number of producers
An increase in the number of producers increases supply because it increases the productive capacity of the
industry. A fall in the number of producers reduces supply.
3. Weather condition
The supply of agricultural products varies with the weather condition. Good weather condition like adequate
and sufficient rainfall and sunshine will lead to an increase in supply. But bad weather conditions like flood,
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droughts, hurricane will lead to a fall in supply. Equally the absence of pests, and other diseases increases the
supply of agricultural products and vice versa.
4. Government policy
When the government gives subsidies to firms, the supply of goods will increase because the subsidies will
help to reduce cost of production. But when the government imposes indirect taxes, the supply of goods will
fall because the indirect taxes will increase cost of production.
5. The state of technology
An improvement in technology will increase the supply of goods because it will improve the performance of
capital goods and labour, and the efficient use of raw material. A fall in technology will reduces the supply
of labour.
6. Import or trade policy
The domestic supply of goods will increase when imports are not restricted. Therefore, when a country is
practicing free trade, that is the absence of trade barriers, the domestic supply of goods will increase. But
when a country is practicing protectionism, that is restricting trade, the supply of goods will fall. Trade is
restricted with the use of custom duties, quotas, embargoes, exchange rates etc.
7. Price of other goods
When two goods are in competitive supply, the supply the two goods cannot be increased at the same.
Therefore, when the price one falls, the supply of the other increases and vice versa.
When two goods are in joint supply eg palm oil and palm kernel, the production of one automatically leads
to the production of the other. Therefore, an increase in the price of one, increases the supply of the other and
vice versa.
8. Economies of scale
When a firm is enjoying economies of scale, its supply of goods will increase because of the falling average
cost of production. When a firm is enduring diseconomies of scale, the supply of goods will fall because of
the increasing average cost of production.
9. Expectation of future change in price
When producers expect that the price of the good will fall in the near future, the supply of the good will
increase today because they want to avoid making losses in future when price falls. When they expect that
the price of the good will increase in future, supply will fall today because they will want to wait and make
more profits when the prices will increase.
10. The goals of the firm
When the aim of the firm is high turnover, it will increase its supply even when profit is falling. But the firm
aims at profit maximisation, it will reduce supply when profit starts falling.
Page 19 of 87
Exercise
1. Bring out the likely factors that will lead to an increase in the supply of good.
2. why would producers generally
3. What factors can lead to an increase in the supply of cocoa?
4. (a) Why would sellers generally offer a greater quantity in the market the higher the price?
(b) Is there any exception to this generalisation?
5. Explain the factors that will guide a producer in setting the price of his/her product
6. With the aid diagrams distinguish between an extension in demand and an extension in demand.
7. Distinguish between a contraction in supply and a decrease in supply
The Equilibrium Price

It is the price at which quantity demanded is equal to quantity supplied. It is therefore the only price at which
the quantity consumers wish to buy is exactly equal to the quantity producers want to sell. The equilibrium
price is determined by the market forces of demand and supply. We can obtain the equilibrium price and
quantity by three ways: From a schedule, graphically and algebraically.
1. From a schedule
We look at the values of quantity demanded and quantity supplied and see where they are equal. The
corresponding price is the equilibrium price.
Price (FCFA) Quantity demanded Quantity supplied Shortage/surplus Pressure on price
600 30 110 Surplus (80) Down
500 45 85 Surplus (40) Down
400 60 60 Equilibrium None
300 75 35 Shortage (40) Up
200 90 15 Shortage (75) Up
From the table above, the equilibrium price is 400FCFA because at this price quantity demanded is equal to
quantity supplied at 60 units.
2. Graphically
We plot the values of quantity demanded and quantity supplied against the prices. Where the two curves
intersect, we read the corresponding values of price and quantity at this point of intersection.
Page 20 of 87
Price
D
Surplus S
E
400----------------------------------
-------------------------
Shortage
S
D
Quantity
60
The equilibrium point is at point E. The equilibrium price is 400FCFA and the equilibrium quantity is 60
units. At any price above the equilibrium price of 400FCFA, there is a surplus because quantity supplied will
be more than quantity demanded. When the price is 500FCFA, Qss is 85 units and Qdd is 45 units. There is
an excess supply (surplus) of 85 units – 45 units = 40 units.
At any price below the equilibrium price of 400FCFA, there is a shortage because quantity demanded will be
more than quantity supplied. When the price is 200FCFA, Qdd is 90 units and Qss is 15 units. There is an
excess demand (shortage) of 90 units – 15 units = 75 units.
If for one reason or the other the market price increases above the equilibrium price, there will be a surplus.
In order to clear this surplus, producers will be forced to reduce their prices to sell their stocks. By so doing
the price will converge towards the equilibrium price.
If for one reason or the other the market price falls below the equilibrium, there will be a shortage. The many
buyers will scramble for the small available quantity. This will put pressure on the prices to increase upwards
towards the equilibrium price.
It is for this reason that we call this equilibrium as a Stable or Convergent Equilibrium because whenever
the equilibrium is distorted, the market forces will always work to restore the equilibrium without any
intervention of the government or other external forces. On this basis, Adam Smith advocated that the
government should not intervene in the economy but should allow the free forces of demand and supply
through the invisible hand to efficiently allocate resources.
3. Algebraically
We equate the demand and supply functions and solve for the equilibrium price. Then we substitute the
obtained equilibrium price in any of the demand or supply functions and evaluate to obtain the equilibrium
quantity.
Page 21 of 87
Example
If the demand function for a good is given by Qd= 1000 – 5P and the supply function is Qs= 400 + 10P,
Determine (1) the equilibrium price and (2) the equilibrium quantity.
Solution
1. At equilibrium, demand = supply
Qd = Qs
1000 – 5P = 400 + 10P
1000 – 400 = 10P + 5P
600 = 15P
600/15 = P, the equilibrium price (Pe) is 40FCFA
2. Using the demand function of Qd= 1000 – 5P,

Qd= 1000 – 5(40)
Qd= 1000 – 200 = 800 units
Or
Using the supply function of Qs= 400 + 10P
Qs= 400 + 10(40) = 800 units
Therefore, the equilibrium quantity is 800 units.
Exercise
1. (a) How do forces of demand and supply determine the price of a product in a free market? (8marks)
(b) Explain why the quantity demanded of product tends to rise as the price falls. (12marks)
2. The following is an individual’s demand function for apples in a certain daily market: Qd=1200 – P where
Qd is the quantity demanded in units and P is the price in FCFA.
a) (i) Briefly define an individual’s demand function. (2 marks)
(ii) Establish the individual’s demand schedule for a price range of 1000FCFA to 500FCFA, given
that price of apples is changing by 100FCFA. (5 marks)
b) Now assume that, there are 10 buyers of apples in the market referred to in (a)
(i) Define a market demand function. (2 marks)
(ii) Derive a market demand function for apples in this market. (3 marks)
(iii) Determine the price per apple that will enable producers to sell 5000 apples. (4 marks)
c) State two concepts which can be used to explain why more apples will be demanded at a lower price
than at a higher price. (4 marks) 2020 P3
3. A hypothetical market is made up of a buyer and a seller having the functions Qd=20 – 2P and Qs=4+2P
respectively.
a. Determine the equilibrium price and quantity algebraically
Page 22 of 87
b. Construct a demand and supply schedules for prices ranging from 1, 2, 3 …6FCFA
c. From the schedule in (b) above, state the equilibrium price and give a reason for your answer.
d. Draw a diagram to represent the equilibrium price and quantity.
e. If the price is fixed at 3FCFA, what will happen in the market?
f. If instead the price is fixed at 5FCFA, what will happen in the market?
4. There are 1000 buyers of meat each with a demand function given as Qd= 12 – 2P and 1000 identical
producers of meat each with a supply function given by Qs= 2P
a. Find the market demand and market supply functions of meat.
b. On a table, show the market demand and supply schedules for meat (in kg) assuming the price
increases in the order 1, 2, 3, ------6FCFA respectively, and from the schedule, determine the
equilibrium price and quantity.
c. Obtain the equilibrium price and quantity algebraically.
d. Plot the market demand and market supply curves for meat and show the equilibrium point
e. Is the equilibrium condition stable? Why?
CHANGES IN EQUILIBRIUM PRICE AND QUANTITY

A change in the equilibrium price and quantity can be caused by changes in demand, supply or both.
1. A change in demand
With supply held constant, an increase in demand leads to an increase in both the equilibrium price and
quantity and vice versa.
Page 23 of 87
Price D2
D
S
D1
500 ------------------------------------
-----------------------------
400----------------------------------
300------------------------- -------------------------
--------------------
D2
S D
D1
Quantity
20 40 60
An increase in income increases demand from DD to D2D2. This increases the equilibrium price and quantity
from 400 – 500FCFA and from 40 – 60 units respectively. A fall in income reduces demand from DD to
D1D1. This decreases the equilibrium price and quantity from 400 – 300FCFA and from 40 – 20 units
respectively.
NB: The effects of a changes in demand on the equilibrium can be illustrated on separate diagrams.
2. A change in supply
With demand held constant, an increase in supply reduces the equilibrium price and increases the equilibrium
quantity and vice versa.
Price
S1
D
S
S2
500----------------------
--------------------------------
400----------------------------------
-------------------------
400----------------------------------------
-------------------
S1
S
D
S2
Quantity
20 40 60
An increase in the number of producers increases supply from SS to S2S2. This reduces the equilibrium price
from 400 – 300FCFA and increases the equilibrium quantity from 40 – 60 units. A fall in the number
Page 24 of 87
producers reduces supply from SS to S1S1. This increases the equilibrium price from 400 – 500FCFA and a
fall in equilibrium quantity from 40 – 20 units.
NB: The effects of a changes in supply on the equilibrium can be illustrated on separate diagrams.
Exercise GCE 2005, Paper 3

Study the table below which shows a hypothetical weekly demand and supply schedules for various
individuals in the Yaoundé neighbourhood and answer the questions that follow.
BUYERS PRICE(FCFA) 40 30 20 10
Peter’s demand 20 30 50 60
John’s demand 20 20 20 30
Mary’s demand 10 25 30 35
SELLERS
Michael’s quantity supplied 80 30 20 0
Tata’s quantity supplied 70 50 40 0
Janet’s quantity supplied 90 70 30 0
Edoa’s quantity supplied 60 50 10 0
a) Determine the market demand and market supply schedules at the various prices quoted
b) Construct (using graph paper) and label the market demand and market supply curves using schedules in
(a) above.
c) What is the equilibrium price and quantity as, identified in your graph?
d) Suppose that the good which is bought and sold in the Yaoundé neighbourhood became so popular that
demand increased by 25 additional units at every price. Illustrate this increase in the market demand on
your graph and identify the new price and quantity.
e) What is the amount of the shortage that would exit at the price of 10FCFA given the original market
supply and market demand conditions?
Page 25 of 87
3. Changes in Both Demand and Supply

A. When Both Demand and Supply Increase. This can be analysed in three situations and diagrams.
i. When the increase in demand is more than the increase in supply
When both demand and supply increase but the increase in demand is greater than the increase in supply,
both the equilibrium price and quantity will increase as shown below.
D2
Price S
D S2
300 -----------------------------
--------------------------------------
200 ---------------
--------------------------------
S
S2 D2
D
40 60 Quantity
When demand increases from D0D0 to D2D2, and supply increases from S0S0 to S2S2, the equilibrium price
and quantity increase from 200 – 300FCFA and 40 – 60 units respectively. This is because the increase in
demand is more than the increase in supply.
ii. When the increase in supply is more than the increase in demand
When both demand and supply increase but the increase in supply is greater than the increase in demand, the
equilibrium price will fall and while the equilibrium quantity will increase as shown below.
Price D2 S
D
300 -------------------- S2
-------------------------------------
200 ---------------------------
----------------------------
D2
S2
D
40 60 Quantity
Page 26 of 87
falls from 300 – 200FCFA and quantity increase from and 40 – 60 units. This is because the increase in supply
is more than the increase in demand
iii. When the increase in demand is equal to the increase in supply
When both demand and supply increase but the increase the increase in demand is equal to the increase in
supply, the equilibrium price remains unchanged but the equilibrium quantity increases as shown below
Price D2 S
D
S2
300 ------------------------
--------------------------------
-------------------------------
S
S2
D2
D
40 60 Quantity
remains unchanged at 300FCFA and quantity increase from and 40 – 60 units. This is because the increase in
demand is equal to the increase in supply.
B. When Both Demand and Supply Fall
Assignment: With the use of three diagrams show the effects on equilibrium price and quantity when both
demand and supply fall.
Relationships Between Markets (Types of Demand and Supply)
A. Types of Demand
1. Joint or Complementary Demand
Goods are compliments when they must be used together in order to obtain full satisfaction eg car and petrol,
mobile phone and sim card, bread and butter etc. The complementarity of goods can be because of the nature
of the good or habit of the consumer. An increase in the price of one, will reduce the demand for the other
and vice versa.
Page 27 of 87
Price S1 Price
D D
S S
D1
300 ----------------- 500 -----------------------
-----------------------------
-----------------------------
300 ------------------
200 ---------------------
-----------------------
-----------------------
S1 D
S S D1
D
40 60 Quantity 20 30 Quantity
Car Petrol
If for one reason or the other (eg fall in the number of producers), the supply of cars falls from SS to S 1S1,
this will cause its price to increase from 200 – 300FCFA while its quantity will fall from 60 – 40 units because
cars have become expensive. Since cars must be used together with petrol to obtain full satisfaction, the
demand for petrol falls from DD to D1D1. This fall in the demand for petrol causes the price of petrol to fall
from 500 – 300FCFA and a fall in quantity from 30 – 20 units. The reverse occurs if the price of cars falls.
Therefore, when goods are compliments, the price and quantity of the two goods move in opposite directions.
2. Competitive Demand
Goods are said to be in competitive demand if they are close substitutes that is, when one can be consumed
in the place of the other and they have the same price range. Therefore, an increase in the price of one
increases the demand for the other and vice versa eg meat and fish, MTN and ORANGE etc.
Price S1 Price
D D1
S S
D
300 ----------------- 500 -----------------------

