CBA 1104

PRINCIPLES OF
MICROECONOMICS
THE THEORY OF PRICE DETERMINATION

THE THEORY OF PRICE DETERMINATION

DEFINATION OF A MARKET:
Means by which buyers and sellers are brought
into contact with each other and goods and
services are exchanged.
The term originally referred to a place where
products were bought and sold; today a market is
any arena, however abstract or far-reaching, in
which buyers and sellers make transactions.
Amarketis one of many varieties ofsystems,
institutions, procedures
andinfrastructureswhereby parties engage in
exchange.
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FIVE CONDITIONS OF THE MARKET

There are five conditions which facilitate the
existence of the market. These are1. Consumers, customers or demanders
2. Firms, suppliers or producers
3. Product, commodity or service
4. Price, exchange rate, wage, rent, fees, fares,
etc
5. Aids to trade (banks, insurance companies,
transport companies, legal sector, etc)

DEMAND

This refers to an active search for a good or a

service coupled with the financial or monetary

ability to acquire that good or service.
THE DEMAND CURVE OR DEMAND SCHEDULE
To come up with a demand curve two key
concepts need to be considered:
First, ceteris paribus: All other influences
on quantity demanded are held constant.
Only the price of a good is allowed to vary.

DEMAND CONTD
Second, marginal analysis: in economics

emphasis is placed on the change in quantity,

not the absolute quantity of a commodity.
It is this change in response to a change in
price which is analysed by economists to
produce a demand curve.
A priori quantity demanded of a good is
expected to be inversely/negatively related to
change in price.
Hence the demand curve is expected to have
a negative/downward slope.
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DETERMINANTS OF DEMAND
A goods or commoditys own price (P x)
Prices of complements or substitutes (P y)
Income (Y)
Tastes or fashion
Number of people in a household
Weather conditions
Government policies e.g. taxes, subsidies, price

controls, etc
Social and cultural factors like religion and race
of customers or potential customers
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THE INDIVIDUAL DEMAND CURVE

The demand function can be written in implicit form

as follows:
QXd = f(Px, Py, Y, T,,Govt)
where QXd - quantity demanded of X
f function of
Px Price of X
Py Price of Y
Y income
T Tastes
Govt government policies
NB: Only Px varies, all other factors are held
constant
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THE DEMAND CURVE CONTD

The demand curve is often graphed as a straight

line of the form Q = a - bP where a and b are

parameters. The constant a embodies the
effects of all factors other than price that affect
demand.
If income were to change, for example, the effect
of the change would be represented by a change in
the value of a and be reflected graphically as a
shift of the demand curve.
The constant b is the slope of the demand curve
and shows how the price of the good affects the
quantity demanded.
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THE DEMAND CURVE CONTD

The graph of the demand curve uses the inverse

demand function in which price is expressed as a

function of quantity.
The standard form of the demand equation can
be converted to the inverse equation by solving
for P or P = a/b - Q/b.
On the above statement a/b is the vertical
intercept.
On the equation:
Qd = 120 10P where Qd quantity demanded
and P is price. 120/10 = 12 is the vertical
intercept.
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THE DEMAND CURVE CONTD

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SHIFT OF A DEMAND CURVE

The shift of a demand curve takes place when

there is a change in any non-price determinant of

demand, resulting in a new demand curve.
Non-price determinants of demand are those
things that will cause demand to change even if
prices remain the samein other words, the things
whose changes might cause a consumer to buy
more or less of a good even if the good's own price
remained unchanged.
Some of the more important factors are the prices
of related goods
(bothsubstitutesandcomplements), income,
population, and expectations.
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SHIFT OF THE DEMAND CURVE CONTD

Changes inconsumer disposable income (Y-T).
Y-Income

T-Tax/taxes
Changes in tastes and preferences - tastes and
preferences are assumed to be fixed in theshort
term/short-run.
This assumption of fixed preferences is a
necessary condition for aggregation of individual
demand curves to derive market demand.
Changes in expectations.
Changes in the prices of related goods
(substitutes and complements)
Population size and composition
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SHIFT OF THE DEMAND CURVE CONTD

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MOVEMENT ALONG THE DEMAND CURVE

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MARKET DEMAND CURVE

The individual consumer, however, is only one

of many participants in the market for goodX.

