Economics - Price Theory s.5

“COPY THE NOTES, DIAGRAM AND CALCULATIONS WILL BE DRAWN WHEN SCHOOL
RESUMES “.
PRICE THEORY
Price theory is a microeconomics principle that involves the analysis of demand and supply
in determining an appropriate price point for a good or service.
This section is concerned with the study of prices and it forms the basis of economic theory.
PRICE DEFINITION
Price is the exchange value of a commodity expressed in monetary terms.
OR
Price is the monetary value of a good or service.
For example the price of a mobile phone may be shs. 84,000/=.
PRICE DETERMINATION
Prices can be determined in different ways and these include;
1. Bargaining/ haggling.
This involves the buyer negotiating with the seller until they reach an agreeable price. The seller starts
with a higher price and the buyer starts with a lower price. During bargaining, the seller keeps on
reducing the price and the buyer keeps on increasing until they agree on the same price.
2. Auctioning/ bidding
This involves prospective buyers competing to buy a commodity through offering bids.
The commodity is usually taken by the highest bidder.
This method is common in fundraising especially in churches, disposal of public and company
assets and sell of articles that sellers deem are treasured by the public.
Note that the price arising out of an auction does not reflect the true value of the commodity.
3. Market forces of demand and supply.
In this case, the price is determined at the point of intersection of the market forces of demand and
supply. This is common in a free enterprise economy. The price set is called the equilibrium price.
4. Fixing price by treaty/ agreement.
This involves the buyer sitting with the seller to negotiate and fix the price at which a good or service
shall be sold and the price remains fixed. The price agreed upon at the time of signing the agreement
can be changed or revived by amending the treaty. For example hire purchase and deferred payments
agreement, rental agreements, land purchase agreements
5. Price leadership
This is the setting of price by either a leader firm or low cost firm in the industry and other firms
follow by charging the same price. This form of price determination is common in oligopolistic firms.
Price leadership takes on the following forms;
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- Dominant price leadership
- Barometric price leadership
- Aggressive or exploitative price leadership
6. Price legislation/ control/ administration.
This is where the government fixes prices of commodities that is either a maximum price to protect
consumers or a minimum price to protect producers.
7. Offers at fixed prices
This is where individuals, government and institutions set the price at which a commodity is to be
sold and whoever is to buy from them must pay the fixed price. For example UNEB fixes prices for
its examinations, UMEME for a unit of electricity, NWSC for a litre of piped water, in super markets.
8. Collusion.
This involves sellers agreeing on the price to charge the buyers. It is common when there are few sellers
who wish to reduce competition among them and avoid price wars.
For example different operators of bus services can collude or agree to charge a uniform transport fare
from passengers on given routes along which their buses operate.
9. Resale price maintenance.

This is a mechanism of price determination where manufacturers set the prices at which their
commodities are to be sold to the final consumers by retailers. The price is usually written on the
commodity. In Uganda, resale price maintenance is practiced by;
Post office on stamps
The press industry on newspapers
The telecommunication network industry on airtime cards, simpacks and phones no
promotion.
MERITS OF RESALE PRICE MAINTENACE
1. Ensures price stability in the market.
2. Stabilises income and profits of retailers
3. Protects small retailers from being outcompeted by large scale retailers.
4. Saves time which would have been spent on bargaining.
5. Enables producers to easily calculate their revenue from sales.
6. Reduces consumer exploitation in form of increased prices by sellers/ retailers.
7. Facilitates the collection of taxes by government because prices are stable.
8. Enables consumers to make consumption plans/ budgets.

CLASSIFICATION OF PRICE
Price may be classified into;
a) Market price
This is the ruling/ prevailing price in the market at a particular time determined by buyers and
sellers. This price changes from time to time since it is determined by a number of factors.
b) Equilibrium price
This is the price at which quantity demanded is equal to quantity supplied in the market.
The equilibrium quantity and price are got at the point of intersection of the demand and
supply forces.
Illustration
OPe is the equilibrium price.

a) Normal price
Is the price attained/ obtained when quantity demanded equals quantity supplied in the long run.
OR
This is the long run equilibrium price that persists in the market when supply and demand conditions
have settled. It is an ideal price which may never be realized and the market price tends to oscillate
around it.
b) Reserve/ reservation price.
Is the least/ minimum/ lowest price a producer/ seller is willing to accept in exchange of his/ her
commodity below which he/ she retains the commodity.

DETERMINANTS OF RESERVE PRICE
1. Expected future demand for a commodity.
A producer who expects demand for his commodities to increase in the nearby future sets a high
reserve price to retain many goods for sell in the future when demand increases while a producer who
expects demand for his commodities to fall in the nearby future sets a low reserve price currently so as
to sell off the commodity very fast before demand falls.
2. Expected future price of the commodity.
A seller who expects the future price of the commodity to increase sets a high reserve price so as to
retain many goods for sell at a higher price in the future. However, sellers expecting reductions in
future prices set low reserve prices such that they sell more currently and avoid the lower prices in the
future.
3. Nature of the commodity (perishable goods vs durable goods)
A seller dealing in durable goods sets a high reserve price because his goods are long lasting and can
remain in good condition even when not bought urgently. However, a seller who deals in perishable
goods sets a low reserve price to sell off the goods before they go bad.
4. Degree of necessity of the commodity.
Sellers dealing in commodities with a high degree of necessity set high reserve prices because they
know that consumers cannot do without them. However, sellers dealing in commodities with a low
degree of necessity set low reserve prices because they know that consumers can do without them.
5. Size of transport (carriage) and storage charges.
High storage and transport charges lead to a low reserve price because the seller wishes to sell off the
commodity very fast before incurring more of these charges. However, low transport and storage
charges lead to a high reserve price because the seller is not scared of transporting or storing goods for
a long period of time.
6. The length of the gestation period
A long gestation period leads to a high reserve price because the producer is aware of the
inconveniences he/ she is going to go through to produce the next commodities. However, a short
gestation period implies that the seller needs less time to produce the commodity and therefore he sets
a low reserve price.
7. Level of liquidity preference of the producer/seller.
Sellers with urgent need for cash (high liquidity preference) set low reserve prices to ensure that they
actually sell the goods for the money they need. However, sellers with no urgent need for cash (low
liquidity preference) set high reserve prices.

8. The cost of production.
Producers who incur high costs of production set high reserve prices because it is expensive for them
to replace the sold goods. However, producers who incur low costs of production set low reserve
prices because it is cheap for them to replace the sold goods.
NB
1. Gestation period is the time it takes before new supplies of goods reaches the market
for example maize takes 3-4 months while mushrooms take 1 month.
2. Liquidity preference (demand for money) is the desire by individuals to hold
assets/ wealth in cash form or near cash form (rather than investing it).
ASSIGNMENT
Explain the factors that lead to high reserve price.
FACTORS THAT INFLUENCE PRICING OF GOODS AND SERVICES
1. Forces of demand and supply.
As supply exceeds demand, low prices are set due to a surplus of commodities on the market.
However when demand exceeds supply, high prices are set for commodities because they are scarce.
2. Aim/ objective of the producer.
Where producers aim at profit maximization, they restrict output charge a high price and where
producers aim at sales maximization, they charge relatively lower prices to encourage people to buy
as much quantities as possible.
3. Cost of production.
High cost of production leads to a high price set since producers aim at profit maximization and low
cost of production leads to a low price set for the commodity.
4. Rate of taxation.
Heavy taxes imposed on goods and services lead to high prices set since producers tend to shift the
burden of paying taxes to consumers in form of increased prices. However, low taxes imposed on
goods and services lead to low prices set.
5. Quality of the commodity.
High quality goods are highly priced since producers incur high costs in producing them while low
quality goods are lowly priced as they are cheap to produce.
6. Elasticity of demand for a commodity.
Producers set high prices for commodities whose demand is price inelastic since people continue to
buy even if prices increase and they set low prices for those whose demand is price elastic since any
slight increase in price results a big fall in quantity demanded.
USES OF PRICE IN A MARKET ECONOMY
• It is used to determine what to produce.
• It is used to determine how to produce.
• It is used to determine where to produce.
• It is used to determine for whom to produce
• It is used to determine when to produce.
• It is used to determined how much to produce.
• It is used to determine the value of a good.
THE MARKET CONCEPT
A market is a mechanism/arrangement in which buyers and sellers come into contact and
exchange goods and services.
A market where goods and services are traded is known as a commodity market.
FEATURES OF A MARKET
✓ There should be sellers and buyers
✓ There should be an interaction between sellers and buyers.
✓ There should be a commodity to be exchanged.
✓ There should be an established medium of exchange.
DEMAND THEORY
DEFINITIONS
Demand is the desire backed by the ability to pay a given amount of money for a particular amount
of a commodity in a given period of time.
OR
Demand is the amount of a good that a consumer is willing and able to buy at a given price in a given
period of time.
Effective demand is the actual buying of goods and services at a given time.
TYPES OF DEMAND
1. Joint/ complementary demand.
This is the demand for commodities which are used together; an increase in the demand for
one commodity leads to an increase in the demand for the other commodity.
Examples of joint demand include;
Demand for cars and fuel
Demand for DVD players and
DVDs. Demand for guns and bullets

