Topic Two The Price System and The Microeconomy

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CHAPTER 2: THE PRICE SYSTEM AND THE

MICROECONOMY
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Market:
 A place where buyers and sellers get together to trade.
 It can either be a labour market where individual services are

bought and sold, commodity market where people exchange
different commodities or stock market where speculators trade
in shares and bonds.
ECONOMICS DEPARTMENT
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Effective demand
 This is demand where there is willingness and ability to pay for

the good or service and in Economics we talk of effective
demand and NOT notional demand.
 If notional demand can be backed with the ability to pay then it

becomes effective demand.
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DEMAND AND SUPPLY
Demand:
It is the quantity of a product that purchasers are willing and
able to buy at various prices per period of time, all other things
being equal.
Demand Schedule:
In economics, the demand schedule is a table of the quantity

demanded of a good at different price levels.
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Factors influencing demand
Income d
r r el at e
of ot h e
ab ili ty
e a n d avail
Pr ic
r o d u cts
p
Preference tastes and attitudes
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Supply:
Is the numerical quantity that sellers are willing and able to sell at
different prices over a given period of time, ceteris paribus.
Supply Schedule;
Is data upon which a supply curve is derived and shows

quantities supplied at respective prices.
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Factors affecting supply
d s:
er Goo
Price of the given Commodity: th
es of O
Pr ic

Prices of Factors of Production (inputs)
State of Technology
Governm
ent P olicy (Taxati
on Policy)
Concept of elasticity 7
It explains the extent of a price change and its impact on quantity
demanded and supplied.
If a change in price brings about a small change in

quantity demanded especially for foodstuffs then
demand is said to be inelastic, otherwise if a small
change brings about a more than proportionate change
in quantity demanded, then demand is said to be
elastic.
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1. Price elasticity of demand
Definition: is the degree of responsiveness of a change in quantity

demanded of a good due to change in price of the good in question,
ceteris paribus.
Formula: PED = the proportionate change in quantity demanded / the

proportionate change in price
con 9
clu
s ion
s
Since quantity demanded of a product varies inversely with its price, the demand
curve will have a negative slope and the value of price elasticity of demand will
always be negative (-) but in economics we ignore the negative sign as we are only
interested in the absolute value.
If the figure is more than 1, economists describe the demand for the product as
elastic, otherwise if it is less than 1, then it is inelastic.
If the figure is zero, it is perfectly inelastic demand, meaning that a change in

price leaves the quantity demanded unchanged.
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2. Income elasticity of demand
Definition: Is the degree of responsiveness of a change in quantity

demanded of a good due to change in real income of the consumers.
Formula: YED= the proportionate change in quantity demanded/the

proportionate change in income
Fin 11
di n
gs:
 From the calculation, the answer could either be positive or negative.
 Positive answer: it is a normal good, meaning that demand

increases as income rise, e.g. good quality clothing, quality food at
a restaurant ………
 Negative answer: it is an inferior good, meaning as income
rises, demand falls e.g. poor quality clothing, poor quality
food …..
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3. Cross elasticity of demand
 Cross elasticity of demand is a

measure of how much the
quantity demanded of one
good responds to a change in
the price of another good.
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Res
ul t
Again the result can either be positive or negative.
Positive Result: the goods are substitutes
Negative Result: the goods are complements

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PRICE ELASTICITY OF SUPPLY
 Price elasticity of supply, PES: is the responsiveness of the quantity

supplied of a product to a change in price.
Calculation: PES = proportionate change in quantity

supplied/proportionate change in price
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Factors affecting the price elasticity of supply
1.Time period The longer the time period the more elastic is supply
2.Availability of The greater the number of resources the more elastic is the
resources supply
3. Spare capacity Existence of spare capacity will make supply more elastic
4. Stocks Supply will be more elastic if stocks are available or easily

obtained
5. Number of
firms in market The greater the number the more elastic is the supply
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PRICE MECHANISM
Price mechanism, also called the invisible

hand of the market, is used to determine the
equilibrium price in the market and is done
through the forces of demand and supply.
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Equilibrium price and quantity
How is equilibrium price and quantity established?

Answer: through forces of demand and supply
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Functions of price mechanism
Three functions:
1. Rationing function
Whenever resources are particularly scarce, demand exceeds

supply and prices are driven up. The effect of such a price rise is
to discourage demand and conserve resources. The greater the
scarcity, the higher the price and the more the resource is rationed.
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2.The signaling function

Price changes send contrasting messages to consumers and
producers about whether to enter or leave a market. Rising prices
give a signal to consumers to reduce demand or withdraw from a
market completely, and they give a signal to potential producers
to enter a market.
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3.The incentive function

An incentive is something that motivates a producer or consumer to
follow a course of action or to change behavior. Higher prices provide
an incentive to existing producers to supply more because they provide
the possibility or more revenue and increased profits. The incentive
function of a price rise is associated with an extension of supply along
the existing supply curve.
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Movement and shift of demand curve
MOVEMENT:
 If there is a change in price,
there is a movement along the
demand curve.
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SHIFT:
A shift in the demand curve occurs when the whole demand
curve moves to the right or left. For example, an increase in
income would mean people can afford to buy more widgets even
at the same price.
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CONSUMER AND PRODUCER SURPLUS
CONSUMER
SURPLUS
 Consumer surplus is derived whenever the price a
consumer actually pays is less than they are
prepared to pay.
g ra m 24
h e di a
n g t
Exp laini
For example, at price P, the total private benefit in terms of utility

derived by consumers from consuming quantity, Q is shown as the
area ABQC in the diagram. The amount consumers actually spend is
determined by the market price they pay, P, and the quantity they buy,
Q - namely, P x Q, or area PBQC. This means that there is a net gain
to the consumer, because area ABQC is greater that area PBQC. This
net gain is called consumer surplus, which is the total benefit, area
ABQC, less the amount spent, area PBQC. Hence ABQC - PBQC =
area ABP.
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PRODUCER SURPLUS
Definition:
Producer surplus is the additional private benefit to producers, in terms of profit,
gained when the price they receive in the market is more than the minimum they
would be prepared to supply for.

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1

CHAPTER 2: THE PRICE SYSTEM AND THE

 It can either be a labour market where individual services are

 This is demand where there is willingness and ability to pay for

 If notional demand can be backed with the ability to pay then it

In economics, the demand schedule is a table of the quantity

Factors influencing demand

Preference tastes and attitudes

Is data upon which a supply curve is derived and shows

Factors affecting supply

If a change in price brings about a small change in

Definition: is the degree of responsiveness of a change in quantity

Formula: PED = the proportionate change in quantity demanded / the

If the figure is zero, it is perfectly inelastic demand, meaning that a change in

Definition: Is the degree of responsiveness of a change in quantity

Formula: YED= the proportionate change in quantity demanded/the

 From the calculation, the answer could either be positive or negative.

 Positive answer: it is a normal good, meaning that demand

 Cross elasticity of demand is a

Again the result can either be positive or negative.

Positive Result: the goods are substitutes

Negative Result: the goods are complements

PRICE ELASTICITY OF SUPPLY

 Price elasticity of supply, PES: is the responsiveness of the quantity

Calculation: PES = proportionate change in quantity

4. Stocks Supply will be more elastic if stocks are available or easily

Price mechanism, also called the invisible

Equilibrium price and quantity

How is equilibrium price and quantity established?

Functions of price mechanism

Whenever resources are particularly scarce, demand exceeds

2.The signaling function

3.The incentive function

For example, at price P, the total private benefit in terms of utility

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