----------------------------
----------------------------
300 ------------------
200 ---------------------
-----------------------
----------------------
S1 D1
S S D
D
Meat Fish
If for one reason or the other (eg fall in the number of producers), the supply of meat falls from SS to S 1S1,
this will cause its price to increase from 200 – 300FCFA while its quantity will fall from 60 – 40 units because
Page 28 of 87
meat has become expensive. Since meat has become expensive, consumers will switch to the consumption of
fish causing its demand to rise from DD to D1D1. This increase in the demand for fish will cause the price of
fish to increase from 300 – 500FCFA and quantity to increase from 20 – 30 units. The reverse occurs if the
price of meat falls. Therefore, when goods are substitutes, the price and quantity of the two goods move in
the same directions.
3. Composite demand
A good is said to be in composite demand when it can be used for more than one purpose. Therefore, the
demand for the good may change due to a change in the demand for one of its uses. An increase in the demand
for one of its uses will reduce the supply available for other uses eg palm oil is used in cooking, and producing
soap, rubber is used in producing plates, shoes, cups, spoons etc.
Price D1 Price S1
D S
S D
500 -------------
300 --------------------------
-----------------------------
----------------------------
300 ------------------
200 ---------------------
-----------------------
----------------------
D1 S1
S D D
S
Palm oil for cooking Palm oil for making soap
An increase in the population increases demand for palm oil for cooking from DD to D 1D1. This causes the
price and quantity to increase from 200 – 300FCFA and from 40 – 60 units respectively. This increase in the
demand for palm oil for cooking, will reduce the supply of palm for making soap to reduce from SS to S 1S1
leading to an increase in price from 300 – 500FCFA and a fall in quantity from 40 – 20 units. The reverse
occurs when the demand for palm oil for cooking falls.
4. Derived Demand
It is the demand for a good which results from the demand for its final product. Therefore, it is the demand
for a good not for its sake but what it will help to produce eg the demand for timber results from the demand
for furniture, the demand for factors of production results from the demand for goods and services.
Page 29 of 87
Price Price S
D S S1
S1 D
500 -------------
-----------------------------
300 ---------------------------------------------
200 --------------------- 300 ------------------
-----------------------
----------------------
S
S
S1 D D
S1
Timber Furniture
An increase in the supply of timber from SS to S1S1 reduces the price of timber from 300 – 200FCFA and
increases the quantity from 40 – 60 units. This reduces the cost of producing furniture causing the supply of
furniture to increase form SS to S1S1, reducing the price of furniture from 500 – 300FCFA and increasing
quantity from 20 – 40 units.
B. Types of Supply
1. Joint Supply
Goods are said to be in joint supply when the supply of one automatically leads to the supply of the other that
is, a single production process gives rise to two or more goods. Therefore, an increase in the price of one,
increases the supply of the other and vice versa eg palm oil and palm kernel, mutton and wool, beef and hides,
kerosene and petrol etc.
Price D1 Price S
D S1
S D
500 -------------
300 --------------------------
-----------------------------
---------------------------
300 ------------------
200 ---------------------
-----------------------
----------------------
D1 S
S D D
S1
Palm oil Palm kernels
An increase in population increases the demand for palm oil from DD to D 1D1. This increase in demand causes
the price of palm oil to increase from 200 – 300FCFA and an increase in quantity from 40 – 60 units. Since
Page 30 of 87
the production of palm oil entails the production of palm kernels, the supply of palm kernels increases from
SS to S1S1 causing its price to fall from 500 – 300FCFA and an increase in quantity from 20 – 40 units.
2. Competitive Supply
Goods are said to be in competitive supply if an increase in the supply of one will reduce the supply of the
other since resources are limited. Their supply cannot be increased at the same time. Therefore, an increase
in the supply of price one will reduce the supply for the other and vice versa, eg land can used for farming,
grazing, building etc. an increase in the use of farm land for grazing reduces the quantity of land left for
building and grazing. More cow milk can only be produced at the expense of beef (cow meat).
Price D1 Price S1
D S
S D
300 -------------------------- 500 -------------

-----------------------------
---------------------------
300 ------------------
200 ---------------------
-----------------------
----------------------
D1 S1
S D D
S
Farm land Grazing land
An increase in income increases the demand for food stuffs and farmland from DD to D 1D1, leading to an
increase in price and quantity from 200 – 300FCFA and 40 – 60 units respectively. Therefore, more of the
land will shifted for farming. Since land is limited, the supply of land for grazing reduces from SS to S 1S1
thereby raising its price from 300 – 500FCFA and reducing quantity from 40 – 20 units. The reverse holds
when the demand for farmland falls.
Exercise:
1. Using diagrams, show how an increase in the demand for one of the goods in joint supply will affect the
prices and quantities of both commodities. (20 marks) GCE 2003
2. Consider the diagram below which shows the demand for and supply of Irish potato produced in
Cameroon. Starting each time from the initial demand and supply curves, DD and SS with equilibrium at
point F, determine the new equilibrium point for each of the following situations.
Page 31 of 87
D2 a) There is an increase in the population of Cameroon.

S1
D C b) There is a pest that destroys Irish potato.
Price
D1 c) There is an increase in the incomes of consumers
B S
G coupled with good weather conditions.
A
F S2 d) There is cheap Irish potato imported from China
J and consumers have developed a greater liking for
S1 E
I Irish potatoes.
D2
e) Farmers of Irish potato in Cameroon have received
S H
D subsidies from the government but there are articles
D1 in newspapers saying Irish potato is dangerous to
S2
human health.
Quantity
3. Consider the diagram below which shows the demand for and supply of beef produced in Cameroon.
Starting each time from the initial demand and supply curves, DD and SS with equilibrium at point F,
determine the new equilibrium point for each of the following situations.
D2 a) There is a decrease in the population of Cameroon.

S1
D C b) There is a pest that destroys cows.
Price
D1 c) There is an increase in the incomes of consumers.
B S
G d) There is a fall in the price of pork and many cows
A
F S2 have been killed by droughts.
J e) Cow owners in Cameroon have received subsidies
S1 E
I from the government but there are articles in
D2
newspapers saying meat is very nutritious to human
S H
D health.
S2 D1
Quantity
Gains from the Equilibrium Price

In a market, when the forces of demand and supply determine the price, both consumers and producers obtain
some benefits in the form of surplus.
1. Consumers’ Surplus or Buyers’ Surplus
It is the total benefit which consumers/buyers receive beyond what they pay for a good/service or it is the sum
of the difference between what each consumer is willing to pay and what he actually pays for a good/service.
Consumer surplus is the area under the demand curve but above the price line.
Page 32 of 87
Price Price Calculate the consumers’ surplus

Consumer’ surplus S
CS= ½ b×h
S 1000
Height CS= ½ × 50 × (1000 – 400)
CS= ½ × 50 × 600 = 15.000FCA

On a diagram,
CS= ½ base × height 400-------------
-------------------
---------------------
-----------------
Base
D
D
Quantity 50 Quantity
2. Producers’ Surplus or Seller’s surplus

It is total benefit which producers/sellers receive beyond the amount required to supply a good/service or it is
the sum of the difference between what a producer is willing to receive and what he actually receives for his
good/service. Producers’ surplus is the area below the price line but the above the supply curve.
Price
Price
S S
On a diagram, Calculate the producers’ surplus

Base
------------------- PS= ½ base × height PS= ½ b×h
400---------------------
--------------------------
--------------------------
PS= ½ × 50 × (400 – 300)
PS= ½ × 50 × 100 = 25,00FCA

Height
Producers’ surplus D
300 D
Quantity 50 Quantity
3. Community surplus
It is sum of the consumers’ surplus and the producers’ surplus or it is the total welfare gained from trading.
Therefore, from the examples above, the community surplus will be
= 15000FCFA+2500FCFA= 175.00FCFA
Page 33 of 87
THE CONCEPT OF ELASTICITY

Elasticity measures the degree of responsiveness of one variable due to a change in another variable. There
are two types: Elasticity of Demand and Elasticity of Supply.
A. Elasticity of Demand
It measures the degree of responsiveness of quantity demanded due to a change in price or income.
i. Price Elasticity of Demand (PED)
It measures the degree of responsiveness of quantity demanded due to a change in price.
PED= Percentage Change in Quantity Demanded
Percentage change in price
Or
PED= Change in Quantity Demanded × Initial/Original Price
Change in Price Initial/Original Quantity Demanded
= Change in Qdd × Qo
Change in Price Po
NB: In calculating PED, we ignore the negative sign.
Example:
The price of mangoes falls from 300 – 250FCFA and quantity demanded rise from 6 – 8 units. What the
coefficient of PED?
 Arc (Average) Elasticity of Demand
It measures elasticity of demand along a given section of the curve or over a range.
PED= Change in quantity demanded × P0 + P1
Change in price Q 0 + Q1
 Point Elasticity of demand
it measures elasticity of demand at a particular point on the demand curve. The coefficient obtained is valid
for all the points along that demand curve.
Point Elasticity of Demand= Number of points down the curve to the quantity axis
Number of points up the curve to the price axis
Example:
Points Price (FCFA) Quantity demanded Calculate the PED at points,
A 100 50 1. A
2. B
B 90 100
3. C
C 80 150 4. D
D 60 200 5. E
E 40 250 6. F
F 20 300 7. G
G 10 400
Page 34 of 87
Solution
Points PED
A 6/0=∞
B 5/1=5
C 4/2=2
D 3/3=1
E 2/4=0.5
F 1/5=0.2
G 0/6=0
Interpretation of the Numerical Values of PED

1. Perfectly Inelastic Demand (PED=0)
It means any proportionate change in price leads to no proportionate change in quantity demanded. Quantity
demanded does not respond to price changes thus quantity demanded is insensitive to price changes. This is
the case of absolute necessities that have no substitutes eg medication, and salt.
Price D
A proportionate change in price from 200FCFA to 400FCFA

400-------------------
leaves quantity demanded unchanged at 50 units.
200-------------------
50 Quantity
2. Fairly Inelastic Demand (PED<1)

A big proportionate change in price leads to a small proportionate change in quantity demanded. Quantity
demanded does not freely respond to price changes thus, quantity demanded is not very sensitive to price
changes. This is the case of goods with very few substitutes.
D A big proportionate change in price from 200FCFA to 400FCFA leads to

Price
a small proportionate change in quantity demanded from 60 to 50 units.
400-------------
------------------------
200-----------------
-----------
D
50 60 Quantity
Page 35 of 87
3. Unit Elastic Demand or Unitary (PED=1)

A proportionate change in price leads to the same proportionate change in quantity demanded.
Price D
A proportionate change in price from 200FCFA to 400FCFA leads to the
400--------------- ------------------------ same proportionate change in quantity demanded from 40 to 20 units.
200---------------------------- -----------
D
20 40 Quantity
4. Fairly Elastic Demand (PED>1)

A small proportionate change in price leads to a bigger proportionate change in quantity demanded. Quantity
demanded freely responds to price changes thus quantity demanded is very sensitive to price changes. This is
the case of goods with many substitutes or whose consumption can be postponed.
Price D A small proportionate change in price from 200FCFA to 400FCFA leads
300---------------------- to a bigger proportionate change in quantity demanded from 80 to 10 units.