Demand for cameras and films
Etc
2. Competitive demand.
This is the demand for commodities which serve the same purpose; an increase in the demand for
one commodity leads to a decrease in the demand for the other commodity.
Examples of competitive demand include;
Demand for butter and honey
Demand for bread and cakes
Demand for tea and coffee
Demand for Omo and Nomi
Demand for close up and fresh
up Demand for beans and peas
Etc
3. Independent demand.
This refers to demand for commodities which are not related such that the demand for one
commodity does not directly affect the demand for another commodity.
Examples of independent demand
include; Demand for clothes and
food Demand for a car and a
pen Etc
4. Composite demand
This is the total demand for a commodity which has several/ many
uses. Examples of composite demand include;
Demand for electricity (for lighting, ironing, cooking, etc)
Demand for water (for cooking, bathing, etc)
Demand for timber (for construction, furniture making, manufacturing,
etc) Demand for cotton wool (for cloth making, cushioning, cleaning, etc)
Demand for steel (for manufacturing machines, motor cars, roofing, etc)
Demand for clay (for making pots, bricks, cups, etc)
Demand for an axe (for splitting wood, tool of defence, etc)
Demand for skins and hides (for making shoes, bags, belts, etc)
Demand for paper (for making books, bank notes, envelopes, toilet paper, etc)
Demand for cloth (for adornment, protection, etc)

5. Derived demand.
This is the demand for a commodity not for its own sake but for the sake of what it helps to produce.
OR
It is the demand for a commodity due to the demand for the commodity that it helps to
produce. Examples of derived demand include;
Demand for land
Demand for labour
Demand for capital
Demand for entrepreneurship
Demand for organisation.
ASSIGNMENT
1. a) What is composite demand? (01 mark)
b) State any three examples of commodities with composite demand in your country.
(03 marks)
THE DEMAND SCHEDULE
This is a table showing the amount of a commodity demanded at various prices by a consumer or
groups of consumers during a particular period of time. This schedule can be compiled either for an
individual or for all individuals in the market.
INDIVIDUAL AND MARKET DEMAND SCHEDULES
Price Quantity demanded Quantitydemanded Market demand
(in Shs. Per kg) By Consumer A by Consumer B (in kg)
5,000 40 20 60
4,000 60 40 100
3,000 80 60 140
2,000 100 80 180
1,000 120 100 220
The market demand schedule is derived by horizontal summation of the quantities purchased at each
price by all the individuals / consumers in the market. The quantities in the market schedule are larger
than those of the individuals demand schedule.
One major characteristic of a demand schedule is that the higher the price the lower the quantity
demanded and the lower the price the higher the quantity demanded of the commodity in question
other factors being constant.

The information tabulated in a demand schedule can be summarized or represented graphically on
a curve
THE DEMAND CURVE
The demand curve is a graphical representation of the demand schedule.
The demand curve is a locus of points showing the quantities demanded of a commodity at
various prices in a given period of time.
Price is represented on the vertical axis while quantity demanded is on the horizontal axis.
From the above table, an individual demand curve (Consumer A) can be drawn as shown below.
A normal demand curve is downward sloping from left to right, that is it has a negative slope meaning
that there is an inverse relationship between price and quantity demanded. (As the price increases,
quantity demanded decreases and vice versa).
QUALITIES OF A NORMAL DEMAND CURVE
1. It must be downward sloping from left to right.
2. It should not touch either of the axes. If it touches the Y-axis, it implies that a consumer incurs a
cost for a commodity which has not been obtained. (He pays a price at zero quantity). If it
touches the X-axis, it implies that the consumer is buying a commodity at zero prices.
THE LAW OF DEMAND

The law of demand states that “the higher the price of a commodity, the lower the quantity
demanded and the lower the price of a commodity, the higher the quantity demanded holding
other factors constant (Ceteris paribus).
REASONS WHY THE DEMAND CURVE SLOPES DOWNWARDS FROM
LEFT TO RIGHT (EXPLAINING THE LAW OF DEMAND)
A normal demand curve is one that slopes downwards from left to right following the law of demand.
The following reasons explain why the demand curve slopes downwards from left to right.
1. The law of diminishing marginal utility
According to this law, when a consumer buys more units of the commodity, the marginal utility of
that commodity continues to decline; and therefore the consumer will buy more units of the
commodity only when the price reduces. When fewer units are available, utility will be high and the
consumer will be prepared to pay more for that commodity. This proves that demand will be low at a
higher price and that is why the demand curve is downward sloping.
2. The substitution effect of a price change.
When the price of the commodity falls, the price of substitutes remaining the same, a consumer
reduces the quantities of other substitute goods whose prices now appear relatively high and
increases the quantity of the commodity whose price has fallen. When the price of the commodity
under consideration increases, the consumer leaves the commodity and buys the substitutes, given
constant prices of substitutes hence the downward sloping demand curve.
3. The income effect of a price change. (Real income effect)
When an individual has a fixed income and the price of the commodity reduces, his real income
increases and hence he can buy more units of the commodity with his fixed income. On the other
hand when the price increases, the consumer’s real income decreases and hence he buys less units of
the commodity hence the downward sloping demand curve.
4. The total effect of a price change.
This is the combination of the substitution and income effects. When the price of the commodity
falls, the quantity demanded increases because many new buyers are attracted while an increase in
price leads to a decrease in demand because it scares away buyers hence the inverse relationship
between price and quantity demanded which produces a downward sloping demand curve.
5. Behaviour/presence of low income earners.

The demand curve depends upon the behaviour of low income earners. They buy more when price
reduces and less when the price increases. This leads to a downward sloping demand curve. (The
rich do not have effect on the demand curve because they are capable of buying the same quantity
even at a higher price)
6. Different/various uses of certain commodities.
Some goods have more than one use e.g. water, electricity, etc such that when the price of the
commodity increases, consumers tend to use it for essential purposes only hence reducing on its
demand. On the other hand when the price reduces, the consumers put the commodity to many
uses thereby increasing quantity demanded hence a downward sloping curve.
DETERMINANTS/ FACTORS INFLUENCING/ AFFECTING DEMAND.
1. Price of the commodity in question.
A high price leads to low demand because it scares away some buyers. However, a low price attracts
new buyers hence high commodity demand.
2. Price of substitutes.
A high price of substitutes leads to high commodity demand because the commodity appears
relatively cheaper. On the other hand, a low price of substitutes leads to low commodity demand
because the commodity appears to be relatively expensive.
3. Price of complements.
A high price of a complement leads to low commodity demand because it is expensive to use both
goods together. On the other hand a low price of a complement leads to high commodity demand
because it is cheap to use both goods together.
4. Level of consumer’s income.
High level of consumer’s income leads to high purchasing power hence high commodity demand.
However, low level of consumer’s income leads to low purchasing power hence low commodity
demand.
5. Tastes and preferences of consumers.
Favourable tastes and preferences result in high commodity demand because they are able to raise the
consumer’s interest in the commodity. However, unfavorable tastes and preferences result into low
commodity demand because they make the consumer to develop bias against the commodity.
6. Size of the market/ population size.
A large population size creates high commodity demand because it is associated with many buyers.
However, a small population size leads to low commodity demand because it has few buyers.
7. Nature of income distribution.

A fair distribution of income leads to high commodity demand because many people can afford to
purchase a commodity. However, high level of income inequality between individuals and different
groups of people leads to low commodity demand because there are few people who can afford to
purchase the commodity.
8. Future price expectation.
Expectation of a high price in the nearby future leads to high commodity demand currently because
buyers stock more goods to avoid the higher prices in the future. However, expectation of a low price
in the nearby future leads to low commodity demand currently because the buyer reserve some money
so as to buy more when the price falls.
9. Government policy on taxation.
High level of direct taxation leads to low commodity demand because people have low disposable
income while low level of direct taxation leads to high commodity demand because people have high
disposable income.
10. Seasonal factors.
Certain commodities are demanded in particular seasons. Favourable season leads to high commodity
demand and unfavourable season leads to low commodity demand. It is common to see vendors
selling success cards during examination periods, Christmas cards in Christmas period and Easter
cards in the Easter period. However outside those periods, one can hardly find them on the market
because no one is willing to purchase them.
11. Level of advertising.
A high level of advertising leads to high commodity demand because it results into high level of
awareness of the consumers about the availability of the commodity. On the other hand, low level of
advertising leads to low commodity demand because it leads to low level of awareness of the
consumers about the availability of the commodity.
12. The prevailing economic conditions in an economy.
Commodity demand tends to be high during periods of economic prosperity (boom) because during
such times, people are employed and earn fair income to purchase the commodity. However,
commodity demand is low during periods of economic depression because many people have no jobs
and thus have no income to purchase the commodity.
13. Quality of the commodity.
A high quality of the commodity encourages people to buy hence high commodity demand while a
low quality of the commodity forces people to abandon it hence low commodity demand.
14. Availability of credit facilities.

