# Summary 2 Price system

Introduction

Demand and Supply are central to ones understanding of how the price system/mechanism works.

They are two sides of the same coin.

(tip: the analysis of demand is the opposite analysis of supply in most cases)

Side 1: Demand

Issues to understand

1. Definition of Demand.

2. Law of Demand and the Demand Curve.

3. Determination of Market Demand.

4. Influences of Demand (dependent on the good).

5. Distinguishing between movement along (Changes in Quantity Demanded) and shifts of a demand curve (Changes in Demand).

Side 2: Supply

Similarly, Issues to Understand

1. Definition of Supply.

2. Law of Supply and the Supply Curve.

3. Determination of Market Supply.

4. Influences of Supply (dependent on the good).

5. Distinguishing between movement along (Changes in Quantity Supplied) and shifts of a Supply curve (Changes in Supply).

Demand and Supply Defined

1. Demand – the amount of a good that a consumer is willing and able to buy at a given price over a given period of time (Sloman, 2003).

2. Refers to a schedule of quantities of a good that will be bought per unit of time at various prices, other things constant Colander, 2006).

3. Is the number of units of a good that consumers want to buy over specified period of time (Baumol and Blinder, 1999).

4. The quantity of a commodity that an individual is willing and able to buy during a given time period (Hardwick et al, 1994).

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5. Where as, supply can be seen as the sum of the quantities of a good that individual firms are willing and able to offer for sale over a given time period (Hardwick et al, 1994).

The Demand and Supply Curves

1. Demand Curve – is a graphical representation of a demand schedule showing how quantity demanded of some product during a specified period of time will change as the price of that product changes, holding all other determinants of quantity demanded constant (Baumol and Blinder, 1999).

2. Supply Curve – similarly is a graphical representation of a supply schedule showing how quantity supplied of some product during a specified period of time will change as the price of that product changes, holding all other determinants of quantity supplied constant (see Baumol and Blinder, 1999).

Appendix: Types of Goods/Commodities

There are many different goods.

1. Normal good which is in keeping with the law of demand. (Quantity demanded increases as income increases or quantity demanded increases as price falls, ceteris paribus).

2. Giffen Good (very inferior good) which is a good for which the relationship between price and quantity demanded goes contrary to the law of demand (There is a positive relationship).

3. Veblen Good shows a similar situation as the giffen good. N.B. See graph below

Exceptional Cases

1. Giffen Good ( focus on poor consumers) e.g. Rice

2. Veblen Good (focus on affluent/rich consumers) e.g. Jewelry, Automobiles etc.

Demand Curve Showing the Exceptional

0 Q1 Q2 Quantity Demanded

Demand Curve for an Individual

D This demand Curve is in keeping

Price

with the Law of Demand. A rise in the price of a good leads to a fall in total quantity demanded. A fall in the price of a good leads to a rise in total quantity demanded, ceteris paribus (Hardwick, 1994).

0 Quantity Demanded

Supply Curve for an Individual Firm

This Supply Curve is in keeping

Price

S with the Law of Supply. A rise in the price of a good leads to an increase in total quantity supplied. & A fall in price leads to a fall in total quantity Supplied, ceteris paribus (See Baumol and Blinder, 1999).

0 Quantity Supplied

Market Demand & Supply Demand

Market demand for a product is the sum of the demands of the individual consumers in the relevant market (Hardwick, 1994). And

Market Supply for a product is the sum of the quantities of a commodity supplied by each individual firm in the relevant market.

N.B. See notes for graphical illustration

Factors affecting Supply and Demand

and Movement along the demand and

Supply Curves versus changes in

Demand and Supply

1. Demand for a commodity is typically affected by; price of the product, price of substitutes and complements, taste, income, government policy etc. (Dx =f(Px, Py, T, Y, G)

2. Supply for a commodity is typically affected by; price of the product, technology, cost of production, government policy, weather etc. (Sx =f(Px, Tec, C, G, W)

N.B. In both instances it really depends on the commodity in question.

Movement along the demand and supply curves.

Movement along the demand and supply curves or changes in quantity demanded and quantity supplied is caused by a change in the price of the commodity ONLY.

Vs

Changes in Demand and Supply/shifts of the demand and supply curves are caused by changes in all other factors affecting demand and supply of the good BUT price of the good itself.

