How prices are decided

Chapter-2 THE PRICE SYSTEM

DEMAND

In Economics the term demand is defined as the desire for a commodity which is backed by the
ability and willingness to pay its price. This forms an effective demand.

LAW OF DEMAND

The law of demand states that “Other things being equal (ceteris paribus) more will be demanded
at lower prices than at higher prices’.

Price in Rs per kg of oranges Total quantity demanded (kgs)

20 31
18 37
16 44
14 52
12 61

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Movement along the Demand Curve (extension or contraction)

A change in price will lead to a change in the quantity demanded. This is shown by the movement
along the demand curve

Shift in Demand curve

A change in any of the factors affecting demand, except price, leads to a shift in demand. At each
and every price there is an increase or decrease in the quantity demanded so the demand curve
shifts.

Outward shifts of the demand curve

The demand curve will shift when more is demanded at each and every price. This could be
because

• Real incomes have risen (assuming the good is normal)

Clearly the more their incomes increase people can buy more goods.a rise in peoples
income will increase the demand for goods and services, while a fall in incomes will cause
demand to fall and demand curves will shift upwards.

Rising incomes however may cause the demand for some goods to fall. These items are
called inferior goods. When people’s income rise they can afford better quality clothes and
food, so that basic clothing and foodstuffs can be classed inferior.

• The price of the substitute has gone up

Some goods and services have substitutes for each other. A good or service is a
substitute when its purchase can replace the want for another good or service. For example:
higher price for coffee might increase demand for tea; a fall in the price of a Hero Honda
motorcycles would reduce the demand for Yamaha motorcylces

• The price of a complement product has gone down

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 Some of the goods and services we buy need other things, or accessories, to go with
them. For example, cars need petrol, compact discs need displayers, bread may need butter.
Goods and services consumers want together, or which are jointly demanded is called
complementary goods or complements.
If the price of cars rise many people may put off buying a new car and so the demand for
petrol will fall. A fall in price of compact discs may cause demand for compact disc-players to
increase and their market demand curve to shift outwards.

• The product has been advertised more effectively

Carefully-planned advertising campaigns cause consumers to buy more of a product
and shift the demand curve for it outwards.

• The population has grown so there are more consumers

A rise in the population means more food; clothes and many other goods and services
are needed. A rise in the population will therefore increase the demand for many commodities
and shift their demand curves outwards.

• Tastes and fashion have changed so more people want the product
The demand for goods and services can change dramatically because of the changing
tastes of consumers and fashions.

• More credit facilities available so people can borrow more money

Availability of credit facilities and hire purchase schemes makes it flexible for
consumers to increase their demand causing the demand curve to shift outwards.

SUPPLY

A supply curve shows the quantity that producers are willing and able to supply at each and
every price, all other things unchanged.
According to the law of supply a higher quantity will be supplied at higher prices, all other
things unchanged.

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 A supply schedule

Price in Rs Quantity of oranges supplied

5 10
10 12
15 15
20 19
25 24

The above supply schedule shows that at lower prices, the quantity of Oranges supplied is less
and at higher prices, the quantity of oranges supplied is more .Hence supply varies directly with
price.

Movement along the supply curve (extension and contraction)

A change in price of the commodity will normally cause its supply to extend or contract. An
extension of supply refers to how supply changes with a rise in the price of a commodity, given
that no other factor affecting supplies changes.

A contraction of supply refers to how supply changes with a fall in the price of a commodity
without a change in any other factor that may affect supply.

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SHIFTS IN SUPPLY CURVE

Changes in the following factors will cause changes in supply and shifts in the supply curve of a
commodity.

• Changes in the price of other commodities

In a free market resources are allocated to those goods and services that yield the
most profit. So if a produce r finds that the demand for a particular product is falling he will
stop producing that particular product and produce another which is in demand.

• Changes in cost of factors of production

An increase in rent, wages etc reduces profits to the firm and they may be less willing
to supply a commodity at each and every price. However a fall in these costs will increase
profits and increase supply

• Technical progress
Technical progress means improvements in the performance of machines, labour,
production methods, and management control, quality etc. This allows more goods to be
produced at regardless of the selling price. Example: the introduction of robots has helped car
firms lower their costs of production.

• Weather conditions
The Weather is an extremely important factor determining the supply of agricultural
products. Favourable weather conditions may bring good harvests so that whatever the price
supply increases. Bad weather conditions cause supply curve to shift leftwards.

• Taxes and Subsidies

If the government wants firms to produce more goods it may give them a subsidy.
A subsidy will lower the cost of the product and increase the supply.

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 A tax on the commodity however will increase the cost of the product and lead to a fall in
supply.

Market Price (or) equilibrium price

We have now looked at the two market forces of demand and supply that determine price. If
the two are combined we will find that the quantity demanded and quantity supplied will be
equal at one price. This is the market price at which the commodity will be sold in the market.
The market price can be found using the market and demand supply curve.

Price in
UK
Pounds Quantity demanded per Quantity supplied per week
week
6 8 36
5 11 32
4 15 27
3 20 20
2 26 13
1 38 5

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PRICE ELASTICITY OF DEMAND (PED)

When prices rise we can assume that quantity demanded will contract. However, firms and
economists alike would like to know by how much quantity demanded will rise or fall given a
change in price.