Commodity demand is high when consumers are allowed to take goods on credit because many
consumers without immediate cash are able to buy the commodity. However, commodity demand is
low when consumers are not allowed to buy goods on credit because the few buyers with cash are the
only ones who buy.
15. The law of diminishing marginal utility.
With high marginal utility, commodity demand is high because the commodity is highly enjoyable
and satisfying to the buyer. However at low marginal utility, commodity demand is low because the
commodity is less enjoyable and satisfying to the buyer.
16. Socio-economic factors.
These include age, sex, religion, culture etc. One or a combination of these factors to some extent
influence demand for a commodity. For instance demand for pork is low in places where there are
many Muslims as compared to places where there are many Christians especially Catholics and
Pentecostals.
ASSIGNMENT
1. Explain the factors that lead to high demand of a commodity.
2. Explain the factors that lead to low demand of a commodity.
SHIFTS IN DEMAND
These involve change in demand and change in quantity demanded.
CHANGE IN DEMAND
A change in demand refers to an economic situation where more or less units of a commodity are
demanded at a constant price brought about by a change in other factors affecting demand for that
particular commodity.
It is illustrated by a total shift of the demand curve either inwards to the left or outwards to the right
holding the commodity price constant.
Illustration

From the above illustration, DODO is the original demand curve.
D1D1 shows a shift of the demand curve inwards from DODO representing a decrease in demand.
D2D2 shows a shift of the demand curve outwards from DoDo representing an increase in demand.
QUESTION
Explain the factors that cause a change in demand for a commodity.
Solution
NOTE
1. The factors that cause a change in demand are generated from the determinants of demand
other than the commodity’s own price.
2. Words that can be used when stating the point include;
3. Avoid words like high/ low in your explanation. Use words like increase, rise, decrease,
decline, fall, etc.
Solutions
1. A change in prices of substitutes.
2. A change in prices of complements.
3. A change in the level of consumer’s income
4. A change in the size of the market/ population size/ number of consumers.

5. Expectation of a future change in the price of the commodity.
6. A change in government policy of taxation and subsidization.
7. A change in the level of advertisement.
8. A change in seasons.
9. A change in tastes and preferences
10. A change in the quality of the commodity
11. A change in the economic conditions.
12. A change in the nature of distribution of income.
INCREASE IN DEMAND
This is the demand for more quantities of a commodity due to conditions of demand/ factors that
influence demand becoming (more) favourable while holding price of the commodity (in question)
constant.
It is represented by a total shift of the demand curve outwards to the right holding the commodity
price constant.
ASSIGNMENT
Explain the factors that lead to an increase in demand for a commodity in your country. (20
marks)
DECREASE IN DEMAND

This refers to a decline in quantity demanded of a commodity due to factors that influence
demand becoming unfavourable while holding price of the commodity (in question) constant.
It is represented by a total shift of the demand curve inwards to the left holding the commodity price
constant.
ASSIGNMENT
Account for a decrease in commodity demand in your country (20 marks)
CHANGE IN QUANTITY DEMANDED
This is an economic situation where more or less units of a commodity are demanded due to change in
its price when other factors affecting demand for that particular commodity have not changed.
OR
A change in quantity demanded refers to a rise or fall in the amount of a commodity demanded due to
changes in price levels of a commodity assuming other determinants of demand are held constant.
It is illustrated by the movement along the demand curve either upward due to price increase
or downward due to price fall.
Illustration

A fall in price from OPo to OP2 leads to an increase in quantity demanded from OQo to OQ2
as illustrated by the movement along the demand curve downwards from point a tob.
A rise in price from OPo to OP1 leads to a decrease in quantity demanded from OQoto OQ1as
illustrated by the movement along the demand curve upwards from point a toc.
INCREASE IN QUANTITY DEMANDED
This refers to the demand for more units of a commodity due to a fall in its price while holding
other factors constant/ ceteris paribus.
Illustration
DECREASE IN QUANTITY DEMANDED

This refers to the demand for lesser quantity of a commodity due to increase in its price
ceteris paribus.
ABNORMAL/ REGRESSIVE/ EXCEPTIONAL DEMAND CURVES

These are curves which do not obey the law of demand which states that the higher the price,
the lower the quantity demanded and the lower the price, the higher the quantity demanded
ceteris paribus. Such curves take a different shape from the one of the normal demand curve.
The following are the factors that violet the law of demand.
1. Demand for articles of ostentation/ luxuries/ conspicuous consumption.
These are goods bought by the rich people to impress or attract the attention of others for example
sports cars, golden earrings. More of such goods are demanded at a higher price than at a lower
price. The demand curve for luxuries is regressive at the upper level.

The quantity demanded is very high at a low price. As the price increases to an average price, the
quantity demanded reduces so much because many poor people can no longer afford. As the price
increases further to a very high price, the quantity demanded increases because all the rich people
start buying the commodity.
2. Demand for giffen goods.
These are inferior goods which take a large proportion of the budget of low-income earners such that
when their prices increase, the consumer reduces the consumption of other goods and buys the giffen
good. Examples of giffen goods are the basic foodstuffs such as rice, maize, bananas and cassava.
For these giffen goods, the demand curve is regressive at the lower level such that if prices over
increase, consumers have to lower the demand altogether.
An increase in the price from OPo to OP1 causes an increase in amount demanded i.e. from
OQoto OQ2.

3. Demand for necessities.
Goods which are very essential tend to have a fixed demand at different price levels. E.g. salt.
4. Speculation (future price expectations)

When consumers expect a future price increase, they buy more units of the commodity in the current
period even if the commodity’s price is high. On the other hand, when they expect a future price
fall, they buy less units of the commodity even if its price is low hence violating the law of demand.
5. Ignorance effect.
Some consumers may buy more units of the commodity at high prices due to information
asymmetry/ market imperfection. Some also buy the more expensive item because they believe it to
be of better quality.
6. Effect of an economic boom or depression.
In times of a depression, fewer quantities of goods are purchased even when their prices are reduced.
This is because in times of an economic depression, purchasing power is very low. In times of an
economic boom, more quantities of goods are purchased even when their prices are increased. This is
because in times of an economic boom, purchasing power is very high. In both cases, the demand
curve is positively sloped.
7. Addiction to the consumption of the commodity.
Consumers who are addicted to consumption of particular commodities normally buy the same
quantities of the good even if the price increases e.g. smokers.
8. Special seasons.
For example Christmas season, Iddi season, in such seasons, people can afford to buy goods at
high prices due to the high need for them.
Assignment
a) Define the term market demand.
b) State the determinants of market demand in an economy.
ENGEL CURVE
This is a curve that describes how household expenditure on a particular good or service varies with
household income. It was named after the German statistician Ernst Engel (1821 – 1896) who was the
first to systematically investigate the relationship between demand and income of the consumer in 1857.
From the diagram above, the following can be observed.

1. For normal goods, the Engel curve has a positive gradient. That is as income increases, the quantity
demanded also increases. Conclusively, normal goods have a positive income elasticity of demand
2. For inferior goods, the Engel curve has a negative gradient. That means that as the consumer’s income
increases, fewer amounts of the inferior good are bought because they are capable of purchasing better
goods. Conclusively, inferior goods have a negative income elasticity of demand.
3. For necessity goods, as the consumer’s income increases, the amount demanded increases slightly and
then becomes constant. Conclusively, necessity goods have zero income elasticity of demand.
REASONS WHY PEOPLE DEMAND FOR GOODS
1. For functional reasons/ to create utility.
Some people buy goods to use them to satisfy their needs. A commodity is demanded because of
its function or use. For example one buys a bottle of water to quench thirst.
2. Impulsive effect.
This is the demand for a good after seeing it. For example as a hawker is moving around, some people
may develop the idea of buying a product because they have seen it.
3. Speculative demand/ effect.
Some people buy more of certain goods hoping that they might become scarce in the future. Others
buy goods hoping to make gains by buying at a lower price and selling them at a higher price in
the future.
4. Snob effect/ conspicuous consumption.
This is the demand for a good in order to impress the public or to show off. In this case, the good is
demanded highly when its price is high and vice versa. The consumption of expensive commodities
in order to show off is referred to as conspicuous consumption.
5. Veblen effect/ exclusivity.
This is the demand for a good in order to look unique or look different from others.
6. Band wagon effect/ inclusivity.
This is the demand for a good so as to like others. Some people buy goods because they have
seen others using them.
7. For purposes of producing other goods.
Some people buy capital goods for use in the production of other goods.
8. For complementary reasons.
Some people buy goods because they want to make other goods in their possession useful
or operational e.g. one buys fuel to make a car useful.
THE THEORY OF CONSUMERS’ BEHAVIOURS
A consumer is an individual who buys products or services for personal use and not for
manufacture or resale.
A consumer is always faced with a problem of allocating a fixed income among a variety of
available options.
A consumer is assumed to be rational i.e. given his income and the market prices of the various
commodities; he plans the spending of his income so as to attain the highest possible utility.
DEFINITION OF CONCEPTS
1. Utility
This is the satisfaction derived from consuming a certain amount of a good or service.
OR
Utility is the ability of a commodity to give satisfaction for example water has utility because it
can quench your thirst.
Utility can be measured in monetary units by the amount of money a consumer is willing to
sacrifice for a given amount of a commodity.
2. Total utility

This refers to the total satisfaction obtained from the consumption of all possible units of a
commodity.
3. Marginal utility
This is the additional satisfaction derived from consuming an extra unit of a commodity.
Marginal utility is calculated as follows. Marginal utility= Change∈ Total
Utility
Change ∈ number of units
MU =∆TU
∆Q
The concepts of total utility and marginal utility can be better understood from the following
schedule and diagram.
Units consumed Total Utility Marginal Utility
0 0 −¿
1 20 20
2 37 17
3 47 10
4 52 5
5 52 0
6 47 −5
7 35 −12

From the schedule and the diagram above, we note the following;
As total utility is increasing, marginal utility is falling but positive.
When total utility is at its maximum (point of satiety), marginal utility is zero.
When total utility is decreasing, marginal utility becomes negative and this shows disutility.
4. Disutility
This is the loss of satisfaction due to consumption of so many units of a commodity.
THE LAW OF DIMINISHING MARGINAL UTILITY
It is states that as more and more units of a commodity are consumed in succession, the
satisfaction derived from each additional unit consumed reduces.