Themarket demand curvefor goodXincludes
the quantities of goodXdemanded
byallparticipants in the market for goodX.
The market demand curve is found by taking
thehorizontal summationof all individual
demand curves.
For example, suppose that there were just two
consumers in the market for goodX, Consumer
1 and Consumer 2.
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MARKET DEMAND CURVE CONTD

These two consumers have different individual

demand curves corresponding to their different

preferences for goodX.
The two individual demand curves are depicted
on the graph on the next slide, along with the
market demand curve for goodX.
NB: horizontal summation implies that we add
the quantities of the two consumers associated
with a given price.
That is, we hold price constant and add the
different quantities to get market quantity
demanded at a particular price.
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MARKET DEMAND CURVE CONTD

demand functions

Q1= 10 - P
Q2= 20 - 2P
Q3= 40 - 4P
Market demandis horizontal sum of individual demand functions:
Q = q
Thus:
Q1= 10 - P where P [ 0 ; 10 ] ; Q [ 10 ; 0 ]
Q2 = 20 - 2P where P [ 0 ; 10 ] ; Q [ 20 ; 0 ]
Q3 = 40 - 4P where P [ 0 ; 10 ] ; Q [ 40 ; 0 ]
Q = Q1 + Q2 + Q3
Market demand: Q = 70 - 7P where P [ 0 ; 10 ] and Q [ 70 ; 0 ]
It is common downward-sloping linear demand with P axis
intercept at P=10 and Q axis intercept at Q=70

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FACTORS AFFECTING MARKET DEMAND

Factors affecting market demand
Market or aggregate demand is the summation
of individual demand curves.
In addition to the factors which can affect
individual demand there are three factors that
can affect market demand (cause the market
demand curve to shift):
a change in the number of consumers,
a change in the distribution of tastes among
consumers,
a change in the distribution of income among
consumers with different tastes.
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FACTORS AFFECTING MARKET DEMAND CONTD

Some circumstances which can cause the

demand curve to shift in include:

decrease in price of a substitute
increase in price of a complement
decrease in income if good is normal good
increase in income if good is inferior good
Changes in weather conditions

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THE SUPPLY FUNCTION

ineconomics,supplyis the amount of

some product producers are willing and able

to sell at a given price all other factors being
held constant.
Usually, supply is plotted as a supply curve
showing the relationship of price to the
amount of product businesses are willing to
sell.
A supply schedule is a table which shows
how much one or more firms will be willing
to supply at particular prices.
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THE SUPPLY FUNCTION CONTD

The supply schedule shows the quantity of

goods that a supplier would be willing and able

to sell at specific prices under the existing
circumstances.
Some of the more important factors affecting
supply are the goods own price, the price of
related goods, production costs, technology
and expectations of sellers.
In other words to come up with a supply curve
or function (in the short run) other factors of
supply are held constant. Only price varies.
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DETERMINANTS OF SUPPLY
A commoditys own price:The basic

supply relationship is between the price of

a good and the quantity supplied.
Although there is no "Law of Supply",
generally, the relationship is positive or
direct meaning that an increase in price
will induce and increase in the quantity
supplied.
Price of related goods:For purposes of
supply analysis related goods refer to
goods from which inputs are derived to be
used in the production of the primary good.
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DETERMINANTS OF SUPPLY
Conditions of production:The most significant

factor here is the state of technology. If there is a

technological advancement in one's good's
production, the supply increases.
For agricultural goods, weather is crucial for it may
affect the production outputs.
Expectations:Sellers expectations concerning
future market condition can directly affect supply.
If the seller believes that thedemandfor his
product will sharply increase in the foreseeable
future the firm owner may immediately increase
production in anticipation of future price increases.
The supply curve would shift out.
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DETERMINANTS OF SUPPLY
Price of inputs:Inputs include land, labor, energy

and raw materials.

If the price of inputs increases the supply curve
will shift in as sellers are less willing or able to sell
goods at existing prices. For example, if the price
of electricity increased a seller may reduce his
supply because of the increased costs of
production.
Number of suppliers:The market supply curve
is the horizontal summation of the individual
supply curves. As more firms enter the industry
the market supply curve will shift out driving down
prices.
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SUPPLY CURVE ALGEBRAICALLY

Qs = a + cP
Where Qs quantity supplied
a- intercept of the supply curve
c- slope of the supply curve
P- price of the good being supplied
Written the other way, the supply curve is:
P = Qs/c - a/c This form of the supply curve

is important when ascertaining the impact

of a tax or a subsidy

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SUPPLY CURVE GRAPHICALLY

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SHIFT OF THE SUPPLY CURVE

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MARKET EQUILIBRIUM
Market equilibrium in this case refers to a

condition where a market price is established

through competition such that the amount of
goods or services sought bybuyersis equal to the
amount of goods or services produced bysellers.
This price is often called thecompetitive
priceormarket clearingprice or just the
equilibrium price and will tend not to change
unless demand or supply changes.
The equilibrium point is a situation in which two
opposite forces are in balance or are equal or
agree.
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MARKET EQUILIBRIUM CONTD

Three basic properties of equilibrium
are:
Equilibrium property P1: The behaviour of
agents is consistent.
Equilibrium property P2: No agent has an
incentive to change its behaviour.
Equilibrium Property P3: Equilibrium is the
outcome of some dynamic process (stability).
The last property implies that equilibrium is
arrived at after a process of adjustment.
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MARKET EQUILIBRIUM CONTD