The demand curve in the first case has a much flatter slope than the steep demand curve in the
second case .As a result a price change in the first case will cause a large movement along the
demand curve while the same price change in the second diagram will only cause a very small
contraction in demand.

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The responsiveness of quantity demanded or how much quantity demanded changes, given a
change in the price of a good or service is known as the price elasticity of demand(Ed).

If a small change in the price of a product causes a substantial change in quantity demanded, the
demand for the product is said to be price elastic, that is quantity demanded stretches a lot as the
price changes.

If a small change in the price of a product causes only a very small change in the quantity
demanded the demand for that product is said to be price inelastic, that is quantity demanded
hardly stretches at all.

Measuring Price Elasticity of Demand (PED)

Price elasticity of demand compares the % change in quantity demanded with the %
change in price that caused it. For example: imagine personal hi-fi producers raise prices from$20
to $25 that is by25%. If the quantity demanded contracted from 1000 per week to 500 per week
then this represents a 50% reduction in quantity demanded, which is double the % change in price.
As demand has changed by a greater % than price, demand is price elastic. That is each 1% change
in price will cause a 2% change in quantity of personal hi-fis demanded.

If on the other hand the percentage change in price caused a much smaller percentage change in
quantity demanded, demand would be price inelastic

The price elasticity of demand for a product is calculated as follows

PED= % change in quantity demanded

--------------------------------------
% change in price

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Percentage is worked out as follows:

change in quantity
%change in quantity demanded = ------------------------ X 100
original quantity

change in price
% change in price = ------------------------ X 100
original price

An example to show how Producer fixes the price for a product

The cost of a flat screen TV is Rs 20,000/ The producer slashes the price during a festival offer to
Rs.18,000/ . At the original price, his sales were 100 TV’s and after the price was slashed; his sales
were 150Tv’s.

Find the PED

Use the formula as shown above

50
% change in quantity demanded= ---------X 100 = 50
100

2000
% change in price = ----------- X 100 =10
20,000

50
Price elasticity of demand = -------- = 5
10

In the price range Rs .20,000/ to Rs18,000/ the demand is elastic

What happens to total revenue?

When the price was Rs 20,000/ he sold 100 tv’s = RS. 20,00,000 (twenty lakh Rs)

When the price was reduced to Rs. 18000/ he sold 150 Tv’s = 27,00,000 (twenty seven lakh Rs)

Factors which affect price elasticity of demand

• Number of substitutes
When consumers can choose between a large number of substitutes for a particular
product, demand for any one of them is likely to be price elastic.
Demand will be price inelastic when there are few substitutes .

• Period of time

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 If the price of a product rises consumers will search for cheaper substitutes. The
longer they have the more likely they are to find one. Demand will therefore be more price
elastic in the long run.

• The proportion of income spent

Goods like matches or newspapers may be price inelastic in demand because they do
not cost very much and any rise in their price will only take a little bit of extra out of a
person’s income. If the price of cars was to rise by 10% this could mean paying an extra $500
or more for a car. This is a considerable part of a person’s income. Demand is likely to be
price elastic.

• Habit -forming goods

People can become addicted to certain products; tobacco and alcohol are obvious
examples. Where this is the case, demand will be inelastic. For addicts, such goods have no
substitutes

• Luxuries and necessities

Demand for necessities is inelastic because we cannot manage without them. The
demand for luxuries are said to be elastic because the amounts people buy will be very much
influenced by their prices.

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 ELASTICITY OF SUPPLY(PES)

We have seen how the price mechanism works whereby an increase in demand will cause the
market price of a commodity to rise. As a result, supply extends so that consumers get what they
want. However, as economists we would wish to know by how much quantity supplied will change
in response to the price change.

Price elasticity of supply (Es) is a measure of the responsiveness of quantity supplied of a product
to a change in price.

To measure price elasticity of supply we use the following formula

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 % change in quantity supplied
Es= - -------------------------------------
% change in price

If the percentage change in price is greater than the percentage change in quantity supplied, supply
is said to be price inelastic and the value of price elasticity of supply will be less than one.

If the percentage change in price causes a much larger percentage change in quantity supplied,
supply is said to be price elastic. Price elasticity of supply will therefore be greater than one.

Factors which affect price elasticity of supply

• Time

Supply of most goods and services like agricultural based products etc, will be fixed at anyone
time. A market will have only a certain amount of products to sell at any given time. It will
take time to get more of these products .In such a case, the supply curve is a vertical line
showing that whatever the price the quantity supplied will be the same.(study the diagram
shown above)

In the short run, firms can produce some more goods for sale but only by using more
labour that is by working overtime or employing more workers. However supply can only
rise a little because the amount of the factors of production used may run out in the short
run. ( study the diagram shown below)

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 In the long run, firms can obtain more labour land and capital to expand their
scale of production, so in the long run supply becomes more price elastic.( study the
diagram shown below)

• Availability of resources
If a firm wishes to expand production it will need more of the factors of production
If the economy is using most of its scarce resources then firms will find it difficult to
Employ more and so output will not be able to rise. the supply of most goods and services
Will be more price elastic.

If however there is much unemployment of resources (example labour) firms will be able
to use them when they want to raise output and supply will be more price elastic.

Some types of supply curves

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