ASSUMPTIONS UNDERLYING THE LAW OF DIMINISHING MARGINAL UTILTIY
It assumes that the consumer aims at utility maximization.
The consumer has a fixed level of income.
The commodity prices are fixed and constant.
The consumer has perfect knowledge about the prevailing market conditions.
The consumer’s tastes and preferences and preferences are constant.
It assumes consumption of only one commodity whose units are homogeneous.
It assumes that the commodity has uniform sizes i.e. the commodity is divisible into similar
portions.
It assumes continuity in consumption i.e. the units of the commodity should be consumed
in succession one after the other.
It assumes that the consumer does not develop addiction to the commodity.
It assumes that utility is measurable in monetary units (utils).
It assumes that the commodity consumed is a normal good.
RELATIONSHIP BETWEEN MARGINAL UTILITY AND THE DEMAND CURVE

The derivation of the demand curve is based on the law diminishing marginal utility. Marginal utility
is the slope of the total utility curve.
As marginal utility declines, the consumer is willing to pay less for the commodity. The consumer can
buy more if the price is reduced since marginal utility is low.
When fewer units of the commodity are available, marginal utility is high and the consumer is willing
to pay high prices for the commodity. This implies that demand is more at lower prices and less at
high prices.
If marginal utility is measured in monetary units, then the demand curve for the commodity is
identical to the positive segment of the marginal utility curve.
APPLICABILITY OF THE LAW OF DIMINISHING MARGINAL UTILITY
1. It helps to explain the law of demand.
2. It is applied under the principle of progressive taxation.
3. The law is used to explain the water – diamond paradox.
4. It explains why discounts are offered on extra units purchased.
5. Guides consumers when making consumption decisions.
6. It guides in pricing of goods and services.
LIMITATIONS/ CRICISIMS/ DEFECTS OF THE LAW OF DIMINISHING MARGINAL
UTILITY
1. It assumes that consumers are rational which is not always the case. Many consumers do not
attach cardinal values on commodities being consumed.
2. It assumes that the units of the commodity consumed are homogeneous which is unrealistic. Units
of the same commodity may be different e.g. when consuming a sugarcane.
3. It assumes constant tastes and preferences yet for the same individual; tastes and preferences keep
on changing from time to time depending on the environment, age, fashion, etc.
4. Consumption is not always continuous i.e. the consumers take breaks when consuming commodities.
5. It assumes that commodities are divisible into standard sizes but this does not apply to
all commodities e.g. furniture, vehicles, etc.
6. The law is not applicable to money because the more money one gets, the more marginal utility
he/she gets.
7. It is not applicable under habitual consumption where marginal utility increases as the
consumer consumes more of the commodity.
8. It is not applicable in situations where the commodity prices keep on changing due to inflation.
9. The assumption that the consumer’s income is fixed is unrealistic.

10. Utility cannot be measured as the law assumes i.e. there is no instrument which can be used
to measure utility.
11. The law is not applicable in situations of joint demand where two commodities are consumed at
the same time. This is because it assumes consumption of only one commodity at a time.
12. In most cases, the consumers are ignorant about the market prices of commodities. This violates
the assumption of perfect knowledge of the consumer about the market price.
CONSUMER’S SURPLUS
This is the difference in monetary units between what the consumer is willing to pay for a commodity
and what he actually pays.
OR
It is the additional utility which the consumer enjoys without paying for it.
Illustration
Consumer’s surplus is represented by the shaded region (Area under the demand curve but above the
equilibrium price) i.e. Area PeABE.
It can be computed using the formula;
Consumer ' ssur plus=Planned expenditure −Actual expenditu ℜ

Example
Study the table below showing the price and quantity purchased of commodity X and answer
the questions that follow.
Price consumers are willing to pay (shs) Units purchased
300 1
250 2
200 3
150 4
100 5
50 6
Calculate the consumer’s surplus if 4 units of the commodity were purchased at shs 150.
Solution
Consume r' ssurplus=Planned expenditure−Actual expenditure
¿shs((300+250+200+150)−(150 × 4 ))
¿shs (900 −600)
¿shs 300
ALT
Consume r' ssurplus=Planned expenditure−Actual expenditure
300−150=150
250−150=100
200−150=50
150−150=0
¿shs 300
Exercise

a) What is consumer’s surplus? (01 mark)
b) Given the table below;
Price consumers are willing to pay (shs) Units purchased

9,000 1
8,000 2
7,000 3
6,000 4
5,000 5
4,000 6
3,000 7
2,000 8
Calculate the consumer’s surplus for the first five units of the commodity purchased.
(03 marks)
PRODUCER’S SURPLUS
This is the difference between the actual revenue a seller gets and the revenue he
expected. Illustration
The producer’s surplus is represented by the shaded area (Area above the supply curve but below the
equilibrium price) i.e. Area. APeEB.
It can be computed using the formula;
Produce r' surplus=Actual revenue−Expected
revenue Example
Given the supply schedule below;
Price(shs) 50 60 80 100 140 200
Quantity supplied 1 2 3 4 5 6
Taking 100 to be the equilibrium price, calculate the producer’s surplus.

Solution
Produce r' surplus=Actual revenue−Expected revenue

¿shs ¿
¿shs (400 −290)
¿shs 110
Exercise
a) Distinguish between producer’s surplus and consumer’s surplus. (02 marks)
b) Given that the market price of the commodity is Uganda shs 65,000; calculate the
producer’s surplus in the table below.
Price (Ugx) 30,000 35,000 40,000 45,000 50,000 55,00 60,00 65,00
0 0 0
Supply 1 2 3 4 5 6 7 8
(02 marks)
SUPPLY THEORY
Supply refers to the quantity of goods and services that sellers are willing to put on the market at
a given price in a given period of time.
TYPES OF SUPPLY
1. Complementary (Joint) supply.
Joint supply refers to the supply of two or more commodities from the same process of production/
same source/ same resources such that an increase in the supply of one commodity leads to increase in
the supply of the other.
Examples of joint supply include;
Supply of meat and skin from slaughtered animals/ beef and hides from slaughtered
animals Supply of petrol, diesel and paraffin from crude oil (through factional distillation)
Supply of mutton and wool
Supply of maize flour and maize bran
2. Competitive supply

This refers to the supply of two or more commodities that use the same resources for their production
such that an increase in the supply of one product leads to decline in the supply/ production of the
other.
Examples of competitive supply include;
Supply of eggs and meat from chicken
Supply of milk and meat from cows
Crop and animal production from a piece of land.
Supply of jerry cans and basins from plastics.
FACTORS THAT INFLUNCE/ DETERMINE / AFFECT THE QUANTITY
OF A COMMODITY SUPPLIED
1. Price of the commodity.
A high price for the commodity in question leads to high supply because it attracts many producers to
produce and maximize profits. However, a low price leads to low amount supplied because it
discourages some producers from engaging in production.
At a high cost, the supply is low because the producer is only able to mobilize few factors of
production or few raw materials. However at a low cost of production, supply is high because the
producer is able to acquire many factors of production.
3. The number of firms in the industry.
A large number of producers for a given commodity leads to high supply because the producers are
jointly able to produce a lot of output. However, a small number of producers leads to limited
competition in production leading to low output and low supply.
4. The level of demand for the commodity/ market size.
High demand for a product leads to high supply because it encourages production and therefore leads
to high output produced.However, low demand leads to low supply of the commodity because it
discourages production and therefore leads to low output produced.
5. Level of technology used in the production of the commodity.
The use of efficient and modern technology leads to high supply since such technology improves the
speed at which goods and services are produced. However, poor methods of production lead to low
supply since the production process is made slow.
6. Length of gestation period.

The longer the gestation period, the longer it takes the producer to make a good hence leading to low
supply. However, a short gestation period creates high supply because the producer is able to produce
a lot of output in a limited period of time.
7. The objective of the firm.
A producer whose main objective is to maximize sales produces high output leading to high supply.
However, a producer whose main objective is to maximize profits limits output in order to charge a
high price hence leading to low supply.
8. The level of supply of factor inputs/ availability of factors of production.
Availability of factors of production encourages production leading to high output and high supply.
However, scarcity of factors of production discourages production leading to low output and low
supply.
9. The price of a jointly supplied commodity.
A high price for the jointly supplied good like beef cause high supply for the commodity in question
like hides. However a low price for the jointly supplied good for example beef leads to low supply for
the commodity in question like hides.
10. The price of a competitively supplied product.
A high price for competitively supplied good like eggs causes low supply for the commodity in
question like meat from chicken. However, a low price for the competitively supplied good for
example eggs leads to high supply for the commodity in question like meat from chicken.
11. Political climate in the area.
During periods of political stability, supply is high because production is encouraged. However
political instability scares away producers and sometimes put production to a standstill leading to low
output and low supply.
12. Natural factors/ climatic conditions.
This is especially with respect to agricultural products. Favourable climatic conditions like reliable
rainfall lead to high agricultural production leading to high supply. However, unfavourable climatic
conditions like long droughts lead to low agricultural production leading to low supply.
13. Level of development of infrastructures.
Availability of adequate and well developed means of transport and communication facilities makes it
possible to move commodities from one place to another hence high supply. However, under
developed infrastructures lead to low supply because they make transportation of raw materials to
production centres and finished goods to market centres difficult.
14. Degree of freedom of entry of firms into the industry.