Market Equilibrium

An understanding of market equilibrium requires the use of concepts learnt when we looked at demand and supply.

What is market equilibrium or market clearing price? The price at which the quantity demanded is equal to the quantity supplied (Hardwick et al, 1994).

Market Equilibrium Illustrated

Graphically

Price

O Quantity

Effect on Market Equilibrium as a result of a change in

Demand/Supply

It is important to note that market equilibrium is not a

PERMANENT

CONDITION

in that a change in a factor

which affects demand (such as income of the consumer, leaving supply curve constant, ceteris paribus) can give rise to a new equilibrium point and likewise, a change in a factor affecting supply (such as cost of production, leaving the demand curve constant, ceteris paribus) will also give rise to a new equilibrium point.

Effect on Market Equilibrium as a result of a change in

Demand/Supply (continue)

Eg. If income increases, this will mean that the consumer can purchase (willing and able) more of the good at all price levels, the demand curve will shift to the right to show an increase in demand and by so doing market equilibrium price and quantity will both increase, ceteris paribus. The opposite effect on market equilibrium price and quantity will occur should income fall.

N.B. That this is true for any other factor but price.

Effect on Market Equilibrium as a result of a change in

Demand/Supply (continue)

Eg. If cost of production decrease, this will mean that the supplier may expand production because it cheaper to produce the good, the supply curve will shift to the right to show an increase in Supply and by so doing market equilibrium price will decrease and market equilibrium quantity will increase, ceteris paribus. The opposite effect on market equilibrium price and quantity will occur should cost of production rise.

N.B. That this is true for any other factor but price.

Effect on Market Equilibrium as a result of a change in Demand/Supply:

An increase in demand or an increase in supply (ceteris paribus).

Market Disequilibrium

Disequilibrium defined: a situation in which the expectations of buyers and sellers in a market are not realized. Therefore, economic forces are being generated to change the situation (Hardwick et al, 1994).

Disequilibrium Analysis

When the economy is in disequilibrium, it means the Quantity demand (Qd) is not equal to Quantity supply (Qs). You can either have a case of excess demand (Qd > Qs) or excess supply (Qs > Qd).

When price is below the equilibrium price excess demand is the result. In this case, there will be upward pressure on price. Suppliers will increase price to encourage competition among consumers chasing the few goods. With the increase in price, QS will expand (as higher prices may signal more profits for producers), while on the other hand, higher prices will discourage consumption as fewer consumers are now willing and able to afford the commodity. These two forces will continue to occur until market equilibrium is restored.

Disequilibrium Analysis

In the case of excess supply (Qs > Qd) price is above the equilibrium price.

In this case, there will be downward pressure on price. Suppliers will decrease price (by giving a sale for instance) to encourage more consumers to purchase the goods. With the decrease in price, QS will contract (as lower prices may signal less profits for producers), while on the other hand, these lower prices will encourage consumption as more consumers are now more willing and able to afford the commodity. These two forces will continue to occur until market equilibrium is restored.

Reasons for Persistent

Disequilibrium

1. Government Interference in terms of setting price control such as a price floor (which is set above what the equilibrium price should be and which gives rise to excess supply in the market – aimed at protecting the produces e.g. EU common agricultural policy)

or

a price ceiling (which is set below what the equilibrium price should be and which gives rise to excess demand in the market- aimed at protecting poor consumers e.g. they are often placed on essential items like food e.g. in St.

Lucia.

Reasons for Persistent

Disequilibrium (continue)

2. Lags inn production plans

3. Unstable Equilibrium situation (e.g. in the exceptional case of a giffen good).

References

1. Baumol, William J, and alan S. Blinder.

Economics: Principles

and Policy. 8 th Edition.

USA: Dryden Press, 1999.

2. Colander, David C.

Economics. 6 th Edition.

New York: McGraw –

Hill/Irwin, 2006.

3. Hardwick, Philip, Bahadur Khan and John langmead.

An

Introduction to Modern Economics

. Essex: Addison Wesley

Longman Ltd, 1994.

4. Lipsey, Richard G. and K. Alex Chrystal.

Economics, 11 th

Edition. New York: Oxford University Press Inc, 2007.

5. Sloman, John.

Economics. 5th Edition

. Essex: Pearson

Education Ltd, 2003