------------------------
200--------------------------------
--------------------
10 80 Quantity
5. Perfectly Elastic demand (PED=∞)

A proportionate change in price leads to an infinite proportionate change in quantity demanded. Quantity
demanded over responds to price changes.
Price A proportionate change in price from 200FCFA leads to an infinite

200 D proportionate change in quantity demanded from 80 to 10 units. If the price
------------------------
-----------------------
increases from 200FCFA, nothing will be bought because quantity

demanded is extremely sensitive to price changes.
10 80 Quantity
Page 36 of 87
The Coefficient of PED Along a Straight Line or Linear Demand Curve

The coefficient of PED generally varies along a demand curve. For any linear demand curve, PED will be
different at different prices.
Price
PED=∞, Perfectly Elastic
A
PED>1, fairly elastic
PED=1, unitary
E
PED<1, fairly inelastic
PED=0, perfectly inelastic
M
Quantity
From the diagram above, we notice that the coefficient of PED keeps changing along the linear demand
curve.
Where the demand curve touches the price line at point A, demand is perfectly elastic and as we move
downwards towards point E, it becomes fairly elastic.
At the midpoint, point E, demand is unit elastic and as we move downwards after point E, demand
becomes fairly inelastic and when it touches the quantity axis at point M, demand becomes perfectly
inelastic.
Elasticity of Demand and Total Revenue

1. If demand is elastic, price and total revenue move in opposite directions that is an increase in price leads
to a fall in total revenue and vice versa. Here the Marginal revenue (MR) is positive.
2. If demand is inelastic, price and total revenue move in the same directions that is an increase in price leads
to an increase in total revenue and vice versa. Here the Marginal revenue (MR) is negative.
3. If demand is unit elastic (unitary), a change in price has no effect on total revenue that is an increase or a
decrease in price will leave total revenue unchanged. Here the Marginal revenue (MR) is zero.
Page 37 of 87
1. Consider the table which shows the demand and supply of a good. Over what price range is
Price (FCFA) Quantity demanded Quantity supplied demand,
600 30 110 a. Inelastic
500 45 85
400 60 60 b. Elastic
300 75 35
200 90 15
2. Consider the table which shows the marginal revenue and price of a good in the market.
Price FCFA 10 20 30 40 50 60 80 90
Marginal revenue (FCFA) -80 -70 -60 0 20 40 60 80
Over what price range is demand
a. Unit elastic
b. Elastic
c. Inelastic
The Determinants of Price Elasticity of Demand
Demand is said to be elastic when quantity demanded is very sensitive to price changes that is a small
proportionate change in price leads to a bigger proportionate change in quantity demanded. Demand is said
to be inelastic when quantity demanded is not very sensitive to price changes that is, a big proportionate
change in price leads to a smaller proportionate change in quantity demanded.
Some of the determinants of PED are
1. Availability or absence of close substitutes
Goods that have good and satisfactory substitutes having the same price range, have an elastic demand since
consumers can easily switch while goods that do not have close substitutes have an inelastic demand since
consumers have no choice.
2. The proportion of consumer’s income spent on the good
When a large proportion of a consumer’s income is spent on a good its demand will be elastic since changes
in price will affect consumers considerably. But when a small proportion of income is spent on a good, its
demand will be inelastic.
3. The degree of luxury or necessity
The demand for goods of necessity is generally inelastic because we cannot do without them while the demand
for luxuries is elastic because their demand can be postponed. However, the classification of goods into
necessities and luxuries depends on the current living standards and the level of development.
4. Number of uses
When a good has many uses, its demand will be inelastic because it must always be demanded for one of the
uses. But when a good has just one use, its demand will be elastic.
Page 38 of 87
5. Habit formation
When people have cultivated a strong habit for the consumption of a particular good, its demand will be
inelastic because, consumers are addicted to it and will always buy the good no matter the price since they
are addicted to the good and find it difficult to do without the good. But when people do not have the habit of
consuming a particular good, its demand will be elastic.
6. Time factor
Demand is inelastic in the short run and elastic in the long run. This is because it takes time for consumers to
adjust to price changes and equally in the long run new substitutes can be discovered.
7. Advertisement
When advertisement is successful, its demand becomes inelastic because the good becomes attractive to
consumers since they feel that the good is superior to others. But when advertisement is unsuccessful, the
demand for the good becomes elastic.
8. Level of income
When the income of a consumer is high, his demand for goods and services becomes inelastic because he
cannot feel the impact since his income is high. Thus, the rich are insensitive to price changes. But when the
income of the consumer is low, his demand for goods and services becomes elastic since changes in price
affect him considerably. The poor are thus very sensitive to price changes reason they complain a lot about
price changes.
The Importance of Price Elasticity of Demand
A. To the Businessman/Firm/Investor/Producer/Entrepreneur
1. Pricing policy
When demand is elastic, it would be important for the firm to reduce prices because it will cause TR to
increase but if demand is inelastic, it will be good for the firm to increase price because TR will also increase.
2. Output policy
When demand is inelastic, output should be reduced so as to increase price and total revenue but if demand
is elastic, output should be increased so as reduce price and increase total revenue.
3. Wage determination policy
When demand is inelastic, wage rates can easily be increased because the increased wages can effectively be
passed unto consumers in the form of high prices. However, when demand is elastic, wage rates can hardly
be increased because of the difficulty of raising prices since consumers will switch to other substitutes.
4. Helps in price discrimination
Page 39 of 87
Price discrimination is the selling of the same good to different consumers at different prices for reason not
related to differences in cost of production. Therefore, PED permits a firm to charge a higher price in the
inelastic market and a lower price in the elastic market.
5. Marketing strategy
When demand is inelastic, advertisement will be a waste of resources if the aim is to increase sales, it should
rather aim at increasing brand loyalty. But if demand is elastic, advertisement will help to increase sales.
6. Indicates the consumption pattern
When the demand for a good is inelastic, it means that the consumption of the good is indispensable to
consumers that is, they cannot do without the good. But when the demand for the good is elastic, it means
consumers can do without the good.
7. Indicator of profitably
Profits will likely increase when the demand for a good is inelastic since there are few competitors. But when
demand is elastic, profits will likely fall because of increased competition. This guides the potential investors
where their investments will provide more profits.
8. Evaluate/assess the success of an advertisement
If after an advertisement, the demand for a good becomes inelastic then the advertisement was successful.
But if after an advertisement, demand becomes elastic, then the advertisement was a failure.
B. To the government/state
1. Raise to revenue
The government will raise more revenue if indirect taxes are placed on goods with inelastic demand since it
can easily be passed to consumers in the form of high prices.
2. Control the consumption of harmful goods
The consumption of harmful (demerit) goods can only be effectively controlled through indirect taxes if
demand for the good is elastic. If demand for the good is inelastic, its consumption cannot be controlled
through indirect taxes.
3. Income distribution
Indirect taxes should target goods that have inelastic demand like luxuries and super luxuries since they are
consumed mostly by the rich. This will generate more income for the government to provide necessities to
the poor. This will help to reduce the gap between the rich and the poor.
4. Correcting BOP disequilibrium
In order to correct a BOP deficit, the currency can be devalued to make imports expensive thus discouraging
imports. To cure a BOP surplus, the currency can be revalued to make exports expensive thus discourage
Page 40 of 87
exportation. Therefore, devaluation or revaluation can only be successful if the demand for imports and
exports is elastic. If it is inelastic, the policies will fail.
5. To know the incidence of an indirect tax
The incidence of a tax is the final resting point of a tax that is, who finally/actually pays a tax. If demand is
inelastic, a greater part of the tax will be paid by the consumers and demand is elastic, a greater part will be
paid by the producer.
6. For economic planning or resource allocation
PED indicates the consumption pattern of consumers. When demand is inelastic, it means consumers cannot
do without the good and when it is elastic, it means consumers can do without the good. This will guide the
state in the allocation of resources as more resources will be diverted to the production of goods with inelastic
demand.
Cross Elasticity of Demand (CED)
It measures of the degree of responsiveness of quantity demanded of a good (good X) due to a change in the
price of another good (good Y). It is calculated using the formula;
CED= Percentage change in quantity demanded of good X

Percentage change in price of good Y
or
CED= Change in Quantity demanded of good X × Initial/Original Price of good Y
Change in Price of good Y Initial/Original Quantity Demanded of good X
Interpretation of the numerical value of CED

1. Positive CED
It means that the price and quantity of the two goods move in the same direction that is an increase in the
price of one, increases the quantity demanded of the other and vice versa. Thus, the goods are substitutes.
2. Negative CED
It means that the price and quantity of the two goods move in opposite directions that is an increase in the
price of one, reduced the quantity demanded of the other and vice versa. Thus, the goods are complements.
3. Zero CED
A change in the price of one has no effect on the quantity demanded of the other. It means the two goods are
unrelated or independent.
Example: The price of good Y increases from 200 to 250FCFA and quantity of good X changes from 20 to
30kg. Determine the value of CED and from your answer describe the relationship between goods X and Y.
Page 41 of 87
The importance of Cross Elasticity of Demand

1. Determines the relationship between goods
CED permits us to determine whether two goods are substitutes, complements or unrelated thereby facilitating
a firm’s prediction of the effect on its demand a competitor changes price.
2. Estimates the impact of demand
If goods are complements, like car and petrol an increase in the price of cars will reduce the demand for petrol
and vice versa. If goods are substitutes, like meat and fish, an increase in the price of meat will increase the
demand for fish and vice versa.
3. A guide to productivity
When CED is positive, output should be increased so as to reduce prices, when it is zero output should be
restricted to increase price since they are unrelated and when it is negative, output should be increased so as
to reduce prices.
(iii) Income Elasticity of demand (YED)

It measures the degree of responsiveness of quantity demanded due to a change in income.
YED= Percentage change in quantity demanded
Percentage change in income.
or
YED= Change in Quantity demanded × Initial/Original income
Change in income Initial/Original Quantity Demanded
Interpretation of the numerical value of YED

1. Positive YED
It means quantity demanded and income move in the same direction that is, an increase in income leads to an
increase in quantity demanded and vice versa. The good can be a normal good or a luxury.
a. If YED is less or equal to one but greater than zero (0<YED≤1), then it is a normal good
b. If YED is greater than one (YED>1), then it is a luxury
2. Negative YED (YED<0)
It means quantity demanded and income move in opposite directions that is, an increase in income leads to a
fall in quantity demanded and vice versa. The good is an inferior or Giffen good.
3. Zero YED (YED=0)
A change (increase or decrease) in income has no effect on quantity demanded. Such a good is an absolute
necessity like salt and medication.
Page 42 of 87
Example:
1. The weekly income of Paul increases from 4000 to 4100FCFA and he now consumes 8600kg of meat
when previously he used to consume 800kg. determine his YED for meat and comment on the nature of
meat.
2. Consider the table below.
Income (000FCFA) 10 15 25 40 50
Quantity demanded (kg) 500 1500 4000 5000 6000
Calculate the YED when income
i. Rises from 15000FCFA to 25000FCFA
ii. Falls from 50000FCFA to 40000FCFA.
3. Using the TR approach in the data below, what is the elasticity of demand between 70FCFA and 60FCFA
Price (FCFA) 90 80 70 60 50
Quantity demanded 400 500 600 700 800
4. From the table below, state at which price range demand is

i. Elastic
ii. Inelastic
iii. Unit elastic
Price (FCFA) 1 2 3 4 5 5 7
Marginal Revenue (FCFA) 100 100 20 20 0 -20 /
Determinants of Income Elasticity of Demand

1. The current living standard: some goods which are considered as inferior goods in some advanced
countries with higher living standards may instead be considered as normal or Veblen goods in LDCs
with low standard of living. Equally some normal goods in DCs may be taken as Veblen goods in LDCs.
2. The passage of time: as time changes, people’s financial situations change. Demand will increase for
some goods when the economy is getting better, remain constant when some level of income is attained
and fall when people become richer and replace the good with Veblen ones.
3. Level income: when income increases, some goods which are highly considered as Veblen goods may
become normal and some normal goods become inferior. When income falls, some previously normal
goods become luxuries or Veblen.
4. Technological changes: technological advancement brings new and better-quality goods making the
already existing ones to be considered inferior.
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The Importance of Income Elasticity of Demand

1. Output policy: it can help a firm to determine what goods to produce or stock that is, as the economy is
growing, firms will want to avoid producing inferior goods since they have negative YED and produce
more normal and Veblen goods.
2. Plan production and employee requirements: as the economy grows, more normal and Veblen goods
will be produced thus employment has to increase in such firms unlike in firms producing inferior goods
where employment has to drop. Firms can plan production because YED helps to forecast or predict the
pattern of consumers’ demand as income changes. As income rises consumers will buy more normal and
Veblen goods and less of inferior goods.
3. Influences allocation of resources: resources will be withdrawn from industries with negative YED to
industries with positive YED as the economy improves upon.
4. Indicates the purchasing power and level of development: if most people spend on inferior goods, the
purchasing power and the level of development are low. When more is spent on normal and Veblen goods,
it means the purchasing power and the level of development are high.
5. Indicates the type of good: it shows whether the good is normal, Veblen, basic necessity or inferior.
6. Provides economic signals: it provides signals of industries that are likely to be victims of contractions
as the economy expands that is, those producing goods with negative YED (inferior goods). They can
therefore, take adequate measures.
The Different Types of Goods
S/N Types of goods Price Elasticity of Demand (PED) Income Elasticity of Demand (YED)
1 Normal Good Negative Positive
2 Veblen Good Positive Positive
3 Giffen Good Positive Negative
4 Inferior Good Negative Negative
Example
The following equation represents the market demand function for good A; Q dA= 400 – 5P – 0.2Y where QdA
is the quantity demanded of good A, P is the price of good A and Y is the income. We can conclude that good
A is;
A. A Veblen good
B. An Inferior good
C. A Normal good
D. A Giffen good
The correct answer is B because in the equation price and income have negative relationships with Qdd.
Page 44 of 87
B. Price Elasticity of Supply (PES)

It measures the degree of responsiveness of quantity supplied due to a change in price.
PES= Percentage Change in Quantity supplied
Percentage change in price
Or
PES= Change in Quantity supplied × Initial/Original Price
Change in Price Initial/Original Quantity supplied
NB: PES is always positive since a supply curve is positively sloped.