Free entry of new firms into the industry leads to high supply because of the high competition
resulting in production of a lot of output. However, restricted entry of firms tends to limit competition
in production leading to low output and low supply.
15. Government policy of taxation and subsidization.
A favourable government policy for example in form of more production subsidies and low taxes to
producers promotes production leading to high supply. However, unfavourable government policy in
form of low subsidies and high taxes to producers discourages producers leading to low supply.
16. Working conditions.
Favourable working conditions encourage production hence high supply. However, poor working
conditions discourage production leading to low supply.
17. Expectation of future price changes.
If the producers expect the prices to increase in future, current supply is low because they store the
goods so as to sell them in the future at high prices and make a lot of profits. However, if the
producers expect a fall in prices, current supply is high because they want dispose of the commodities
before prices fall to avoid making losses.
THE LAW OF SUPPLY
The law of supply states that the higher the price, the higher the quantity supplied and the lower the
price, the lower the quantity supplied ceteris paribus.
THE SUPPLY SCHEDULE
This is a table showing the number of units of a commodity sellers are willing to offer at alternative
prices during a given period of time all other things being equal.
ILLUSTRATION
Price in shillings Quantity supplied in kg
500 10
1000 20
1500 30
2000 40
2500 50
From the table above, it can be seen that as the price increases, quantity supplied also increases.
THE SUPPLY CURVE

The supply curve is the graphical representation of the supply schedule.

The supply curve is a locus of points showing the quantities supplied of a commodity at various prices in
a given period of time.
From the above table, we derive the supply curve by plotting price against quantity supplied as
shown below.
A normal supply curve is upward sloping from left to right, that is it has a positive slope meaning that
there is a direct relationship between price and quantity supplied. (As price increases, quantity supplied
increases and vice versa).
ABNORMAL/ REGRESSIVE/ EXCEPTIONAL SUPPLY CURVES
These are curves which do not obey the law of supply which states that the higher the price, the higher
quantity supplied and the lower the price, the lower the quantity supplied ceteris paribus. The following
are the factors that violet the law of supply.
1. Supply of labour.
The supply curve for labour is as shown below.

From the curve, when the wage increases from OW1to OW2, labour supply increases from Oh1 to
Oh2. Further increase in wages from OW2to OW3leads to a reduction in labour supply from Oh2to
Oh3. This is due to the following factors;
Presence of target workers
Preference of leisure to work
Existence of a progressive tax system/ increased rate of taxation
Cultural and political factors which influence reduction in labour supply (Discrimination in the
employment sector)
Declining working conditions
Effect of old age
Decline in the real wage of workers due to high levels of inflation
2. Supply rigidities.
At times the producers may not supply more even if the price of the commodity increases due to
supply rigidities such as drought, political instabilities, etc. this causes a fixed supply.

From the diagram above, same quantity is supplied at different prices until when the supply rigidities
are removed.
3. Supply of land.
The supply of land cannot be increased. It is a fixed resource.
From the diagram, supply remains constant in spite of price changes.

4. Expectation of future price changes (speculation)
If producers expect the prices to increase in future, they put less on the market even if prices are
slightly increasing. This is because they expect to get a lot of profits in future by selling at high prices.
On the other hand, if the prices are expected to fall in the future, producers supply more even if the
prices are slightly decreasing. This causes an abnormal supply curve.
5. Supply of perishable goods
For perishable goods, more is supplied immediately after harvest whether prices are high or low hence
violating the law of supply.
6. Exhaustion of raw materials.
In this case, even if there is an increase in price, quantity supplied may not increase because the
producers have no requirements to produce final goods.
7. Existence of commodities supplied by the government.
The government may decide to supply certain essential commodities to consumers at lower prices to
improve peoples’ standards of living. This creates a regressive supply curve.
CHANGE IN SUPPLY AND CHANGE IN QUANTITY SUPPLIED
CHANGE IN SUPPLY
A change in supply is where more or less units of a commodity are supplied due to changes in other
factors that determine supply keeping price of the commodity constant.
It is illustrated by the total shift of the supply curve either inwards to the left of outwards to the right
at a constant price.
Illustration

From the diagram above, SoSo is the original supply curve.
S1S1shows a shift of the supply curve inwards from SoSo representing a decrease in supply
S2S2shows a shift of the supply curve outwards from SoSo representing an increase in supply.
FACTORS THAT CAUSE A CHANGE IN SUPPLY OF A COMMODITY

1. Change in the cost of production.
2. Change in the number of firms in the industry.
3. Change in the level of demand for the commodity/ market size.
4. Change in the level of technology used in the production of the commodity.
5. Change in the objective of the firm.
6. Change in the gestation period of the commodity
7. Change in the level of supply of factor inputs/ availability of factors of production.
8. Change in the price of a jointly supplied commodity.
9. Change in the price of a competitively supplied product.
10. Change in the political climate in the area.
11. Change in natural factors/ climatic conditions.
12. Change in the level of development of infrastructures.
13. Change in the degree of freedom of entry of firms into the industry.
14. Change in government policy of taxation and subsidization.
15. Change in working conditions.
16. Expectation of future price changes.
INCREASE IN SUPPLY
This is an economic situation where more units of a commodity are supplied at a constant price due to
other factors affecting supply of that particular commodity becoming (more) favourable.

Illustration
CAUSES OF AN INCREASE IN SUPPLY

1. Decrease in the cost of production.
2. Increase in the number of firms in the industry.
3. Increase in the level of demand for the commodity/ market size.
4. Improvement in technology used in the production of the commodity/ shift from inferior/ poor/ labour
intensive technology to capital intensive/ superior technology.
5. Change in the objective of the firm from profit maximization to sales maximization
6. Reduction in the gestation period of the commodity
7. Increase in the level of supply of factor inputs/ availability of factors of production.
8. A fall in the price of a jointly supplied commodity.
9. Increase in the price of a competitively supplied product.
10. Political climate in the area becoming favourable
11. Natural factors/ climatic conditions becoming favourable
12. An improvement in infrastructures.
13. Increased freedom of entry of firmsinto the industry.
14. Government policy on production of a commodity becoming favourable.
15. Working conditions becoming favourable.
16. Expectation of future price fall
DECREASE IN SUPPLY
This is an economic situation where less units of a commodity are supplied at a constant price due
to other factors affecting supply of that particular commodity becoming unfavourable.

Illustration
ASSIGNMENT
Account for a decrease in commodity supply in an economy (20 marks)
CHANGE IN QUANITY SUPPLIED
This is an economic situation where more or less units of a commodity are supplied due to changes
in the price of the commodity keeping other factors determining supply constant.
it is illustrated by movement along the supply curve either upward due to price increase or
downward due to price fall.
Illustration
A fall in the price from OPo to OP1leads to a decrease in the quantity supplied from OQo to
OQ1as illustrated by the movement along the supply curve from point a to b and this is known as a

contraction in supply.
A rise in the price from OPo to OP2leads to an increase in quantity supplied from OQo to OQ2as
illustrated by the movement along the supply curve from point a to c and this is known as an
expansion in supply.
INCREASE IN QUANTITY SUPPLIED

This is an economic situation where more units of a commodity are supplied due to an increase in
its price when other factors that affect supply of that particular commodity have not changed.
Illustration
DECREASE IN QUANTITY SUPPLIED

This is an economic situation where less units of a commodity are supplied due to a decrease in
its price when other factors that affect supply of that particular commodity have not changed.
Illustration

RELATIONSHIP BETWEEEN DEMAND AND SUPPLY
By the term relationship, we refer to the interaction between demand and supply. The
interaction between demand and supply gives rise to the equilibrium concept.
The term equilibrium refers to a state of stability when the economic forces as they exist a
particular time have no tendency to change the state of variables under consideration.
ILLUSTRATION OF THE EQUILIBRIUM CONCEPT

(THE MARKET EQUILIBRIUM)
Where E = equilibrium point

Pe = Equilibrium price
Qe = Equilibrium quantity
At a price P2 above the equilibrium (Pe), supply exceeds demand and therefore a surplus of
Q1Q2created. The effect is that producers decrease the price in order to sell the surplus and in the
process, equilibrium is restored in the market at point E.
At a price P1below the equilibrium (Pe), quantity demanded exceeds quantity supplied hence a
shortage Q1Q2is created. This forces the producer/ seller to increase the price and again the
equilibrium is restored at point E.
The price where the amount consumers want to buy equals the amount producers are prepared to sell
is the equilibrium market price.

