how prices are determined

How Prices are Determined?

What is demand?

• Demand is the want or the willingness of consumers to buy goods and services.

Effective Demand

• When willingness to buy is backed/supported with the purchasing power, it becomes an effective demand.

Price mechanism

• Prices act as the signals for producers.• It is based on the price signals that they

decide how to use their scarce resources.

Quantity demanded

• The amount of a good or service consumers are willing and able to buy is known as the quantity demanded.

• Eg: Number of oranges bought per week.

Individual demand and Market demand

• Individual demand: The quantity of a good/service that an individual is willing and able to buy for different prices over a particular period of time.

Individual demand and Market demand

• Market Demand: The sum of all individual demand or total demand for the product from all consumers

Demand Schedule

• Demand schedule is the tabular presentation of quantity demanded and price of a good or service.

Price of Chocolate Bar(Pence) Your demand per month

200

150

50

30

10

5

1

Demand Curve

• A Demand Curve is the diagrammatical representation of price and quantity demanded for a good or service over a period of time.

Extension and Contraction of Demand

• An extension of demand or increase in quantity demanded refers to the way in which demand changes with a fall in price, with no change in any other factor that could affect demand.

• A contraction of demand or decrease in quantity demanded refers to the way in which demand changes when prices rises, with no change in any other factor that could affect demand.

Extension and Contraction of Demand

The market demand curve

• The market demand curve for a particular good or service will display the demand of all the consumers of that commodity given a set of possible prices.

Shifts in Demand

• When there is a change in the factors influencing the demand other than price (like income, advertising, changes in population etc)changes, it leads to a shift in demand curve.

Increase in demand • An increase in demand means that consumers now demand more of a

product at each and every price than they did before.• Eg: Market Demand for chocolate bars:• Draw two demand curves for the data given.

Price of chocolate Original demand Increased demand

50 100 000 200 000

40 150 000 250 000

30 200 000 300 000

20 260 000 360 000

10 330 000 430 000

5 400 000 500 000

Fall in Demand

• A fall/ decrease in demand means that consumers now demand less of a product at each every price than they did before.

Possible price per DVD disc(pence)

Original demand per week

Decreased demand per week

100 10 000 5 000

80 15 000 10 000

60 20 000 15 000

40 25 000 20 000

20 30 000 25 000

What causes a shift in demand?

• 1. Changes in consumers income: • As income rise consumers will be able to buy

more, while a fall in incomes will cause demand to fall.

• But it is depended on the type of product concerned.

Normal Goods and Inferior Goods

• Normal Goods: If the demand for a product tends to rise as income rise, the product is called to be a normal good.

• Inferior Goods: If demand tends to fall as income rise, the product is said to be an inferior good.


• 2. Changes in taxes on incomes• Any change in the level of income tax rates

and allowances results in a change in the quantity of goods and services demanded.

Disposable income: • The income people have left to spend or save

after taxes on their incomes have been deducted.


• 3. The prices and availability of other goods and services:

• Substitutes: A product is a substitute when its purchase can replace the want for another good or service. Eg: Butter and Margarine, Tea and Coffee

• Complementary goods: A pair of goods consumed together. Eg: Car and Petrol, DVDs and DVD player.

• Joint Demand


• 4. Changes in tastes, habits and fashion:• Changing tastes, habits and fashion can play a

big change in demand.


• 5. Population Change:• An increase in population will tend to increase

the demand for many goods and services.• Size and nature of population growth matters.


• 6. Other factors:• Weather• Interest rates• Changes in laws

What is supply?

• Supply refers to the amount of a good or service firms or producers are willing and able to sell at a number of possible prices.

Quantity supplied

• The amount of a good or service producers are willing and able to make and sell to consumers in a market is known as the quantity supplied.

Movement along the supply curve

• Any price change to the product causes a movement along the supply curve.

Extension of supply

• As the price increase, the quantity supplied also rises along with it. This is called an extension of supply.

Contraction of supply

• As the price of the product decreases, the supply also decreases with it. This is called a contraction of supply.

Exercise 1

Possible price of ice cream Market supply per month

20 1600

16 1100

12 700

8 300

4 100

Construction of Supply Curve

Exercise 2

• What will cause an extension of supply?• What will cause a contraction of supply?• Use your graph to work out how many ice

cream will be supplied at a price of a. 6 dollarsb. 10 dollars

Exercise 3

• Using the market supply schedule, (given in Ex No:1)complete the table and explain why the market supply curve slopes upward from left to right. Output per

monthTotal cost ($)

Total Revenue($) (PxQ)

Profit ($)

100 100 400 300300 280700 4201100 5801600 760

Possible price of ice cream

Market supply per month

20 1600

16 1100

12 700

8 300

4 100

Shifts in Supply

• Changes in things other than price of a good can cause its market supply curve to move. This is called a shift in supply curve.