 Arc (Average) Elasticity of supply
It measures elasticity of supply along a given section of the curve or over a range.
PES= Change in Quantity Supplied × P0 + P1
Change in price Q 0 + Q1
Interpretation of the Numerical Value or Degrees of PES

1. Perfectly inelastic supply (PES=0)
It means any proportionate change in price leads to no proportionate change in quantity supplied. Quantity
supplied does not respond to price changes thus quantity supplied is insensitive to price changes.
Price S A proportionate change in price from 200FCFA to 400FCFA

leaves quantity supplied unchanged at 50 units. The supply of
400-------------------
all goods is perfectly inelastic in the momentary or market
period since all factors are fixed.
200-------------------
50 Quantity
2. Fairly Inelastic Supply (PES<1)

A big proportionate change in price leads to a small proportionate change in quantity supplied. Quantity
supplied does not freely respond to price changes thus quantity supplied is not very sensitive to price changes.
This is case of agricultural products that take long periods of time to get ready for harvest.
Page 45 of 87
S
A big proportionate change in price from 200FCFA to 400FCFA leads to
Price
a small proportionate change in quantity demanded from 50 to 60 units.
400------------
------------------------
200---------
-----------
S
50 60 Quantity
3. Unit Elastic supply or Unitary (PES=1)

A proportionate change in price leads to the same proportionate change in quantity supplied.
Price S A proportionate change in price from 200FCFA to 400FCFA leads the

400-------------------- same proportionate change in quantity supplied from 20 to 40 units.
------------------------
200---------
----------
20 40 Quantity
4. Fairly Elastic Supply (PES>1)

A small proportionate change in price leads to a bigger proportionate change in quantity supplied. Quantity
supplied freely responds to price changes thus quantity supplied is very sensitive to price changes. This is the
case of manufactured goods that take very short period of time to be produced.
Price
S
300----------------------------
------------------------
A small proportionate change in price from 200FCFA to 300FCFA leads

200------------
to a bigger proportionate change in quantity supplied from 10 to 80 units.
----------------
10 80 Quantity
5. Perfectly Elastic Supply (PES=∞)

A proportionate change in price leads to an infinite proportionate change in quantity demanded. Quantity
demanded over responds to price changes.
Page 46 of 87
Price A proportionate change in price from 200FCFA leads to an infinite

200 S proportionate change in quantity supplied from 10 to 80 units. If the price
------------------------
-----------------------
falls from 200FCFA, nothing will be supplied because quantity supplied is
extremely sensitive to price changes.
10 80 Quantity
The Determinants of PES or Why PES Changes Over Time

Supply is elastic if producers can easily cut back stock or take off output from the market and keep in the
warehouse when price falls and can quickly release stocks or expand output when price increases. Supply is
inelastic when producers cannot reduce or expand output. PES depends on the following factors:
1. The length of the production period: when the length of the production period is long, supply becomes
inelastic and when the production period is short, supply becomes elastic. This is why the supply of
agricultural products is inelastic and that of manufactured products is elastic.
2. The number of producers: when there are many producers producing a good, its supply will be elastic
but if there are few producers, supply will be inelastic because it becomes difficult for producers to
respond quickly to price changes.
3. Factor mobility: supply is elastic when factors of production or resources can freely move from one
geographical region or occupation to another since output can easily be adjusted. When resources are
immobile, supply becomes inelastic.
4. The ability to store output and the amount of stocks held: when it is possible to store output in large
quantities without it getting bad, supply becomes elastic since firms can easily react to price changes. But
if output cannot be stored easily in large quantity, supply will be inelastic. This is why the supply of
agricultural products is inelastic and that of manufactured products is elastic.
5. The level of spare capacity: if an industry is operating below full capacity that is operating with unused
resources, supply will be elastic because supply can easily be increased by reengaging the idle resources
if price rises. Supply will be inelastic when the industry is operating at full capacity.
6. Time period: supply is inelastic in the short and elastic in the long run. This is because in the long run,
new machines can be acquired, new and better methods of production discovered, new firms can join the
industry and workers may work over time.
Page 47 of 87
Importance of PES
A. To The Businessman/Producer/Firm/Investor/Entrepreneur
1. Indicator of the level of spare capacity: it indicates the level of unused resources a producer has
thus its ability to react to price changes. if supply is inelastic no matter the change in price, quantity
supplied cannot be varied but when supply is elastic, it means there are unused resources which can
permit the firm to react to price changes.
2. Amount of stocks to hold: it guides producers on the amount of stocks to hold so as to meet up with
any fluctuations in demand. If supply is inelastic a large quantity of stocks must be kept if producers
speculate a favourable change in the market.
3. Employment policy: it guides producers either to reduce or increase the amount of labour employed.
The amount labour can be varied when supply is elastic but it is needless when supply is inelastic.
4. Estimate impact on producer’s revenue: when supply is elastic, and supply increases, the producer’s
revenue increases because the increase in quantity will be more than the fall in price. But if supply is
inelastic and supply increases, the producer’s revenue will fall because the fall is price will be bigger
than the increase in quantity.
B. To the Government
1. Indicates how the tax burden will be shared: when supply is elastic, a greater part of the indirect
tax will fall on consumers and when supply is inelastic, a greater part will fall on producers.
2. How to eliminate shortages and surpluses: if supply is inelastic, a shortage could be solved through
favourable import policies like reduction in tariffs. When supply is elastic, a surplus can be wiped out
by encouraging exports.
3. To know the effect of a tax or subsidy: if supply is elastic, a subsidy will greatly increase the size of
the industry while a tax will reduce it. There is little or no effect of a subsidy on the size of the industry
if supply is inelastic.
ELASTICITY OF SUPPLY AND THE TIME PERIODS
The time periods generally reflect the ease with which supply can be adjusted. We have three time periods in
economics: momentary/market period, short run and long run periods.
a) The momentary or market period: It is the period of time during which supply is restricted only to the
quantity actually available in the market. Thus, supply is perfectly inelastic in the momentary period
because all factors are fixed.
Page 48 of 87
Price An increase in demand from DD to D0D0 with supply

D0
Sm
held constant at Q0 increases the equilibrium price
D
from P0 to Pm. that is, price increases by the full
PM---------------------------------- EM
amount of the increase in demand and vice versa.
P0---------------------------------- E
D0
Q0 Quantity
b) The Short Run Period

It is that period of time which must elapse before more goods can be supplied with the existing capacity.
In the short run, at least one factor is fixed. Output can be altered in the short run by altering the variable
factors like employing more labour or working overtime. Thus, supply is elastic in the short run.
Price D0
Sm
An increase in demand from DD to D0D0 will cause
D
PM---------------------------------- EM SR price to increase from P0 to PS and quantity increases
from Q0 to QS. The short run price of PS is not as high
PS--------------------------------------------
ES as the momentary period price of PM. This is because
-----------------------
P0---------------------------------- E
firms increase supply from Q0 to QS.
D0
D
SR
Q0 QS Quantity
c) The Long Run Period

It is that period which is long enough for the whole scale of production to be changed. All factors are
variable in the long run. The whole scale of production can be changed in the long run. Therefore, supply
is very elastic in the long run.
Page 49 of 87
In the long run, supply increases from SR to SL in response

Price D0
Sm to the increase in demand from DD to D0D0. Supply
D SR increases because there has been an increase in the scale
PM---------------------------------- EM
of production since all factors of production are now
ES
PS-------------------------------------------- SL variable. Consequently, price falls to PL and quantity
------------------------
PL-------------------------------------------------EL
P0---------------------------------- E increases to QL. the long run price of PL is lower than the
SL ------------------- D0 short run price of PS and a greater quantity is offered. The
D new price can be equal to, lower or higher than the initial
SR
price of P0 depending on the extent to which supply may
Q0 QS QL Quantity
have increased.
Example:
1. The following table shows the market situation of a good. The movements from D to D 1 and S to S1
represent increases in demand for and supply of the commodity respectively.
Price/kg D D1 S S1
FCFA (Thousands of kg per annum)
800 10 25 45 53
700 14 30 42 52
600 18 35 35 50
500 25 40 25 48
400 30 43 14 43
300 34 45 10 34
200 35 47 7 30
100 36 48 6 25
a) Determine equilibrium price and quantity in the initial situation.
b) Assuming that demand increases from D to D1, determine the new equilibrium price and quantity in;
i. The Momentary period
ii. The Short run
iii. The long run
c) List four factors that can cause the increase in demand from D to D 1.
d) Illustrate the situations in i, ii and iii above on the same diagram.
THE PRICE MECHANISM (THE PRICE SYSTEM)
Price refers to what we pay in order to obtain a unit of a good or service. It includes the reward to factors of
production like wages, interest, profit and rents. Price is generally determined by the market forces of
demand and supply.
Price mechanism is an automatic device used for the allocation of resources through the market forces of
demand and supply.
Page 50 of 87
Functions (Roles) of the Price Mechanism or Price.

1. Signalling function: prices indicate changes in demand and supply and provides a means by which
consumers inform their changing preferences to producers. High prices indicate that more of the good is
needed and vice versa. Equally producers send information to consumers through prices. It tells consumers
what is available in the market and what terms.
2. Rationing function: since economic goods are always scarce, price helps to distribute these scarce goods.
When a good is too scarce, it is the price that distributes the scarce good to the few who can afford to pay
the high price and when the good is abundant, prices fall so as to permit consumers clear the stocks.
3. Rewarding function: price is used to reward the various factors of production for taking part in the
production process that is rents to land, wages to labour, interest to capital and profit to the entrepreneur.
Therefore, the higher the price, the higher the reward and vice versa.
4. Motivating or inducing function: price motivates/induces produces producers to either reduce or
increase quantity supplied. When demand increases, prices increase and producers are motivated to
increase quantity supplied in order to make more profits. When demand falls, prices fall and produces are
motivated to reduce quantity supplied in order to avoid making losses.
5. Allocative function: prices help to allocate resources in the economy among the competition uses. When
the prices of goods in a particular sector are increasing, entrepreneurs will direct more resources in that
sector so as to make more profits. But when the prices of goods in a particular sector are falling,
entrepreneurs will avoid directing resources in that sector so as to avoid making losses.
Advantages and disadvantages of the price mechanism as a means of allocating resources

See notes under advantages and disadvantages of the market economy.
Advantages: Disadvantages
1. Self-regulatory 1. Inadequate provision of public and demerit goods
2. Competition and self interest 2. Wide inequality in the distribution of income and wealth
3. Incentive to innovate and invent 3. Waste of resources through competition
4. High standard of living 4. Duplication of goods
5. Economic freedom 5. Exploitation of consumers
6. Economic efficiency 6. Emergence of monopolies
7. Consumer sovereignty 7. Instability in economic activities
8. Reduction in government intervention 8. Negative externalities are neglected
9. Promotes entrepreneurship 9. High rate of unemployment
10. Unbalanced development
11. Producer sovereignty Page 51 of 87
Market Failure
Market failure arises whenever; the price system or price mechanism fails to lead to an optimal allocation
of resources in the economy. This gives rise to over production in some markets and under production in
other markets. Market failure can also arise from market imperfections.
Causes of market failure
1. Advertisement: Excessive persuasive adverts has given rise to producer sovereignty that is, producers
produce what they like and persuade/convince consumers to buy rather than producing what
consumers want. Producers mostly produce false wants.
2. Externalities: These are costs and benefits that the society suffers or enjoys because of an economic
activity but which are not reflected in the prices of goods and services. It can be positive or negative.
A positive externality (external benefit) is the advantage that the society as a whole enjoys from an
economic activity but it is not reflected in the price of the product. A negative externality/external cost
is any loss that the society as a whole suffers from an economic activity and it is not reflected in the
price of the product. Price mechanism does not take into account these externalities.
3. Imperfect competition: Firms operating under monopoly or monopolistic competition often produce
a smaller quantity and charge higher prices on consumers.
4. Inequitable distribution of income: This is because of unfair distribution of resources given that
there is private ownership, use and disposal of these resources. The rich get richer as the market fails
to limit the size of the gap between income earners.
5. Merit and demerit goods: Merit goods are goods whose consumption gives more benefits to the
society than to the individual thus they are socially useful like education, and health. Demerit goods
are goods which are considered to be socially harmful like alcohol, cocaine, and marijuana. Market
failure arises because the market tends to produce more of demerit goods and less of merit goods.
6. Public goods: These are goods which when provided to one person can be provided to another person
at no extra cost like defence, street lights, law and order, public roads. They have two characteristics;
non rivalry and non-excludability in consumption.
Non rivalry means that the consumption of the good by one consumer does not stop another consumer
from consuming the good at the same time because of all them can have it.
Non excludability means that people who do not pay for the good cannot be prevented from consuming
it therefore not only those who pay consume it.
Because of these characteristics, public goods are unprofitable thus cannot be provided by private
sector yet despite the negative market signals, such goods must be produced.
Page 52 of 87
Solutions/Remedies to market failure.

1. Advertisement: The government should put in measures to ensure that advertisement should be
more informative than persuasive.
2. Externalities: Subsidies should be given to activities that produce external benefits and heavy
taxes be imposed on activities that produce negative externality.
3. Imperfect competition: Monopolies can be nationalised, maximum price instituted, imports
encouraged, heavy taxes imposed on their profits or the government declares them illegal.
4. Inequitable distribution of income: The progress tax system should be adopted and price
controls implemented.
5. Merit and demerit goods: The production and consumption of demerit goods should be heavily
taxed and banned while subsidies and tax holidays be given to producers and consumers of merit
goods.
6. Public goods: The government should produce such goods.
GOVERNMENT INTERVENTION IN THE MARKET
The government intervenes in the market through, indirect taxes, subsidies, price controls, provision of public
and merit goods. All these affect the equilibrium price and quantity.
A. The Effect of an Indirect Tax on the Equilibrium Price and Quantity
It is tax imposed on goods and services. It can be specific or ad valorem. It is specific when it is levied
according the weight or volume of the good and ad valorem when it is imposed according the value or price
of the good. Consider the table below which shows the demand and supply of fish and the government has
imposed a tax of 20FCFA/unit.
Price Quantity Quantity supplied before Quantity supplied after
(FCFA) demanded tax of 20FCFA/unit tax of 20FCFA/unit
100 100 1100 900
90 200 1000 800
80 300 900 700
70 400 800 600
60 500 700 500
50 600 600 400
40 700 500 300
30 800 400 /
20 900 300 /
Page 53 of 87
The imposition of an indirect tax increases cost of production leading to a fall in supply. This causes the
equilibrium price to increase and the equilibrium quantity to fall. There is a difference between the market
price and the supply price. The market price is the price actually prevailing in the market while the supply
price is what gets into the pocket of the producer. Therefore, what determines quantity supplied is the
supply price and not the market price. If the market price is high but the supply price is low, producers will
reduce quantity supplied. Indirect taxes increase the market price but reduce the supply price.
Before the imposition of the tax, the market price is equal to the supply price. After the imposition of the
indirect of 20FCFA/unit, the supply price reduces by 20FCFA at all prices. Thus, when the market price is
100FCFA, the market supply will 900units because at the market price of 100FCFA, the supply price after
tax is only 80FCFA. What was supplied at 80FCFA will now be supplied at 100FCFA. Before the imposition
of the tax of 20FCFA, the equilibrium price and quantity are 50FCFA and 600units respectively and after the
imposition of the tax, the equilibrium price and quantity are 60FCFA and 500units respectively.
The imposition of an indirect tax;
1. Increases cost of production
2. Reduces supply price
3. Reduces supply
4. Increases the equilibrium price
5. Reduces the equilibrium quantity
6. Reduces the consumers’ surplus
If the above schedule is plotted, we will obtain;
S1
Price
D S
60------------------
---------------------------------
50------------------------
-------------------------
40------------------
S1
D
S
500 600 Quantity
The total tax revenue is= (60FCFA – 40FCFA) × 500 units = 10.000FCFA
Page 54 of 87
Consumers’ share= (60FCFA – 50FCFA) × 500 units = 5.000FCFA