NOTE
1. Stable equilibrium is a situation whereby divergence from the equilibrium point can be
restored through variation of the market forces
2. Unstable equilibrium is a situation whereby divergence form the equilibrium point can never
be restored through variation of the market forces.
THE CONCEPT OF ELASTICITY
Elasticity refers to the degree of responsiveness of the dependent variable to a change in the
independent variable.
The independent variable may be quantity demanded or quantity supplied while the independent
variables are the factors which influence the above dependent variables. Elasticity is categorized into
two;
1. Elasticity of demand
2. Elasticity of supply.
ELASTICITY OF DEMAND
Is the measure of the degree of responsiveness of quantity demanded of a commodity to change(s) in any
of the factors influencing demand like price of the commodity in question, income of the consumers, and
prices of other goods.
OR
Is the ratio of change in demand of a commodity to change in the factors that affect demand.
There are as many types of elasticity of demand as the determinants of demand. However, the
most important types of elasticity of demand are;
1. Price elasticity of demand (P.E.D)
2. Income elasticity of demand (Y.E.D)
3. Cross elasticity of demand (C.E.D)
PRICE ELASTICITY OF DEMAND
Refers to the measure of the degree of responsiveness of quantity demanded of a commodity to change
in the price of that particular commodity
OR
P.E.D is the percentage (proportionate) change in the quantity demanded of a commodity due to
a percentage (proportionate) change in the price of the commodity.
P.E.D=¿
NB

The negative is multiplied in the formula because of the negative relationship between quantity demanded
and the price of the commodity.
Let Qo = original quantity
Q1= new quantity
Po = original price
P1= new price
∆Q = (Q1 – Qo) → change in quantity
∆P = (P1 – Po) → change in price
Percentage change ∈ quantity demanded=Change ∈ quantity × 100 Original quantity
∆Q
¿ ×100
QO Change ∈ price
Percentage change ∈ price= × 100
Original price
∆P
¿ ×100
Po
P.E.D=¿
¿¿
Worked examples
1. Given that the price of the commodity decreased from Shs 500 to Shs 400 and as a result, the
quantity demanded increased from 10kg to 20kg. Calculate the price elasticity of demand.
Solution
Given that;
Po = shs 500
P1 = shs 400
Qo = shs 10 kg
Q1 = 20kg

P.E.D=¿
¿¿
¿5
2. Assuming that the price of the commodity rises from Shs 1500 to Shs 2000 per kg and as a result
the quantity demanded falls from 20kg to 15kg. Calculate the price elasticity of demand.
Solution
Given that;
Po = shs 1500
P1 = shs 2000
Qo = 20 kg
Q1 = 15 kg
P . E. D=¿
¿¿
¿0.75
Trial question
The price of a given commodity decreased from Shs 10,000 to Shs 9000 and as a result,
quantity demanded increased by 25%. Calculate the price elasticity of demand.
INTERPRETATION OF PRICE ELASITICITY OF

DEMAND Price elasticity of demand ranges from zero to infinity (0 ≤ P.E.D ≤ ∞)
1. Perfectly inelastic demand (P.E.D = 0)
This is where a change in price does not affect the quantity demanded of the commodity. It is
common with necessities. The demand curve is vertical.

Illustration
2. Inelastic demand (Low elasticity of demand) (0 < P.E.D < 1)

This is where a big change in price results into a small change in quantity demanded. The slope of
the demand curve is very steep.
3. Unit/ unitary elasticity of demand (P.E.D = 1)

This is where a change in price results into an equal change in quantity demanded. The percentage
change in price is equal to the percentage change in quantity demanded. It is illustrated by a
rectangular hyperbola.

4. Elastic demand(High elasticity of demand) (1 < P.E.D < ∞)
This is where a small change in price results into a big change in quantity demanded. The
demand curve is gently sloped.
5. Perfectly elastic demand(P.E.D = ∞)

This is where different quantities of a commodity are demanded at a constant price. This means that
the commodity has got perfect substitutes and therefore a seller cannot increase the price. The demand
curve is horizontal.

EXERCISE
A change in price of a commodity from15/= to 5/= led to an increase in quantity demanded from 2kgs
to 5kgs. Calculate the price elasticity of demand and interpret your answer.
FACTORS INFLUENCING PRICE ELASTICITY OF DEMAND
1. Availability of substitutes/ degree of substitutability of the commodity.
Demand for commodities that have close substitutes is price elastic because slight changes in price
make consumers to buy more of the other alternatives. However, demand for commodities that have
no close substitutes is price inelastic because consumers have no alternatives to resort to in case of
price changes.
2. Availability of complements.
Demand for a commodity which is a strong complement to what the consumer has is price inelastic. For
example the demand for fuel remains inelastic despite its price increase because people already have cars.
However, demand for a commodity which is not a strong complement to what the consumer has is price
elastic because the consumer has a choice whether to buy or not in case of price changes.
3. Proportion of the consumer’s income spent on the commodity.
Demand for commodities which take a very small proportion of the consumer’s income is price
inelastic. E.g. an increase in the price of a razor blade may not greatly affect the quantity demanded.
However, demand for commodities which take a big percentage of the consumer’s income is price
elastic.
4. Level of consumer’s income.
Rich people continue to buy even if the commodity’s price increases but the poor people will always
stop buying even if there is a slight increase in the price hence demand is price inelastic among the
rich and price elastic among the poor.

5. Degree of necessity of the commodity
Demand for necessities like soap, salt is price inelastic because consumers cannot easily do without
them. However, demand for non – essential items is price elastic because consumers easily reduce the
amount they buy when price increases.
6. Level of addiction in the use of the commodity.
Demand for an addictive commodity like cigarettes is price inelastic because such a commodity forms
a habit in the consumer and the consumer almost the same units regardless of the changes in price.
However, demand for non – addictive commodities is price elastic because the consumer easily
reduces the amount demanded when prices increase.
7. Level of durability of the commodity/ level of perishability of the commodity/ nature of the
commodity i.e. perishable or durable commodity.
Demand for durable goods such as cars, furniture tends to be price inelastic because even if the price
of such a commodity falls, a consumer may not demand more of that commodity because he already
has it. On the other hand, demand for perishable goods is price elastic because slight changes in price
bring about big changes in amount demanded.
8. Number of uses of the commodity.
Demand for goods having several uses is price elastic. E.g., if the unit of price for electricity
increases, consumers use less of it for only vital purposes such as lighting. On other hand, demand for
goods having a single or few uses is price inelastic because consumers continue buying the same units
at all times regardless of the changes in price.
9. Time period of consumption i.e. short run or long run.
In the short run, the demand for a commodity tends to be price inelastic while in the long run, the
demand for the commodity is price elastic. This is because in the long run, consumers are able to learn
the market conditions and look for substitutes.
10. Possibility of postponement of consumption of the commodity.
The demand for commodities whose use can be postponed to a future date is price elastic because
small changes in the price force the consumers to postpone consumption and this creates a big change
in the quantity demanded. On the other hand the demand for commodities whose use cannot be
postponed is price inelastic because even with big changes in price, the amount demanded is so low.

11. Speculation about price changes
When the consumers expect the price of the commodity to fall in future, the current demand tends to
be price elastic because consumers easily reduce the amount demanded when the price slightly
increases. On the other hand if consumers expect a future price increase, the current demand for the
commodity tends to be price inelastic because consumers continue buying even if prices are rising due
to fear of purchasing at very high prices in the future.
12. Level of awareness of availability of cheaper goods/ level of advertisement.
Demand for highly advertised goods is price inelastic because the persuasive adverts convince the
buyers to continue buying the commodity regardless of the changes in price. However, demand for
less advertised commodities is price elastic because of the limited awareness of the public about the
commodities.
13. Degree/ extent of convenience in acquiring/ accessing the commodity.
Demand for commodities that are conveniently accessible is price inelastic whereas demand for those
that are difficult to access is price elastic. This is because consumers prefer buying commodities that
are within their reach compared to those that are scarce.
CAUSES OF PRICE INELASTIC DEMAND
1. The commodity not being substitutable/ the commodity having no substitutes.
2. The commodity being a complement
3. Proportion of the consumer’s income spent on the commodity being high
4. The commodity being a necessity
5. The consumer’s income being high
6. The commodity being habit forming/ addictive
7. The commodity being durable
8. The commodity having one or few uses

9. Short run situation
10. The consumption of a commodity not being deferrable.
11. Consumers speculating a future price increase
12. The commodity being highly advertised.
13. The commodity being conveniently accessible.
ASSIGNMENT
Explain the causes of high price elasticity of demand in your country.