An increase in supply

• An increase in supply means that the producers are now more willing and able to supply a product than they were before at all possible prices.

• Draw supply curves for the schedule given below:

Possible price of razors (pence)

Original supply per month

Increased supply per month

50 10 000 12 00040 8 000 10 00030 6 000 8 00020 4 000 6 00010 2 000 4 000

A fall in supply

• A fall in supply means that producers are now less willing and able to supply a product at each and every price than they were before at all possible prices.

What causes a shift in supply?

• 1. Changes in the cost of factors of production.

• Payments for:• Raw materials• Land• Labour• Interest• Tax…….


• 2. Changes in price of other goods and services:

• Price acts as the signals.

• Resources are allocated to those goods and services that will yield the most profit.


• 3. Technological advance• Technological improvement

improves the performance of machines, employees, production methods, management control, product quality etc.


• 4. Business optimism and expectations

• Fears of economic downturn may cause some firms to move their resources to more safer products.(Left ward shift)

• Expectation of economic recovery may result in reallocation of resources.(Right ward shift)


• 5. Global factors• These factors can not

be controlled by producers.

Sudden climatic change Trade sanctions Wars Natural disasters Political factors

Market Price

• When quantity demanded and quantity supplied becomes equal then the market price is fixed for the product.

Finding the market pricePrice Qty

Demanded

Qty Supplied

50 100 000 420 000

40 150 000 300 000

30 200 000 200 000

20 260 000 120 000

10 330 000 60 000

5 400 000 40 000

Find the market price.

Price at which there is an excess demand.

Prices at which there is an excess supply.

If there is excess demand what will happen to price?

If there is excess supply what will happen to price?

Equillibrium

• The price at which the quantity demanded and quantity supplied gets equal is called the equilibrium price or market price.

How do market prices change?

• A shift in demand:• An increase in

demand for a commodity (increase in income /rise in price of substitutes..) will shift the demand curve to outwards.

How do market prices change?

• A shift in supply:• An increase in supply

of product (due to low wages/technical progress..) supply curve shifts outwards.

What is price mechanism?

• The forces of demand and supply establish the market price of a product automatically. This is called price mechanism.

• A free market economy allows the freedom of demand and supply in the market.

Elasticity…..how much do consumer’s react?

Elasticity – the concept

• Elasticity is the responsiveness of quantity demanded to a price change

• E.g. When price rises what happens to demand?

BUT….

By how much does demand

fall?

Demand falls

Elasticity – the concept

• If price rises by 10% - what happens to demand?

We know demand will fall• By more than 10%?• By less than 10%?• Elasticity measures the extent to which demand

will change

Elastic

Inelastic

Price Elastic

%change in price is less than %change in demand.

The demand curve is flat.

If a small change in price causes a big change in quantity demanded, then the product is said to be price elastic.

Price Inelastic• If a big change in price causes a

small change in quantity demanded, then the product is said to be price inelastic.

The demand curve is steep.

%change in price is more than %change in demand.

A ‘stretching’ exercise

product Small/large change in quantity demanded

Price elastic/inelastic

why

OilDVD recordersBreadCarsNewspapers

Situation: rise in price about 10%

Conclusion

An increase in price have very small impact on demand• Price inelastic

An increase in price have very big impact on demand• Price elastic

An increase in price have very small impact on demandPrice inelastic

How to measure PED?

How to calculate percentage changes?

• % change in quantity demanded= Change in quantity 100---------------------------- X ------- Original quantity 1

% change in price= Change in price 100---------------------------- X ------- Original price 1

If PED is 1, demand is price elastic .

If PED is 1 demand is price inelastic

Using the formulaPrice of beans (per tin)

Market demand(per week)

40 pence 1 000

30 pence 1 500

Calculate the PED(use 40 pence as your

original price)

Draw a demand curve for the data.

Comment on the PED value.

Price elasticity and total revenue

• It is very important for a firm to know whether an increase or decrease in price will cause their total revenue to rise or fall.

Look at these two scenarios and answer for the following questions

Price per loaf of bread

Quantity demanded per month

*25 pence 10 000

20 pence 10 500

Price per DVD recorder

Quantity demanded per month

*$500 1 000

$400 1 800

Questions

Calculate PED and comment on the

value.