Producers’ share= (50FCFA – 40FCFA) × 500 units = 5.000FCFA
INCIDENCE OF A TAX BURDEN

 Tax burden: it is the amount of tax to be paid.
 Impact of a tax: it is the person who is supposed to pay the tax to the government or it is the person on
whom the tax has been imposed.
 Incidence of a tax: it is the final resting point of a tax or the person who finally/actually pays the tax or
bears the tax burden.
The impact of an indirect tax falls on the producer but the incidence can fall on the producer, consumer or
both depending on the elasticity of demand for and supply of the good.
1. Perfectly Inelastic Demand: the consumer pays all the tax that is all the tax burden falls on the
consumers. Therefore, the price of the good increases by the full amount of the tax. The producer shifts
all the burden to consumers is because he knows that no matter the increase in price, the consumer will
not change the quantity demanded. Consumers are insensitive to price changes.
S1
Price The imposition of an indirect tax shifts the supply to
S
D
the left from SS to S1S1. The tax per unit is P2P3 or
XY. The total tax is P2P3XY which have all been
P3------------------ X shifted to consumers in the form of increased prices.
NB
P2-------------------Y  Total tax revenue= P2P3XY
S1  Consumers’ share= P2P3XY
S  Producers’ share= 0
Q0 Quantity
2. Fairly Inelastic Demand: the consumers pay a greater part of the tax. The producer shifts a greater part
of the tax in the form of high prices because are not very sensitive to price changes.
Page 55 of 87
The tax per unit is P1P3 or XZ. The total tax is P1P3XZ of which
S1
Price a greater part of P2P3 or XY is shifted to consumers in the form
D S
of increased prices and producers pay only a small part of P 1P2
or YZ. As a result, the equilibrium price increases from P 2 to
X P3 while the equilibrium quantity falls from Q0 to Q1.
P3------------------
---------------------------------
NB
Y  Total tax revenue= P1P3XZ

P2--------------------
--------------------
Z
P1------------------  Consumers’ share= P2P3XY
 Producers’ share= P1P2YZ
S1
S D
Q1Q0 Quantity
3. Unit elastic demand (Unitary): the consumers and the producers pay the same amount that is, they
share the tax equally.
S1
Price
S The tax per unit is P1P3 or XZ. The total tax is
D
P1P3XZ. Consumers share of P2P3 or XY is shifted
X to consumers in the form of increased prices and

P3------------------
---------------------------------
producers pay P1P2 or YZ. The pro

Y
P2------------------------
-------------------------
NB
Z
P1------------------  Total tax revenue= P1P3XZ
S1 D  Consumers’ share= P2P3XY
S
Q1 Q0 Quantity
4. Fairly Elastic Demand: the producers pay a greater part of the tax. The producer shifts a small part of
the tax to consumers in the form of increase prices because they are very sensitive to price changes.
Producer suffer in the form of reduced supply prices.
Page 56 of 87
S1
Price
S
The tax per unit is P1P3 or XZ. The total tax is
P1P3XZ of which a smaller part of P2P3 or XY is
D
shifted to consumers in the form of increased prices
X
P3------------------ and producers pay a greater share of P1P2 or YZ.
---------------------------------
P2--------------------------
Y
---------------------------
NB
Z
P1------------------  Total tax revenue= P1P3XZ
D
S  Producers’ share= P1P2YZ
Q1 Q0 Quantity
5. Perfectly Elastic Demand: the producer pays all the tax that is all the tax burden falls on the producers.
Therefore, the supply price of the good falls by the full amount of the tax. The producer cannot shift any
burden to consumers is because he knows that any increase in price will cause nothing to be bought.
Consumers are infinitely sensitive to price changes.
S1
Price
S
The tax per unit is P1P2 or YZ. The total tax is P1P2YZ
which is all paid by the producer. The producer pays
Y D all in the form of reduced supply prices.
P2
---------------------------------
NB
Z  Total tax revenue= P1P2YZ
P1-------------------
 Consumers’ share= 0
S1
S

Q0 Quantity
Mathematically, the incidence of a tax burden borne by consumers and producers is given by:
Consumer’s share = ES × Amount of tax NB:
ES + ED  When ES is > than ED, consumers pay
a greater share
Producer’s share= ED × Amount of tax
ES + ED  When ED is > than ES, producers pay a
greater share.
Equally, Proportion of Producer’s Share= ED  When ES=ED, consumers and
Proportion of Consumer’s Share ES producers pay the same amount.
Page 57 of 87
Example 1: an indirect tax of 1000FCFA has been imposed on a good. Given that PED is 03 and PES is 1,
how much of the tax is borne by (i) Consumers (ii) Producers
Example 02: consider the following table which shows the demand supply schedules for a litres of palm oil
during given week.
Price (FCFA)/litre Quantity demanded (000 litres) Quantity supplied (000 litres)
2300 100 190
2200 120 180
2100 140 170
2000 160 160
1900 180 150
1800 200 140
a) What is the equilibrium price and quantity?
b) What will be the new equilibrium price and quantity if an indirect tax of 300FCFA per litre is imposed
per litre?
c) Sketch a graph to illustrate the equilibrium price and quantity before and after the tax.
d) How much of the tax is borne by;
i. Consumers
ii. Producers
e) How much revenue does the government collect from the imposition of such a tax?
f) What are the values of elasticity of demand and elasticity of supply?
g) What are the consequences of such a tax?
B. The Effect of a Subsidy on the Equilibrium Price and Quantity
A subsidy is a grant given by the government to producers. A subsidy reduces cost of production and increases
supply. Consider the table below which shows the demand and supply of fish and the government has granted
a subsidy of 20FCFA/unit.
Price Quantity Quantity supplied before Quantity supplied after tax
(FCFA) demanded tax of 20FCFA/unit of 20FCFA/unit
100 100 1100 /
90 200 1000 /
80 300 900 1100
70 400 800 1000
60 500 700 900
50 600 600 800
40 700 500 700
30 800 400 600
20 900 300 500
Page 58 of 87
When a subsidy of 20FCFA is granted, the supply price increases by 20FCFA at all price levels while the
market price falls by 20FCFA at all price levels. What was supplied at 100FCFA will be supplied at 80FCFA.
At the market price of 80FCFA, supply price is 100FCFA and thus 1100 litres will be supplied at 80FCFA.
After the subsidy, the equilibrium price falls from 50 – 40FCFA while the equilibrium quantity increases from
600 – 700 litres. A subsidy therefore,
1. Reduces cost of production
2. Increases the supply price
3. Increases supply
4. reduces the equilibrium price
5. increases the equilibrium quantity
6. increases the consumers’ surplus
If the above schedule is plotted, we will obtain;
S The total subsidy is= (60FCFA – 40FCFA) × 500 units =
Price
D S1 10.000FCFA
Producers’ share= (60FCFA – 50FCFA) × 500 units =
60----------------------- A
-----------------------------------------
5.000FCFA
50------------------------ B Consumers’ share= (50FCFA – 40FCFA) × 500 units =

---------------------------------
5.000FCFA
40------------------------ C
Consumers benefit in terms of reduced prices and

increased quantity while producers benefit in terms of
S
D increased supply price.
S1
600 700 Quantity
The extent to which consumers and producers benefit from a subsidy depends on PED and PES of the good
in question.
1. Perfectly Inelastic Demand: The consumers enjoy all the subsidy.
Page 59 of 87
Price The granting of a subsidy tax shifts the supply to the

S
D S1 right from SS to S1S1. The subsidy per unit is P2P3 or
XY. The total subsidy is P2P3XY which is all enjoyed
P3------------------- X
by consumers in the form of reduced prices
NB
P2------------------- Y
 Total subsidy= P2P3XY
S
Q0 Quantity  Producers’ share= 0
2. Perfectly Inelastic Demand: consumers enjoy a greater part of the subsidy

S
Price The subsidy per unit is P1P3 or XZ. The total subsidy is P1P3XZ of
D S1
which a small part of P2P3 or XY is enjoyed by producers in the form
of increased supply prices and consumers enjoy part P1P2 or YZ in
P3-------------------- X the form reduced prices. As a result, the equilibrium price falls from
--------------------------
P2-------------------- Y
----------------------
P2 to P1 while the equilibrium quantity increases from Q1 to Q0.
NB
P1---------------------Z
S  Total subsidy= P1P3XZ
D
S1  Producers’ share= P2P3XY
Q1Q0 Quantity  consumers’ share= P1P2YZ
3. Unit Elastic Demand: consumers and producers enjoy the same amount.
S
Price
The subsidy per unit is P1P3 or XZ. The total subsidy is
S1
D P1P3XZ. P2P3 or XY is enjoyed by producers in the form
P3------------------------X of increased supply prices and consumers enjoy P 1P2 or

-----------------------------------------
YZ in the form reduced prices. The consumers’ share is

P2------------------------Y equal to the producers’ share.
---------------------------------
P1----------------------- Z NB
 Total subsidy= P1P3XZ
 Producers’ share= P2P3XY
S  consumers’ share= P1P2YZ
S1 D
Q1 Q0 Quantity
4. Fairly elastic demand. Producers enjoy a greater part of the subsidy.
Page 60 of 87
S The subsidy per unit is P1P3 or XZ. The total subsidy is

Price
D P1P3XZ of which a greater part of P2P3 or XY is enjoyed
S1
P3---------------------------- X by producers in the form of increased supply prices and
------------------------------
consumers enjoy small part P1P2 or YZ in the form reduced
P2----------------------------Y
---------------------
prices. As a result, the equilibrium price falls from P2 to P1
P1--------------------------- Z
while the equilibrium quantity increases from Q1 to Q0.
S NB
S1 D  Total subsidy= P1P3XZ
Q1 Q0 Quantity  Producers’ share= P2P3XY
 Consumers’ share= P1P2YZ
5. Perfect elastic demand. All the subsidy is enjoyed by producers.
S
Price The subsidy per unit is P1P3 or XZ. The total subsidy is P1P3XZ
P3---------------------------- X S1
------------------------------------------------
of which all, P2P3 or XY is enjoyed by producers in the form of

increased supply prices. As a result, the equilibrium price falls
from P2 to P1 while the equilibrium quantity increases from Q1
P1 D to Q0.
-------------------------------
Z
NB
 Total subsidy= P1P3XZ
 Producers’ share= P1P3XZ
S
 Consumers’ share= 0
S1
Q1 Q0 Quantity
Mathematically, consumers’ and producers’ share are given by:

Consumer’s share = NB: ES × Amount of subsidy
ES + ED
 When ES is > than ED, consumers pay
a greater share
Producer’s share= ED × Amount of subsidy
ES + ED  When ED is > than ES, producers pay
a greater share.
Equally, Proportion of Producer’s Share= ED  When ES=ED, consumers and
Proportion of Consumer’s Share ES producers pay the same amount.
Example 1: the government grants a subsidy of 200FCFA/kg of sugar. Assuming the PED and PES are 2 and
3 respectively, how much of the subsidy per kg is enjoyed by
(i) Producers
(ii) Consumers
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Example 2. Consider the following table which shows the demand and supply schedules for a kg of pork
during a given week.
Price (FCFA)/kg Demand (000kg) Supply (000kg)
230 100 190
220 120 180
210 140 170
200 160 160
190 180 150
180 200 140
a) What is the equilibrium market price and quantity?
b) What will be the equilibrium market price and quantity if a subsidy of 30FCFA per kg is given to pork
producers?
c) Sketch a graph to illustrate the initial equilibrium price and quantity and the equilibrium price and quantity
after the subsidy.
d) By how much per unit has the subsidy benefited consumers and producers respectively?
e) What are the numerical values of PES and PED?
f) What is the total revenue accruing to pork producers after this subsidy and what is the total value of the
subsidy which the government has to pay?
C. PRICE CONTROLS
The government sometimes intervenes through price controls to influence the functioning of the economy.
However, the laws of demand and supply cannot be cancelled, they can only be distorted for a short while.
There are two types of price controls: maximum and minimum price controls.
1. Maximum Price (Ceiling price): It is the price above which a product cannot be sold. It is officially set
by the government below the equilibrium price because she thinks that the equilibrium price is too high
for consumers. If the maximum price is set above the equilibrium price, it will have no effect because
consumers and producers had already attained equilibrium.
Reasons for setting a maximum price
1. Prevent consumer exploitation
2. Control inflation
3. Reduce poverty
4. Reallocate resources
5. Increase consumption
Page 62 of 87
Price
D S The equilibrium price is Pe and the equilibrium
PB----------- quantity is Qe. The government sets maximum
----------------------------------
E price at Pm which is below the equilibrium price.
Pe--------------------
------------------------- The quantity demanded at the price of Pm is Q2
while the quantity supplied is only Q1. There is
PM----------------------------- --------------
Shortage therefore an excess demand (shortage) of Q2-Q1.
S D
Q1 Qe Q2 Quantity
Consequences (Effects) of a maximum or Ceiling Price