IMPORTANCE/ USES PRICE ELASTICITY OF DEMAND IN AN ECONOMY
The concept of price elasticity of demand is of great importance to the following people;
1. Producer.
a) Fixing prices for the commodities.
Price elasticity of demand helps the producer to fix prices for the commodity so as to maximize
revenue. For commodities with elastic demand, the producer charges a lower price and for
commodities with inelastic demand, the producer fixes a high price.
The above situation is illustrated below.
Elastic demand
Inelastic demand
NOTES
In case the price elasticity of demand for a commodity is unitary, the producer does not need to change
his prices.

b) Fixing prices of commodities by discriminative monopolists.
Price discrimination is the selling of similar units of a commodity at different prices to different
consumers when the differences in price are not based on the cost of production. This can only be
successful if the price elasticity of demand for that commodity is different in different markets. For a
market with inelastic demand, the producer charges a high price and for a market with elastic demand,
the producer charges a low price.
c) Pricing of joint products.
The concept of price elasticity of demand is of much use in the pricing of joint products like wool and
mutton, wheat and straw, cotton and cotton seed, meat and hides or skins, etc. In such cases, separate
costs of production of each commodity are not known and therefore the price of each is fixed on the
basis of its elasticity of demand. That is why products like wool, wheat, meat and cotton having an
inelastic demand are priced very highly as compared to their bi-products mutton, straw, hides or skins
and cotton seeds with an elastic demand.
d) Determination of the degree of advertisement for the commodity.
For commodities with elastic demand, there is need for massive advertisement so as to increase the
firm’s revenue. This is because increasing prices in such a case leads to a fall in revenue due to
reduced quantities demanded. On the other hand, little or no advertisement is required for
commodities with inelastic demand.
e) Determination of wages of a particular type of labour.
Labour producing a commodity with inelastic demand is paid a high wage. This is because the
producer can recover the cost of labour by increasing the price of the commodity. However labour
producing a commodity with elastic demand is a paid a low wage.
2. Government.
a) Used by government to determine goods to be provided as public utilities.
Government’s decision to declare certain industries as public utilities depends on elasticity of demand
for their products. If the demand for the product is inelastic and it is necessary to the general public,
the state usually takes over the production of such products. This is because if production is left to
private industries, then they will overcharge the consumers and hence the danger of monopolistic
exploitation.

b) Formulation of taxation policies.
Taxes are imposed for various reasons of which we may consider these two cases.
(i) Raising revenue.
Government raises more revenue by taxing highly commodities with inelastic demand such as
petroleum products. This is because these commodities are demanded irrespective of the price
changes. However, low taxes should be imposed on commodities with elastic demand.
(ii) Discouraging the production and consumption of undesirable commodities

If the government wants to discourage the production and consumption of a product, it may
impose a tax. The extent to which the taxation policy succeeds depends on the price elasticity
of demand for the commodity. The government will be successful with commodities that have
got elastic demand.
c) Devaluation of currency (exchange rate manipulation)
The main objective of devaluation is to improve the country’s balance of payments position.
Devaluation makes imports expensive thereby reducing their importation and exports cheaper thereby
encouraging and increasing their volume. However, this is only successful when the demand for both
imports and exports is price elastic.
NB:
Devaluation refers to the legal/ofcial reduction in the value of the country’s currency
in relation to other currencies.
d) It guides in subsidization.
Usually, subsidy or protection is given to only those industries whose products have elastic demand.
This is because they are unable to face foreign competition unless their prices are reduced through
subsidy or by increasing the prices of imported goods by imposing heavy duties on them.
e) Price legislation
This is where the government fixes the price at which the commodity is to be sold to the consumers. If
the commodity has inelastic demand, the government fixes a maximum price so as to protect
consumers from being exploited by profit motivated producers. For commodities with elastic demand,
the government fixes a minimum price in order to protect producers from being exploited by
consumers.
f) Wage determination
Labour with inelastic demand is paid higher rates than labour with inelastic demand.

g) Used in making of foreign trade policies.
The concept of elasticity of demand has great practical importance in analyzing some of the complex
problems of international trade such as terms of trade, gains from international trade, BOP
disequilibria and the effects of import tax. For instance tariff barriers (taxes) are more effective in
controlling the importation of goods whose demand is price elastic. This is because tariff barriers
increase price and this forces many people to reduce the importation/ consumption of such goods.
However, non – tariff barriers like total ban, quotas are more effective in controlling importation of
goods whose demand is price inelastic.
h) Determines the incidence of the tax.
Incidence of a tax refers to the final resting place of a tax and it falls on either the producer or the
consumer or a combination of the two depending on the price elasticity of demand. If the demand is
price inelastic, more of the tax is paid by the consumers and if the demand is elastic; more of the tax is
paid by the producer. With unitary elasticity, the tax is shared equally between the consumer and
producer. If the demand is perfectly elastic, the tax is fully paid by the producer alone. It is fully paid
or met by the consumer alone if the demand for the product is purely or perfectly inelastic.
3. Consumers.
a) Guides consumers in planning of their expenditure.
Consumers plan to spend more on commodities whose demand is price inelastic and less on
commodities whose demand is price elastic. for example they plan to spend more money on food,
fuel, school fees but less money is put on luxuries like buying movies or organizing parties.

ELASTICITY AND INCIDENCE OF A TAX
Incidence of a tax refers to the final resting place of a tax and it falls on either the producer or
the consumer or a combination of the two depending on the price elasticity of demand.
Case 1: Taxation and perfectly inelastic demand
ab = total tax paid by the consumer.

When demand is perfectly inelastic, the total tax is paid by the consumer.
Case 2:Taxation and perfectly elastic demand.
ab = total tax paid by the producer.

When demand is perfectly elastic, the total tax is paid by the producer.

Case 3: Taxation and inelastic demand
When demand is inelastic, the consumer pays more tax than the producer as illustrated below.
abc = total tax

ab = tax paid by the consumer
bc = tax paid by the producer
Case 4: Taxation and elastic demand
When demand is elastic, the producer pays more tax than the consumer.
abc = total tax.


Case 5: Taxation and unitary demand
When demand is unitary, the tax is shared equally between the consumer and the producer.
abc = total tax

INCOME ELASTICITY OF DEMAND
This is the measure of the degree of responsiveness of quantity demanded of a commodity to a
change in consumer’s income.
OR
It is the percentage change in the quantity demanded of a commodity due to a percentage change
in the consumer’s income.
Income elasticity of demand = Percentage change in quantity demanded

Percentage change in price
Where ∆Q = change in quantity demanded

∆Y = change in consumer’s income
Qo= original quantity demanded
Yo= original income.

INTERPRETATION OF INCOME ELASTICITY OF DEMAND
If Y.E.D is positive, the commodity is a normal good.
If Y.E.D is negative, the commodity is an inferior good.
If Y.E.D is zero, the commodity is a necessity.
Worked examples
1. Use the table below to answer the questions that follow;
Period Income Quantity
2007 150,000 50
2008 200,000 80
a) Calculate the income elasticity of demand.
b) State the type of the commodity in question.
Solution
a) Given that;
Yo = 150,000
Y1 = 200,000
Qo = 50
Q1=80
∆Q YO
Y .E. D= ×
∆ Y QO
¿ 80−50 × 150,000
200,000−150,000 50
¿1.8
b) The commodity is a normal good.
2. Use the table below to answer the questions that follow.
Period Income Quantity

2007 150,000 50
2008 200,000 50
a) Calculate the income elasticity of demand.
b) State the type of the commodity in question.

Solution
a) Given that;
Yo = 150,000
Y1 = 200,000
Qo = 50
Q1=50
∆Q YO
Y .E. D= ×
∆ Y QO
50−50 150,000
¿ ×
200,000−150,000 50
¿0
b) The commodity is a
necessity. Trial questions
1. Given that an individual’s income increased from shs 50,000 to shs 80,000 per month and this led to
an increase in the demand for the commodity by 10%. Calculate the income elasticity of demand and
comment on the type of the good.
2. Study the table below showing income and quantity demanded of commodity X and answer the
questions that follow.
Income (Ug. Shs) Quantity demanded of X (kg)

10,000 50
30,000 20
a) Calculate the income elasticity of demand for commodity X.
b) What type of commodity is X? Give a reason for your answer.

IMPORTANCE OF INCOME ELASTICITY OF DEMAND
1. A consumer is able to tell or predict the amount of a commodity which would be bought depending on
the on the nature of the commodity. If it is an inferior good, less of it will be demanded following an
increase in the consumers’ income. If it is a normal good, more of it will be demanded as ones income
increases and if it is a necessity, quantity demanded remains constant irrespective of changes in the
consumer’s income.
2. It helps in determining the type of a commodity i.e. inferior, necessity or normal good.
3. Helps the government in distribution of social utilities.
4. It helps importers in determining what to import.
5. Helps the government in policy making for example taxation.
6. Helps a seller / producer to predict future demand as income changes.
CROSS ELASTICITY OF DEMAND
This is the measure of the degree of responsiveness of quantity demanded of one commodity (X) due to
a change in the price of another commodity (Y).
OR
This is the percentage (proportionate) change in quantity demanded of one commodity due a
percentage change in the price of another/ related commodity.
Cross elasticity of demand = Proportionate change in quantity demanded of commodity

X Proportionate change in the price of commodity Y
Where ∆Qx= change in quantity demanded of commodity

X ∆Py= change in the price of commodity Y

Py= original price of commodity Y
Qx= original quantity of commodity X
INTERPRETATION OF CROSS ELASTICITY OF DEMAND
Here we give the relationship between the two commodities.
If C.E.D is positive, the two commodities are substitutes.
If C.E.D is negative, the two commodities are complements.
If C.E.D is zero, the two commodities are unrelated/ there is no relationship between the
two commodities.
Worked example
Given that the price of commodity X increased from Shs 50,000 to Shs 80,000 and this led to increase in
quantity demanded for commodity Y by 10%. Calculate the cross elasticity of demand for the two
commodities and state the relationship between them.
Solution
Given that;
Po = shs 5,000/=
P1 = shs 80,000/=
Quantity demanded for commodity Y changed by 10%

C. E . D=%age ∆ ∈ qnty demanded for commodity Y
P1 −PO
%age ∆∈ the price of commodity X
%age ∆∈ price of commodity X = ×100

PO

¿80,000−50,000 × 100
50,000
30,000
¿ 50,000 ×100
¿60 %
10 % 1
C. E . D= = =0.167
60% 6
X and Y are substitutes.
Trial questions
1. Given that an increase in the price of commodity X form Shs 1500 to Shs 1800 resulted into a
change in quantity demanded for commodity Y from 600 units to 570 units;
a) Calculate the cross elasticity of demand
b) State the relationship between commodities X and Y.
2. If the price of commodity X falls from Ug. Shs 2,000,000 to Ug. Shs 1,600,000 per unit and
the quantity demanded of commodity Y increases from 40,000 to 60,000 units,
a) Calculate the cross elasticity of demand.
b) State the relationship between commodities X and Y.
ELASTICITY OF SUPPLY
This is the measure of the degree of responsiveness of quantity supplied of a commodity to changes
in factors which influence supply.
PRICE ELASTICITY OF SUPPLY
This is the measure of the degree of responsiveness of quantity supplied of a commodity to a change
in the commodity’s price.