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MARKET EQUILIBRIUM CONTD

Q quantity demanded and supplied
S supply curve
D demand curve
P0 equilibrium price
A excess demand when P<P0
B excess supply when P>P0

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MARKET EQUILIBRIUM CONTD

Market equilibrium occurs at the intersection

of market supply and demand (QS = QD)

Given:
Qd = 185 20P
Qs = 85 + 30P
Equilibrium occurs when:
185 20P = 85 + 30P
Q = 185 20
(2)
50P = 100
Q = 185 40
P=2
Q = 145
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MARKET EQUILIBRIUM CONTD

10
9
8
7
6

Qs = 85+30P

Price5
4
3
2

Qd = 185 20P

1
0

20

40

60

80
100 120 140 160 180 200
Quantity
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MARKET EQUILIBRIUM CONTD

If QS > QD , there is a market surplus= QS-

QD
If QS < QD , there is a market shortage =QD
- QS
If QS = QD , there is a market equilibrium =
QD- DS = 0
From a price of $2 to $5 there is a surplus
in the market. This is also called excess
supply.
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MARKET EQUILIBRIUM GRAPHICALLY

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CHANGE IN EQUILIBRIUM
If there is a change in one of the other

determinants of supply or demand, there will

be a change in market equilibrium.
Suppose there is an increase in taste, or income,
or prices of substitutes or expected price.
Then the market demand curve will shift up,
leading to a new intersection or equilibrium with
the given supply.
The equilibrium point changes as a result. This
is illustrated on the next slide.
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CHANGE IN EQUILIBRIUM
Below both price and quantity change, i.e.,

both price and quantity increase

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GOVERNMENT INTERVENTION IN THE MARKET

Government intervention may take many

forms. These are price ceiling, price floor,

tax or subsidy.
Aprice ceilingis a government-imposed
limit on the price charged for a product.
Price ceiling: themaximum price a seller is
allowed to charge for a product or service.
Price ceilings are usually set by law and
limit the seller pricing system to ensure fair
and reasonable business practices.
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GOVERNMENT INTERVENTION IN THE MARKET

CONTD
Price ceilings are usually set for essential expenses;

for example, some areas have "rent ceilings" to

protect renters from climbing rent prices.
Governments intend price ceilings to protect
consumers from conditions that could make
necessary commodities unattainable.
However, a price ceiling can cause problems if
imposed for a long period without controlled
rationing.
Price ceilings can produce negative results when the
correct solution would have been to increase supply.

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GOVERNMENT INTERVENTION IN THE

MARKET CONTD
Effective or binding price ceiling and its

consequences.

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GOVERNMENT INTERVENTION IN THE

MARKET CONTD
A price ceiling set below the free-market price has

several effects.
Suppliers find they can't charge what they had been.
As a result, some suppliers drop out of the market.
This reduces quantity supplied. Meanwhile,
consumers find they can now buy the product for
less, so quantity demanded increases.
These two actions cause quantity demanded to
exceed quantity supplied, which causes a shortage
unless rationing or other consumption controls are
enforced. It happened in Zimbabwe in 2008.

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GOVERNMENT INTERVENTION IN THE

MARKET CONTD
Numerical Example on Price Ceilings : (Rent

control and shortages)

QD = 100 5P (where P is expressed in
$100 but we ignore the zeros)
QS = 50 + 5P (where number of apartments
is in 10,000 an zeros will be ignored).
Ceiling PC = $1 (one hundred) as set by the
government. Calculate the total shortage.
Show the consequences of the price ceiling
graphically.
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GOVERNMENT INTERVENTION IN THE

MARKET CONTD

Aprice flooris a government- or group-

imposed limit on how low a price can be

charged for a product.
A price floor must be greater than
theequilibrium pricein order to be effective.
A price floor set above the market equilibrium
price has several side-effects. Consumersfind
they must now pay a higher price for the same
product.
As a result, they reduce their purchases or
drop out of the market entirely.
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GOVERNMENT INTERVENTION IN THE

MARKET CONTD
Price floor: consequences
Oversupply of agricultural produce
Oversupply of labour or unemployment
Under-employment in some sectors of the

economy
Wage-wage spiral
Deadweight loss in welfare to society
Monitoring and evaluation costs
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GOVERNMENT INTERVENTION: SUBSIDY

Given Qd = 185 20P
Qs

= 85 + 30P
Assume a subsidy introduced of $ 3
per unit.
What is the impact on supply?
What is the impact on the equilibrium
quantity and the equilibrium price?
Clue: working is via the supply curve.

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GOVERNMENT INTERVENTION: TAX

Comment on the relative benefits of the

subsidy to consumers and suppliers.

Assume excise duty is imposed on alcoholic
beverages of $3 per unit.
What is the impact on equilibrium quantity
and the equilibrium price?
What is the relative share of the tax burden
between consumers and producers?

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