A. Positive Effects or advantages
1. Consumers’ welfare increases prices have reduced and consumer exploitation is also reduced. This
increases consumption.
2. It leads to equitable distribution of income in favour of the poor because they can now buy goods which
they could not because of the high prices.
3. It improves the BOP as exports become cheap making the quantity of exports to increase. Consumers too
tend to consume more of homemade products than imported goods.
4. It helps to reduce the rate of inflation if it is set on almost all goods. This helps to keep cost of living low
during periods of inflation.
5. It increases the efficiency of firms that want to stay in production since the low profit drives out inefficient
firms.
6. It increases consumer surplus as the price line is pushed downwards.
B. Negative Effects (Disadvantages or limitations)
1. It leads to shortage: Maximum price causes an increase in quantity demanded but a fall in quantity
supplied thus leading to an excess demand over supply causing a shortage.
2. Black Market develops: Due to excess demand over supply, there will be buyers who will be willing to
buy the good at a higher price. This leads to black market and a black-market price result. A black-market
price is any price illegally charged for a product different from the price set by the government or any
price that violates the price officially set by the government. With the existence of the black market,
consumers tend to pay a price that is even higher than the equilibrium price. P B on the diagram is the
black-market price.
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3. Creation of artificial scarcity (hoarding of goods): Producers tend to hide part of their goods because
the maximum price is low. This is done so as to force consumers to propose higher prices before the goods
can be released.
4. Fall in the quality of goods: Producers may reduce the quality of their goods because they have lower
financial resources to reinvest in their businesses because of the fall in profit.
5. Increase in unemployment: In the long run, producers may respond to the maximum price by reducing
the number of workers due to the fall in profit.
6. Rationing: As a result of the shortage, the government could be forced to ration the available quantity.
Consumers will not be able to get the quantity they desire.
7. Discrimination: In the process of rationing, discrimination may develop. Discrimination can in terms of
sex, political party, religion, language, race, tribe, colour etc.
8. Long waiting lists (queues): Consumers would be served on the basis of first come, first served. This
would lead to the development of long lines that cause waste of time and energy.
9. Increase in government spending. Government spending increases because, government officials have
to be sent to the field to implement the maximum price.
10. Fall in profit. Maximum price reduces the revenue per unit thereby reducing the profit of firms. This
discourages investment.
11. Fall in producers’ surplus
12. Social unrest
13. Distortion of the price mechanism as it fails to signal, reward, motivate, induce and allocate resources
properly.
It is because of the above reasons that maximum price is looked upon as good politics but bad economics.
Measures to make a Maximum Price Effective
1. Increase subsidies to producers
2. Reduce restrictions on the importation of the good or similar good so as to encourage its imputation like
reducing indirect taxes on imports.
3. Direct production of the good by the government in order to increase supply
4. Heavy sanctions on defaulters
5. Encourage NGOs that will comply with government policy to produce the good
6. Rationing
7. Education of sellers
8. Release unsold stocks if any
Page 64 of 87
9. Discourage the exportation of the good

Domains where the maximum price can be implemented
1. Rent payment
2. Interest rate
3. Health care
4. Education
5. Transport
6. Public utilities (telephone, electricity, water)
7. Basic necessities (cooking gas, palm oil, meat, fish)
8. Insurance premium
2. Minimum Price (Price Floor). It is the price below which a product cannot be sold. It is officially set by
the government above the equilibrium price because she thinks that the equilibrium price is very low for
producers. If the minimum price is set below the equilibrium price, it will have no effect because
consumers and producers had already attained equilibrium.
Reasons for setting a minimum price
1. Raise the income of farmers
2. In the labour market it guarantees the wage rate of workers
3. Ensure a steady and regular supply of the product
4. To maintain the quality of the good by ensuring that producers earn a sustainable level of profit.
5. Protect producers from low prices
Price
The equilibrium price is Pe and the equilibrium
D S
Surplus
quantity is Qe. The government sets minimum
PMIN----------------------------
-----------------------------------
----------------------------------
price at Pmin which is above the equilibrium

E
Pe-------------------- price. The quantity supplied at the price of Pm is
-------------------------
QS while the quantity demanded is only QD.

PB----------------------------
There is therefore an excess supply (surplus) of
S D
QS-QD.
QD Qe QS Quantity
Page 65 of 87
Consequences (Effects) of a minimum or Price Floor

A. Positive Effects or advantages
1. The production of some goods like agricultural goods is encouraged as producers increase their scale of
production and new producers are attracted by the high price.
2. Producers are protected from low prices thereby stabilising their incomes during periods of good harvests.
3. Workers are guaranteed a minimum wage which can enable effective planning of their incomes.
4. It helps the economy to recover from deflation.
5. It helps to ensure a steady and regular supply of the product
6. The quality of the product is maintained and even improved upon.
B. Negative Effects (Disadvantages or limitations)

1. It creates excess supply of the good as supply exceeds demand that may cause prices to fall if the
government does not buy the surplus.
2. Because of the surplus that arises, some sellers may be forced to reduce their prices below the equilibrium
price so as clear their stocks. Therefore, leading to a black-market price of P B.
3. Government spending increases because for her to maintain the price at P min, she has to buy the surplus at
the price of Pmin and store it.
The minimum price may encourage inefficient firms to continue production as they are unfairly protected
by the government through the minimum price. The total cost to the government is obtained by
multiplying the surplus by the minimum price.
4. It distorts the function of the price mechanism as price fails to signal properly leading misallocate of
resources.
5. In the labour market, it will to unemployment as many people will be willing to work but will not find
jobs
6. It discourages firms from producing alternative goods which they could produce more efficiently or which
has high demand but with a lower market price.
Measures to make a Minimum Price Effective
1. Stimulating demand for the product through adverts, increase in income etc.
2. Restricting the importation of the good by adopting protectionist policies.
3. Encourage the exportation of the good
4. Buying the surplus at the minimum price and storing it or destroying.
Domains where the Maximum Price can be implemented
1. The agricultural industry
Page 66 of 87
2. The labour markets

Exercise. Study the following information about the market of yams and answer the questions that follow.
Price (FCFA)/bucket Quantity demanded (000buckets) Quantity supplied (000buckets)
9000 30 62
8000 35 60
7000 41 57
6000 45 53
5000 49 49
4000 53 45
3000 57 41
1. What is the equilibrium price and why?
2. Suppose the government fixes the price of yams at 4000FCFA per bucket,
a) What is the name of such a price?
b) Draw a diagram to represent the situation in (a) above.
c) State any two effects of such a price mentioned in (i).
3. The government now guarantees yam producers a price of 6000FCFA per bucket.
a) What is the name of such a price?
b) Draw a diagram to represent the situation in (a) above
c) How many buckets would she buy from producers?
d) How much will this cost the government?
4. What will be the effect on the equilibrium price and quantity of yams if the demand for yams increases by 8000
buckets at all price levels?
THE AGRICULRURAL INDUSTRY
It is one of the most important sectors especially in developing countries but the sector faces many problems,
the greatest being instability of the prices leading fluctuations in farmers’ incomes.
Reasons/causes of instability of prices of agricultural produce

1. Perishable nature of agricultural produce
Agricultural products are very perishable and more perishable than any other product. They cannot be
stored for long because they will easily get bad. Consequently, farmers have a very limited time to sell
their harvests. Prices will fluctuate because during good harvest, prices will fall and during bad harvest,
prices will increase.
2. The behaviour of farmers
Farmers are always very naïve, behave in an uncoordinated manner and always refuse to learn from their
past mistakes. They continue to cultivate according to the current prices in the market. When prices are
high, they cultivate more the next season causing prices to fall. Because of the low prices, in the next
Page 67 of 87
season they cultivate less. This reduces supply and increases prices. We therefore have a rotation of
surpluses and shortages from one season to another causing price to fall and rise.
3. Natural factors
The quantity and quality of farm produce farmers supply in the market is highly determined by natural
factors like weather (rainfall/sunshine, droughts/floods), pests, diseases etc all of which are beyond human
control. This makes it difficult for farmers to control supply no matter the level of demand. This causes
wide fluctuations in output and consequently prices.
4. Number of farmers/producers
The agricultural sector has so many small-scale farmers producing identical products. Therefore, it is very
difficult for these so many farmers to come together and agree on the price and quantity of their goods
leading to wide fluctuations in output and prices.
5. The demand for agricultural produce is inelastic
Since agricultural products especially food stuffs serve just one purpose, consumers do not easily change
their quantity bought as price changes. As a result, prices tend to fluctuate whenever there is an increase
or decrease in supply.
6. The supply of agricultural produce is inelastic
Producers of agricultural produce cannot easily change supply due to a change in price. Supply of farm
produce is inelastic in the short run because output cannot be stored for long and it has time period which
must elapse/pass before output can be increased unlike manufactured products.
7. Supply lags/delays
The fluctuations and instability of prices of agricultural produce results from supply delays which exist
between the decision to produce and the products coming to the market. This is explained by the Cobweb
Theory.
The Cobweb Theory
It is a dynamic model of the relationship between demand and supply of agricultural products in a
particular market.
Assumptions
1. The present supply of a good depends on the last year’s price of the good.
2. Demand depends on the price prevailing in the market
3. Farmers are naïve and behave in an uncoordinated manner that is, they refuse to learn from past errors.
4. There are many buyers and sellers
5. Resources are perfectly mobile
Page 68 of 87
6. The products are identical (homogenous)

7. There is free entry into and exist out of the market
8. There is no government intervention
9. Producers cannot create artificial scarcity so as to increase price
Types of Cobwebs
There are three types of cobwebs: Convergent/Stable Cobweb, Divergent/Unstable Cobweb, Constant
or Perfect Cobweb.
1. Convergent or Stable Cobweb/oscillation
It shows how yearly fluctuations in the supply of agricultural products move the economy towards the
equilibrium each time this equilibrium is distorted. Therefore, the price fluctuates more towards the
equilibrium price because PED is greater than PES. Therefore, the demand curve is elastic while the
supply curve is inelastic. It has fluctuations/oscillations which reduce in amplitude. The convergent
cobweb is shown below
S
Price Price
P*
P*
P1
P1
Pe -------------------------------------------Pe-----------------------------------------------------
-
P2 P2
Q* Q1 Qe Q3 Q2 Quantity Time (years)

The equilibrium price is Pe and equilibrium quantity is Qe.
A fall in the number of farmers reduces quantity supplied to fall from Qe to Q* leading to an increase in
price from Pe to P* and quantity demanded equally falls from Qe to Q*. Because of this inducing and
encouraging price, farmers produce and supply more (an output Q2) the next year but demand is only Q*.
Therefore, there is surplus of Q2–Q* which causes prices to fall to P2.
Page 69 of 87
This low price discourages farmers from producing. This causes quantity supplied to fall to Q 1 the next
year but demand increases to Q2. This fall in quantity supplied causes prices to increase to P 1 since there
is a shortage of Q2–Q1. The high price will again encourage farmers to plant more crops the next year
causing quantity supplied to increase to Q3 and price falling.
This process will continue every year and as the years go by, the price moves towards the equilibrium
until the equilibrium is restored at Pe and Qe.
2. Divergent or unstable cobweb/oscillation
It shows how yearly fluctuations in the supply of agricultural products move the economy away from the
equilibrium. Therefore, once the equilibrium is distorted/disturbed, the equilibrium will never be restored.
The price fluctuates away from the equilibrium price because PES is greater than PED. Therefore, the
supply curve is elastic while the demand curve is inelastic. It has fluctuations/oscillations which increase
in amplitude. The divergent cobweb is shown below.
Price
Price
P3
P3
P1
P1
Pe-----------------------------------------------------------------------------Pe--------------------------------------------------------------
------------------------------
P2
P2
D
Q3 Q1 Qe Q2 Quantity Quantity
The equilibrium price and quantity are Pe and Qe respectively.
Bad weather condition causes quantity supplied to fall to Q 1 causing the market price to increase from Pe to
P1 because there is a shortage. This increase in price encourages farmers to supply more the next year.
Page 70 of 87
The increase in price to P1 encourages farmers to increase quantity supplied the next year to Q2. Quantity
supplied has increased to Q2, but demand is only Q1. This creates a surplus of Q2-Q1. This surplus will cause
the market price to fall from P1 to P2.
This low price discourages farmers the next year and they reduce quantity supplied to Q 3 which will cause
price to increase from P2 to P3.
This process of fluctuations/oscillation continues and keeps the price further away from the equilibrium every
year.
3. Perfect or Constant or Stationary Cobweb/Oscillation
Here the price fluctuation is between two levels and never moves towards the equilibrium. The price falls and
increases by the same amount causing fluctuations to take place around the equilibrium which however is
never attained/reached because PES=PED. The perfect cobweb is shown below.
Price Price
P2
S
P2
Pe---------------------------------------------------------Pe----------------------------------------------------
---------------------------
p1
p1
Q1 Qe Q2 Quantity Quantity
The equilibrium price and quantity are Pe and Qe respectively. Bad weather reduces supply from Qe to Q1.
This causes price to increase the next year to Q2. But demand is only Q1. This causes a surplus which causes
price to fall to P1. Price keeps fluctuating only between P1 and P2 but equilibrium is never attained.
Limitations/weaknesses/criticisms of the theory

1. Producers may anticipate price fluctuations and not simply rely on current prices.
2. The demand and supply curves may shift.
3. Farmers may experience a better or worse harvest than expected
4. Producers may release stocks which will reduce the price fluctuations
Page 71 of 87
5. There may be delays in adjustments due to price changes