Calculate the total revenue for Bread and DVD recorders at each

price.(PxQ)

Would you advise bread

maker to reduce the price from 25 to 20 pence? Why?

Would you advice the

DVD recorder manufacturers to cut price from 500 to 400 dollars?

Why?

Decisions

If demand is price

inelastic, a cut in price

reduces total

revenue.

If demand is price

inelastic, a rise in price increases the total revenue

If demand is price

elastic, a cut in price

increases the total revenue.

If demand is price

elastic, a rise in price decreases the total revenue.

Factors affecting Price Elasticity of Demand

• The number of substitutes:• When consumers can choose

between a large number of substitutes for s particular product, demand is likely to be price elastic. (soft drinks, cosmetics etc)

• When there are few substitutes, demand becomes price inelastic.

( milk, medicines etc)


• The period of timeIf the price of a product

rises consumers will search for cheaper substitutes. If time period is longer, demand becomes elastic.


• The proportion of income spent on a commodity.

If the price of the commodity takes only bit extra from a person’s income, demand will be inelastic.[Ex; 10% increase/decrease in the price of matches/ newpapers]

If the price of the commodity takes a large share from a person’s income, demand will be elastic. .[Ex; 10% increase/decrease in the price of car]

Special demand curves

• Perfectly price inelastic:• A rise or fall in the price

of product causes no change in quantity demanded.

• PED=0

SPECIAL DEMAND CURVES

• Infinitely price elastic:• Product is demanded at

one particular price only.

• A small change in price will cause quantity demanded to fall to zero.

• PED=∞

SPECIAL DEMAND CURVES

• Unitary elastic:• A percentage change in

price will cause an equal percentage change in quantity demanded.

• PED=1

Price Elasticity of Supply

• Price Elasticity of Supply (PEs) is a measure of responsiveness of quantity supplied to a price change.

Elastic and Inelastic supply

• 1. Inelastic Supply.• Large rise in price; but

small rise in supply.

• 2. Elastic Supply.• Small rise in price; but

large rise in supply.

Formula

PES

Calculate

Price Quantity supplied per month

100 cents 10 000

200 cents 12 000

Factors affecting PES

• Time• Momentary period• Supply will be fixed at any one

moment.(Perfectly inelastic)• Short run• Only some changes.(Inelastic)• Long run• Can increase in large quantity.

(Elastic)

Factors affecting PES

• Availability of resources.• If resources are not available,

output cannot be increased in response to price.(Price inelastic)

• If resources are available, output can be increased in response to price.(Price elastic)

Calculate

Price per KG Quantity supplied of natural rubber per month

Rs.80 1000

Rs.100 1100

Price per KG Quantity supplied of man-made rubber per month

Rs.80 2000

Rs.100 2800

Calculate the PES for natural rubber and man-made rubber.Comment on their values and suggest reasons why they differ.

Special supply curves

• Perfectly price inelastic: Quantity supplied remains

the same whatever its price.PES=0• Perfectly price elastic: At one particular price,

producers are willing to supply as much as they can.

PES=∞

Special supply curves

• Unitary elastic: percentage change in

price and percentage change in quantity supplied is equal.

PES= 1

Taxes and Subsidies

• Tax is a compulsory payment charged by the government on income and expenditure of the people and firms.

• Tax makes the goods and service expensive reduce the demand.

• Tax makes the production expensive reduces the supply.

Tax

Direct Tax Indirect Tax

Indirect Tax

Specific Tax

VAT and Specific

• Ad valorem tax (VAT) is imposed on the basis of the monetary value of the taxed item. Literally the term means “according to value.”

• A per unit tax, or specific tax, is a tax that is defined as a fixed amount for each unit of a good or service sold, such as cents per kilogram.

Effect of a tax on market price

• Tax shifts the supply curve to the left.

• The vertical distance between two supply curves shows the tax amount.

• Supply contracts from Q2 to Q3

• Price increase from p1 to p2

Effect of ad valorem tax on supply

• Supply curve shifts up by the amount of tax.

• The vertical distance between two supply curve widens as price increase.

Subsidy

• A benefit given by the government to groups or individuals usually in the form of a cash payment or tax reduction.

• It reduces the cost of production for the producers.

+ves of subsidy

• Encourages the production of new and innovative goods and services.

• Expand the production and lower the market price.

• Helps the producers to reduce the cost of production.

-Ves of subsidy

• Inefficiency.• Distorts competition.• Can result in excess

supply.• Market price collapses.

how prices are determined

Education