6. The scope of application of the theory is limited. It is only applicable to the agricultural sector.
Question (GCE 2019)
(a) Why might the price of cocoa fluctuate more than the price of computers? (8 marks)
(b) What factors can lead to an increase in the supply of cocoa? (12 marks)
STABILISATION PROGRAMS
The unstable nature of prices of agricultural products has led to the need for some policies to be undertaken
either by farmers’ organisation or the government in order to stabilise prices and incomes of farmers.
A. Internal Measures
1. Farmers’ Stabilisation Program
Farmers stabilise the prices of their products through producer cooperatives. The main objective is to control
the quantity of the good getting into the market. This is done by withholding output during good harvest or
surplus and releasing the stocks during periods of bad harvest or shortage. This helps to reduce violent
fluctuations in prices and maintain prices of farm produce high and stabilise farmers’ incomes.
Price D S2
S
A
P2------------------- S1
-------------------------------
E
P0--------------------------
------------------------
B
P1----------------------------------
------------------
S2
S D
S1
0 Q2 Q0 Q1 Quantity
The cooperative works to stabilise price at P 0 and quantity at Q0 and the income realised is 0P0EQ0.
In the year of good harvest, supply increases from SS to S1S1 and farmers produce Q1. If the cooperative does
not intervene, prices will fall to P1 and farmers’ incomes will fall to 0P1BQ1. Consequently, the cooperative
intervenes and withdraws the excess quantity (Q1-Q0) and stores so that only Q0 is sold at the price of P0.
In the year of bad harvest, supply falls from SS to S 2S2 and farmers produce Q2. Under normal circumstances
the price will increase to P2 leading to an increase in farmers’ incomes to 0P2AQ2. But to avoid such a
situation, the cooperative releases the output (Q0-Q2) into the market. This will maintain the price at P0 and
Page 72 of 87
income at 0P0EQ0. In this way the cooperative stabilises both the price and income of farmers despite
fluctuations in output.
2. Government Stabilisation Program (Buffer Stock)

In the absence of a viable producers’ cooperative, the government must design programs aimed at stabilising
the prices of farm products and income of farmers. In attempt to stabilise the prices, the government can apply
the Buffer Stock System in which the excess which is not bought in the market is bought by the government
and stored in the warehouse and the stock is released during periods of bad harvest.
Price D
S2 S S1
P2------------------- A
P0----------------------------E
P1--------------------------------- B
0 Q2 Q0 Q1 Quantity
The government needs to maintain sales at P 0 and Q0 respectively and maintain income at 0P0EQ0.
In the year of good harvest, supply increases from S to S1 and farmers produce Q1. If the government does not
intervene, prices will fall to P1 and farmers’ incomes will fall to 0P 1BQ1. Consequently, the government
intervenes and withdraws the excess quantity (Q1-Q0) and stores so that only Q0 is sold at the price of P0.
In the year of bad harvest, supply falls from S to S2 and farmers produce Q2. Under normal circumstances the
price will increase to P2 leading to an increase in farmers’ incomes to 0P2AQ2. But to avoid such s situation,
the government releases the output (Q0-Q2) into the market. This will maintain the price at P 0 and income at
0P0EQ0. In this way the government stabilises both the price and income of farmers despite fluctuations in
output.
Advantages of the Buffer Stock Scheme
1. Farmers are sure of a stable price, income and standard of living.

2. The reduction in price fluctuations will stabilise export earnings in the producer country.
3. The consumers are sure of a steady supply of the product.
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4. Consumers enjoy the market economies of bulk buying

5. Consumers buy at lower prices when shortages threaten to increase prices.
6. The scheme is self-financing since it buys at lower prices and sells at higher prices.
7. Producers sell at higher prices when surpluses threaten to reduce prices
8. If the product is sold internationally, it strengthens international cooperation between partners and protects
trading partners.
Disadvantages (problems) of the Buffer Stock Scheme
1. Technological advancement, continuous good weather and other developments may cause the scheme
promoters to remain eternal buyers.
2. Storage and administrative costs could be too high when it becomes necessary to stock pile large quantities
over long period.
3. Agricultural products are highly perishable thus; they cannot be stored for long.
4. Continuous bad harvests may lead inadequate supply.
5. It may cause excess tax burden as taxes may be increased to raise funds for the scheme.
6. It is difficult to organise and control a large number of small producers
7. The scheme might set a single price which maybe too high or too low
8. Some producers may cheat on the collective agreement by disrespecting the agreed quota.
B. External Measures
1. International Commodity Agreement
These are arrangements between consumers and producers of certain goods like coffee, rubber, cocoa etc. It
can be in the form of multilateral contracts, buffer stock or quota system. Such agreements;
 Defines the quota of all member countries to avoid shortages and surpluses
 Stabilising prices of products and incomes of farmers
 Preventing excessive and unhealthy competition amongst member state
2. International Compensatory Schemes
It consists of providing finance to offset unexpected reductions in the export earnings especially in developing
countries whose main exports are primary products. When export earnings of these countries are low, the
scheme compensates them for the loss in export revenue
Questions
1. With the help of a well labelled diagram, explain how the prices of primary products can be stabilised.
(20 marks) (GCE 2016)
Page 74 of 87
2. The following table refers to an imaginary market for corn in which farmers are assumed to plan next
year’s production on the basis of last year’s price.
Year Price per kg (FCFA) Amount bought and sold (kg)
1990 150 3000
1991 200 1000
1992 125 4000
1993 165 2500
1994 145 3250
1995 150 3000
1996 150 3000
(a) Plot the price of corn against the various years. (Use a graph paper) (8 marks)
(b) Make a brief comment on the price trend of corn over the years. (4 marks)
(c) List four factors that may account for this tendency in price. (4 marks)
(d) What type of price legislation would you advice your government to pass for the product and why? 4
CONSUMER BEHAVIOUR (Demand Theories)

It seeks to explain how a consumer will spend his limited income on a range of products with the aim of
maximizing his satisfaction.
A. The Utility Theory of Household Behaviour
Utility refers to the satisfaction derived from the consumption of a particular good/service at a particular time.
It is measured in utils. Utility changes with time and from one person to another.
Types of Utility
1. Total Utility (TU). It refers to total satisfaction derived from the consumption of all the units of
good/service at a particular time.
2. NB: TU is the sum of the MU values
3. Marginal Utility (MU). It is the satisfaction derived from the consumption of an extra or additional unit
of good/service at a particular time.
Marginal Utility= Change in TU/Change in Quantity
Quantity Total Utility (TU) in utils Marginal Utility (MU) in utils
1 5 5
2 9 4
3 12 3
4 13 1
5 13 0
6 11 -2
From the table above, we notice that:
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 As more units of the good are consumed, the MU keeps falling. This is The Law of Diminishing Marginal
Utility (DMU) which states that, as more of a good is consumed, the MU keeps falling.
 The MU keeps falling until it reaches zero when 5 units are consumed. This is the point of satiety or point
of maximum satisfaction. Any consumption beyond this point (e.g. 6 th unit) will lead to negative
satisfaction (Marginal Disutility). The point of satiety is not the same for all consumers. Those with large
consumption capacities will take longer to reach satiety than those with small consumption capacities and
this point is not same for an individual all the time.
 The values of TU keep increasing, reaches maximum and starts to fall.
 When TU is increasing, MU is falling but still positive
 When TU is at maximum, MU is zero
 When TU is falling, MU is negative
If we plot the above figures of TU and MU on a graph, we will obtain the following diagram.
Utility
---------------------------------------
TU
Quantity
MU
Derivation of the Demand Curve from the Marginal Utility

The price a rational consumer pays for an extra unit of a good depends on the satisfaction derived from its
consumption. The price a consumer pays measures the sacrifice he is prepared to make in order to obtain a
given unit of a good. Therefore, the MU curve can be used to derive a normal demand curve for a good. The
MU curve is a demand curve but it is limited to the positive portion.
Quantity Total Utility Marginal Utility Price (FCFA)
1 5 5 5
2 9 4 4
3 12 3 3
4 13 1 1
5 13 0 0
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Utility Price
DD curve
MU curve
Quantity Quantity
MU curve Demand curve
The demand curve derived from the MU curve is downward sloping. This shows that consumers are ready to
buy extra units only if price is reduced.
NB: In using the law of DMU to explain why a normal demand curve is negatively sloped, it is necessary
to establish a utility schedule showing quantity demanded, TU and MU then transform the MU schedule
into an MU curve (demand curve)
Consumer Equilibrium
A consumer is in equilibrium when he is able to maximise TU from spending his limited income. There are
two main approaches: The Cardinal Approach (marginal utility theory) and the Ordinal approach.
1. The Cardinal Approach or the Marginal Utility Theory to Consumer Equilibrium

This theory states that a consumer maximises satisfaction from his income when the utility from the last franc
spent on each good is the same and the budget is exhausted.
Assumptions of the model
1. There is a given income that a consumer can spend
2. There are given prices of goods are constant
3. The consumer’s taste is given and is constant.
4. Consumer is rational that is, he picks the combinations of goods that maximises his satisfaction.
5. There are many consumers, the reason why one consumer cannot influence price.
6. The consumer knows the amount of satisfaction that each good will render him.
7. Utility derived is independent that is, it does not depend on other goods.
Illustration of the Cardinal Approach of consumer equilibrium
The consumer is in equilibrium when the ratios of the MUs to prices (weighted MU) of the various goods are
equal and the budget is exhausted. This means if the consumer is consuming two goods x and y with different
prices, then he will be in equilibrium when,
MUx/Px = MUy/Py and

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PxQx +PyQy = R
Where:
MUx= marginal utility of good x
Px= price of good x
Qx= quantity of good x
R= income or revenue
 Where there is only one good, good x, the consumer is in equilibrium when Px=MUx. If this condition
cannot hold, the consumer will consume the highest possible quantity provided MU is positive.
 If there are two or more goods with the same prices, determine the quantities of each good consumed in
descending order of MU until the budget is exhausted.
 Where they are two or more goods with different prices, equilibrium is attained where;
MUx/Px=MUy/Py=MUz/Pz ------- MUn/Pn and
PxQx +PyQy + PzQz + --- +PnQn = R
The case of disequilibrium

Suppose a consumer is consuming two goods – yams and potatoes – and the utility obtained from yams is
more than that from potatoes that is:
Mu of yams/price of yams>Mu of potatoes/price of potatoes
The quantities of the two goods should be adjusted until a franc spent on yams yields the same satisfaction as
a franc spent on potatoes. The consumer should spend more on the consumption of yams which renders more
satisfaction. By so doing this, the MU of the two goods will equalise because following the law of DMU, the
TU of yams will be increasing giving it a falling MU while the TU of potatoes will be falling giving it an
increasing MU. This exercise continues until the utility of a franc spent on yams is just equal to the utility of
a franc spent on potatoes that is
Mu of yams/price of yams=Mu of potatoes/price of potatoes.
This point is called the Optimal Consumption point that is, the combination of goods that maximises the
utility attainable for the consumer’s available income.
Calculating Consumer Surplus Based on the Marginal Utility Theory

Method 1:
Total Utility (TU) – Total Expenditure at the given quantity (price x quantity)
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Method 2:
Subtracting the price from the MU for each unit and summing them up.
NB: consider only the positive difference
Importance of the utility theory
1. They help explain the paradox of value
2. They help in distinguishing between value in use and value in exchange
3. They help explaining the downward sloping nature of a normal demand curve
4. They help a consumer share his budget between different combinations of goods so as obtain maximum
satisfaction from the last franc spent.
Limitations of the utility theory/the law of DMU
1. It cannot explain habit forming goods that experience no DMU.
2. Since satisfaction is subjective (changes from one person to another), there is a difficulty of measurement
of utility.
3. It explains that TU falls only after a certain point but it is difficult to determine with exactitude this point.
4. Consumer goods are generally indivisible making it difficult to assess the utility derived from additional
units.
5. It is difficult to assess utility derived from complementary goods that is, interdependent utility.
6. There is the time factor too as utility changes with time.
7. It assumes that consumers are rational and consistent but man is always irrational and inconsistent.
8. It cannot explain exceptional demand situations like positively sloped demand curves.
9. It assumes that income remains unchanged but any change in price will cause a change in real income.
Exercise
1. The below shows the daily utility function for fish, pork and meat for a French housewife who buys from
a cold store with a weekly budget of 72FF
Item Fish Pork Meat
Price 4FF/kg 8FF/kg 12FF/kg
Quantity Total Utility Total Utility Total Utility
1 16 20 28
2 28 38 54
3 36 54 78
4 42 68 98
5 44 80 110
6 48 90 120
7 50 98 124
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a) The first time the housewife visited the cold store, only pork was available for sale? How many kilograms
of pork would she buy and why?
b) In the circumstance in (a) above, calculate the consumers’ surplus for pork.
c) On her second visit to the store with another 72FF, all three commodities are now available. How would
she now allocate her budget among the three commodities?
d) What is unusual about the total utility figures for fish?
2. With the aid of the utility theory, establish a demand curve for a normal good. Why do exceptional
demand curves exist? (20 marks) GCE 2012
3. Show how the law of DMU can be used to explain the shape of a normal demand curve and discuss
briefly the conditions which might alter the position of such a curve. (20 marks) GCE 1983
4. Given below are the utility functions of three types of hot drinks for a man who prepares to receive friends during
Xmas with a budget of 28000FCFA
PRICE PER BOTTLE WILSON GRANTS J&B
(2000FCFA) (4000FCFA) (6000FCFA)
QUANTITY (Bottles) Total Utility Total Utility Total Utility
1. 8 8 14
2. 14 13.25 27
3. 18 18.25 39
4. 21 23 49
5. 22 27.5 55
6. 24 31.75 60
7. 25 35.75 62
Assuming that the holding of money has no utility for him and that he seeks to maximise his satisfaction, answer the
following questions
a) Going to the all the shops in Bamenda on the 24th of December, WILSON and J&B were all exhausted and only
GRANTS was available. How many bottles of GRANTS will he buy if he wants to spend all his money on it? Give
your reason. (4 marks)
b) Another group of friends indicate to visit him on New Year Day. He budgets another 28000FCFA for them. On the
31st of December, he visits New Life Shop and he is lucky to find all the three drinks at the same prices as indicated
in the table above. How will he now allocate his budget among the three drinks? (6 marks)
c) New Year celebrations announce more than grandiose that he had thought. Another group indicates to visit him on
January 4th. He now steps up his budget to 60,000FCFA given the increased size of the group. On January 3 rd, he
visits all the shops but discovers that Wilson is finished. He finds only GRANTS and J&B.
(i) How should he now allocate his budget between the two drinks? (4 marks)
(ii) Will he be able to spend all his money? (1 mark)
d) State three limitations of the law of Diminishing Marginal Utility. (DMU) (3 marks)
e) What is the basic difference between the utility concept and indifference concept of analysing consumer behaviour?
(2 marks)
Page 80 of 87
5. The table below shows the utility function of a housewife for beans, rice and flour every Saturday with a budget of
36000FCFA.
Beans Rice Flour
Quantity
Total Utility Total Utility Total Utility
1 8000 10000 14000
2 14000 19000 27000
3 18000 27000 39000
4 21000 34000 49000
5 23000 40000 55000
6 25000 45000 60000
7 27000 49000 62000
8 27000 52000 63000
Assuming that the items have the following prices;
Beans = 2000FCFA/kg
Rice = 4000FCFA/kg
Flour = 6000FCFA/kg
a) If the housewife were to consume only rice, what quantity will she buy to maximise satisfaction given the budget
constraint? (4mks)
b) Calculate from (a) above
i. The consumer surplus
ii. The balance of income after expenditure. (3mks)
c) The housewife wishes to consume all the three goods and maximise satisfaction. How many of each will he consume
and why? (6mks)
d) List four limitations of the Utility Theory. (4 marks)
2. The Indifference Curve Theory or the Ordinal Approach to Consumer Equilibrium

The utility theory uses the cardinal approach that is; it assumes that utility can be measured. The indifference
curve theory uses the ordinal approach that is it assumes that utility cannot be measured. It is drawn on the
basis of the preferences of the consumer.
An indifference curve shows the various combinations of two goods which yield the same level of satisfaction
to a consumer and to which he is indifferent.
Plotting an indifference curve

Consider the table below
Combinations A B C D E
Yams 1. 2. 3. 4. 5.
Potatoes 13 9 6 4 3
Page 81 of 87
Plotting this on a graph, we will obtain;

Quantity of
Potatoes
IC
Quantity of yams
The curve labelled IC represents the combination of yams and potatoes to which the consumer is indifferent
because they yield the same of satisfaction. If a consumer is given the choice to choose any point on this
indifference curve, he will not know which combination to choose since all the combinations yield the same
satisfaction.
An indifference Map
It is a collection or a family of many indifference curves.
Good Y
IC3
IC2
IC1
Good X
Characteristics/Features of an Indifference Curve

1. It is downward slopping (negatively sloped) or convex to the origin. This is because, one good can be
substituted for another that is, as more units of one good are consumed, less of the other good will be
required.
2. They pass through all the points on the commodity space.
3. Indifference curves do not intercept.
4. Higher indifference curves yield higher level of satisfaction to the consumer. Indifference curves further
away from the origin yield higher satisfaction.
Page 82 of 87
The Marginal Rate of Substitution (MRS)

It is the rate at which a good can be substituted for another keeping the consumer om the same indifference
curve or it is the amount of a good which a consumer is prepared to give in order to obtain an additional unit
of another good while remaining on the same indifference curve. MRSxy means marginal rate of substitution
of good x for y that is, consuming more of good x and less of y. Therefore MRSxy will measure the units of
good y that must be given up to consume more units of good x.
MRSxy= change in good y/change in good x
Combinations A B C D E
Yams 1. 2. 3. 4. 5.
Potatoes 13 9 6 4 3
Change yams / 1 1 1 1
Change in potatoes / 4 3 2 1
MRSyp=ϪP/ϪY / 4 3 2 1
We notice that the MRSyp keeps falling. This is because the lesser the quantity of a good a consumer has, the
more unwilling he will want to give it up for another good. This is the law of Diminishing Marginal Rate of
Substitution.
The Budget Line
It is line or graph which shows the maximum combination of two goods that can be bought if the entire
consumer’s income is spent.
Construction of a Budget Line
We assume that they are two goods x and y with their prices given and the consumer’s income given. The
prices of good x and y are 2000FRS and 4000FRS respectively and consumer’s income is 120.000FRS. To
construct a budget line,
1. We first assume that all the income is spent on good x that is 120.000FRS/2000FRS= 60units
2. We equally assume all the income is spent on good y that is 120.000FRS/4000FRS= 30 units.
These two points 60units of good x and 30units of good y represents the extreme coordinates of the budget
line on the x and y axis as shown below.
Good y
30
60 Good x
Page 83 of 87
The slope of the budget line is given by the ratio of the prices of the goods that is Px/Py. Therefore, the slope
of the above curve is 2000FRS/4000FRS= 0.5
Effects of a Change in Income on the Budget Line

An increase in consumer’s income with prices remaining constant shifts the budget line outward since the
consumer can now buy more of both goods. A fall in income with prices remaining constant will shift the
budget line inward.
If the consumer’s income increases from 120.000FRS to 180.000FRS, the consumer will now buy 90 units of
good x (180.000FRS/2000FRS) and 45 units of good y (180.000FRS/4000FRS)
If the consumer’s income falls from 120.000FRS to 60.000FRS, the consumer will now buy 30 units of good
x and 20 units of good y.
Good y
45
30
20
30 60 90 Good x
Exercise
Suppose Musa has a weekly income of 16.000FRS which he spends on sugar and garri. Garri sells at
8.000FRS and a sugar sells at 4.000FRS per packet.
1. Draw Musa’s budget line putting sugar on the vertical axis and garri on the horizontal axis and label the
budget line A.
2. What is the slope of this budget line?
Due to his assiduity, Musa’s salary was increased by 32.000FRS.
3. On the same budget line in (1) above, draw a new budget line to represent this situation and label it as B.
Because of covid 19, Musa’s salary was reduced by 50%.
4. On the same budget line in (3) above, draw another budget line to represent this situation and label it as
C.
Effects of a change in price on the Budget Line
A fall in the price of good x with the price of good y and income remaining constant will shift the budget
line for good x outward while an increase in price of good x with the price of good y income remaining
Page 84 of 87
constant will shift the budget line for good x inward. In this case, the budget line pivots on the side of the
good whose price is unchanged.
Good y
L
M” M M’ Good x
LM is the original/initial budget line

LM’ is the budget line when the price of good x falls.
LM’’ is the budget line when the price of good x increases.
Exercise
Sandra has a weekly income of 50.000FRS which he spends on eggs and spaghetti. A tray of eggs sells at
5.000FRS while a carton of spaghetti sells at 10.000FRS.
1. Draw a budget line to represent this situation putting eggs on the x-axis and spaghetti on the y-axis.
Heavy custom duties from the state have caused the price of spaghetti to increase by 100%.
2. On the same budget line drawn in (1) above, draw another budget line to represent this increase in price.
An increase in the number of producers has caused the price of spaghetti to fall by 5.000FRS.
3. On the same budget line drawn in (2) above, insert a budget line to illustrate this fall in price.
Consumer Equilibrium
Equilibrium is attained where the MRS (slope or gradient of the indifference curve) is equal to the ratio of
the prices of the two goods (slope or gradient of the budget line)
Good y
Y1 --------------------------E
-----------------------
IC
X1 B Good x
From the diagram above, equilibrium point is attained at point E because at this point,
Page 85 of 87
1. The slope of the indifference curve and budget line are the same.
2. The budget line is tangential to the highest possible indifference curve.
3. It gives the maximum satisfaction with the given budget constraint.
Exercise
This question is based on the figure below which illustrates the equilibrium situation of a consumer faced
with the consumption of goods x and y.
Good y
B1
B F
E
I3
I2
D
I1
A A1
Good x
AB is the consumer’s budget line. I1, I2, I3 are three indifference curves.
a) Define each of the following
i. Indifference curve
ii. Budget line
iii. Indifference map
b) Assuming the consumer is rational and is provided only two options to choose one between combinations
C and E, which of them should he choose and why?
c) List two characteristics of an indifference curve.
d) What can cause the budget line to shift from AB to A 1B1?
e) Which of the points above represents the consumer’s equilibrium and why?
Effects of changes in income and price on consumer equilibrium

A. Effects of changes in income
An increase in consumer’s income with price remaining constant shifts the budget line outward and vice versa.
This will equally move the consumer to a higher indifference curve and thus raising his equilibrium position.
Good Y
B2
B ICC
E2
B1
E
E1 IC3
IC1 IC2
A1 A A2 Good x
Page 86 of 87
The line passing through origin and linking all the equilibrium positions is called the Income Consumption
Curve (ICC). ICC is a line connecting the equilibrium combinations of goods resulting from changes in
income with constant prices.
B. Effects of changes in price
A fall in the price of good x with the price of good y and income remaining constant will shift the budget line
for good x outward and vice versa. This will equally move the consumer to a higher indifference curve and
thus raising his equilibrium position.
Good Y
PCC
E2
E
E1
IC3
IC1 IC2
M’ M M’’ Good x
The line passing through origin and linking all the equilibrium positions is called the Price Consumption
Curve (PCC). PCC is a line connecting the equilibrium combinations of goods resulting from changes in price
with income constant.
3. The Revealed Preference Theory
According to this theory once the preference of a consumer has already been revealed (indicated), it will give
a guide to his behaviour when price changes. This theory equally uses the ordinal approach. A change in price
leads a substitution effect and an income effect which together guides the consumer.
a) Substitution Effect (SE)
Goods are close substitutes when one can be consumed in the place of the other and they fall within the
same price range. A fall in the price of one makes a consumer to substitute the good for others whose
prices have remained unchanged. The reverse occurs when the price of the good rises. The SE operates
to increase quantity demanded of good whose price has fallen and the quantity demanded for the good
whose price has risen.
b) Income Effect (IE)

A fall in the price of a good increases a consumer’s real income. This enables the consumer to buy more
of that good if it is a normal good making the consumer attain a higher indifference curve. Similarly, a
rise a rise in price reduces a consumer’s real income making him consume less if it is a normal good.
NB: The sum of SE and IE gives Total Effect that is, Total Effect = SE + IE
Page 87 of 87

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PRICE THEORY PREPARED BY KONGNSO RENE, TEL 674729925

Price (FCFA) Quantity demanded (kg)

2. The Substitution Effect

1. Regressive at the top.

A CHANGE IN QUANTITY DEMANDED AND A CHANGE IN DEMAND

DETERMINANTS (CAUSES) OF CHANGES IN DEMAND OR FACTORS THAT AFFECT

5. The price of other goods

3. What factors affect the demand for goods and services?

B. The Supply Theory

PRICE (FCFA) QUANTITY SUPPLIED (units)

2. Market Supply Schedule

THE SUPPLY CURVE

3. Good profit margin

The Equilibrium Price

2. Using the demand function of Qd= 1000 – 5P,

CHANGES IN EQUILIBRIUM PRICE AND QUANTITY

Exercise GCE 2005, Paper 3

3. Changes in Both Demand and Supply

300 ----------------- 500 -----------------------

300 ----------------- 500 -----------------------

200 --------------------- 300 ------------------

300 -------------------------- 500 -------------

D2 a) There is an increase in the population of Cameroon.

D2 a) There is a decrease in the population of Cameroon.

Gains from the Equilibrium Price

Price Price Calculate the consumers’ surplus

CS= ½ × 50 × 600 = 15.000FCA

2. Producers’ Surplus or Seller’s surplus

On a diagram, Calculate the producers’ surplus

PS= ½ × 50 × (400 – 300)

PS= ½ × 50 × 100 = 25,00FCA

THE CONCEPT OF ELASTICITY

Interpretation of the Numerical Values of PED

A proportionate change in price from 200FCFA to 400FCFA

2. Fairly Inelastic Demand (PED<1)

D A big proportionate change in price from 200FCFA to 400FCFA leads to

3. Unit Elastic Demand or Unitary (PED=1)

4. Fairly Elastic Demand (PED>1)

Price D A small proportionate change in price from 200FCFA to 400FCFA leads

300---------------------- to a bigger proportionate change in quantity demanded from 80 to 10 units.

5. Perfectly Elastic demand (PED=∞)

Price A proportionate change in price from 200FCFA leads to an infinite

increases from 200FCFA, nothing will be bought because quantity

The Coefficient of PED Along a Straight Line or Linear Demand Curve

PED>1, fairly elastic

PED<1, fairly inelastic

PED=0, perfectly inelastic

Elasticity of Demand and Total Revenue

CED= Percentage change in quantity demanded of good X

Interpretation of the numerical value of CED

The importance of Cross Elasticity of Demand

(iii) Income Elasticity of demand (YED)

Interpretation of the numerical value of YED

4. From the table below, state at which price range demand is

Determinants of Income Elasticity of Demand

The Importance of Income Elasticity of Demand

B. Price Elasticity of Supply (PES)

NB: PES is always positive since a supply curve is positively sloped.

Interpretation of the Numerical Value or Degrees of PES

Price S A proportionate change in price from 200FCFA to 400FCFA