OR
This is the percentage change in the quantity supplied of a commodity due to a percentage change in
the price of the commodity.
Percentage change ∈ quantity supplied
Price elastcity of supply= Percentage change∈ the price of the commodity
∆Q PO
P.E. S= ×
∆ P QO
Where;
∆Q =Change ∈ quantity supplied
∆ P=Change∈ price of the commodity
PO =Original price QO
=Original quantity
Worked examples
1. The price of a commodity increased from shs 800 to shs 1200 per kg and the quantity supplied in
the market increased from 2000kgs to 5000kgs. Calculate the price elasticity of supply.
Solution
Given that;
Po = shs 800
P1 = shs 1200
Qo = 2000kgs
Q1 = 5000kgs

∆Q PO
P.E. S= ×
∆ P QO
¿ 5000−2000 × 800
1200−8002000
¿3
Exercise
1. An increase in price from 60,000 to 90,000 led to an increase in quantity supplied of commodity
by 50%. Calculate the price elasticity of supply.
2. An increase in price from shs 40/= to 400/= led to an increase in the quantity supplied of a
commodity from 30kgs to Xkgs. If the price elasticity of supply is 2, find the value of X.
INTERPRETATION OF PRICE ELASTICITY OF SUPPLY
1. Perfectly inelastic supply (P.E.S = 0)
This is where price changes do not affect the quantity supplied i.e. quantity supplied remains
constant at different price levels.
2. Inelastic supply (0<P.E.S<1)
This is where a big change in price results in into a small change in the quantity supplied. This
is common with agricultural products that take long to be produced.

3. Unitary supply (P.E.S = 1)
This is where a change in price results into an equal change in the quantity
supplied. This is an ideal situation which does not occur in reality.
4. Elastic supply (0<P.E.S<∞)
This is where a small change in price results into an equal change in the quantity supplied.

5. Perfectly elastic supply
In this case, price of a commodity is constant at all levels of the quantity supplied. This situation
does not exist in the real world.
FACTORS THAT INFLUENCE PRICE ELASTICITY OF SUPPLY
High costs of production make supply to be price inelastic because if price increases, the producers
cannot be able to increase output and supply due to high expenses incurred. However, low costs of
production make supply to be price elastic because if price increases, producers are in position to
increase supply.

2. Gestation period/ Length of the production process.
A long gestation period implies inelastic supply because if prices increase, supply cannot be increased
within a short period of time. For example agricultural products with a long gestation period have
inelastic supply. However, with a short gestation period like the one for manufactured goods, supply
is elastic because if price increases, output can easily be increased within a short period of time.
3. Availability of factors of production/ level of supply of factor inputs.
High supply of factor inputs leads to elastic supply because producers can easily increase output in
response to a rise in price. However, scarcity (limited supply) of factors of production makes supply
to be price inelastic because it is difficult for the producers to increase output evenif there is a rise in
price.
4. Natural factors.
Favourable climatic conditions make supply of agricultural products to be elastic because more output
can be put on the market in response to arise in price. However unfavourable climatic conditions like
drought make supply of agricultural products to be inelastic because output levels cannot be increased
even if there is a price increase.
5. The level of technology used in production.
High level of technology such as use of modern techniques of production is associated with elastic
supply because supply can easily be increased when prices increase. However, low level of
technology is associated with inelastic supply because it is difficult to increase output when prices
increase.
OR

Use of simple technology in production makes it easy to increase output in response to price increase
thus supply is elastic. However, use of advanced (complicated) technology which is difficult to adopt
makes supply price inelastic since it is not easy to increase output in response to a price increase.
6. Nature of the commodity in terms of durability or perishability.
Durable commodities have elastic supply because they can be stored and in case of a price increase,
producer/ suppliers just get commodities from their storage facilities and supply. However, perishable
commodities have inelastic supply because they cannot be stored for a long period of time therefore
an increase in price is not accompanied by an increase in supply.
7. Political climate.
Favourable political climate in an economy makes supply price elastic because production of a
commodity is encouraged due to the confidence among producers in regard to national security.
However, unfavourable political climate in an economy makes supply price inelastic since production
is discouraged as the producers have fear for loss of their life and property.
8. Number of producers.
A commodity with many producers has elastic supply because a slight increase in price is
accompanied by an increase in output by the many producers. However, a commodity with few
producers has inelastic supply because if price increases, supply cannot be easily increased by the few
producers.
9. Degree of freedom of entry of new firms in the industry.
Free entry of new firms in the industry makes supply to be price elastic because an increase in price
attracts other firms to join and increase production of the commodity. However, restricted or blocked

entry of new firms in the industry makes supply to be inelastic because when price increases, other
firms cannot join the industry to increase output levels.
10. Future price expectations.
If producers expect a future price fall relative to the current prices, the current supply of the
commodity is elastic because producers sell more now to avoid making losses in the future when the
prices have fallen. However, if producers expect a future price increase relative to the current prices,
current supply is inelastic because producers supply less even if prices increase because they are
waiting to sell at high prices in the future and make a lot of profits.
11. Availability of excess capacity.
Firms operating at excess capacity make supply to be price elastic because there is underutilisation of
the production potential which makes it possible to employ more resources to increase output in
response to a price increase. However, firms operating at full capacity make supply to be price
inelastic because the economy is already using most of it scarce resources and thus firms find it
difficult to employ more resources and thus output cannot be increased in response to a rise in price.
12. Government policy of taxation and subsidization.
Favourable government policy in form low taxes, highsubsidies and other incentives makes supply
price elastic because of the reduction in the average costs of production that enables the producers to
increase output in response to a price increase. However, unfavourable government policy in form of
high taxation makes supply price inelastic because of the increase in the costs of production that
makes it difficult for producers to increase output even if there is a rise in price.
13. Level of development of infrastructure.
Well developed infrastructure in form better road networks and communication facilities makes
supply to be price elastic because producers can easily increase supply in response to a price increase
due to increased access to the market. However, poor infrastructure in form of poor transport facilities
makes supply price inelastic because producers cannot increase output on time when prices increase.
14. Time period in production.

In the short run, some factors of production are fixed and it is not easy to increase output to respond to
increase in prices hence inelastic supply. However in the long run, all factors of production are
variable and so it becomes easy for the producer to increase supply when prices increase hence elastic
supply.
15. Degree of factor mobility
Mobility of factors of production makes supply price elastic because producers can easily switch
resources to production of a commodity whose price has increase. However, immobility of factors of
production makes supply price inelastic because producers cannot easily switch resources to
production of the commodity whose price has increased.
16. Objectives of the firm.
Where producers aim at profit maximization, supply is inelastic since they limit production and supply
to force the prices upwards. However, if the goal of the firm is to maximize sales, supply is elastic
since more output is put on the market whenever prices increase so as to maximize sales.
17. Price of a jointly supplied product.
A low price of a jointly supplied product makes supply of the commodity in question to be price
inelastic because it discourages production of the commodity in question even if the price is
increasing. For example a low price of maize flour makes supply of maize bran to be inelastic.
However a high price of a jointly supplied product makessupply of the commodity in question to be
price elastic because it encourages production of the commodity in question.
18. Price of a competitively supplied product.
A high price of a competitively supplied product makes the supply of the product in question to be
price inelastic because it makes production of the commodity in question unprofitable. However, a
low price of a competitively supplied product makes supply of the commodity in question to be price
elastic because it makes it makes production of the commodity in question profitable.
Assignment
Account for low price elasticity of supply in an economy.

PRICE MECHANISM (PROFIT – PRICE MECHANISM/ THE INVISIBLE HAND) AND
RESOURCE ALLOCATION
Price mechanism is a system in free enterprise economy where prices in the market are determined
by market forces of demand and supply with limited or no government intervention.
Price mechanism is a system where prices act as automatic signals in the allocation of resources.
To understand better the concept of price mechanism, we need to note the following.
1. Demand dictates what is to be supplied by the producers.
2. Consumers’ expenditure is equal to seller’ revenue. It means that one’s expenditure on a commodity
is what a seller gets as his or her income.
3. Consumers are regarded as voters. It follows that whenever consumers buy a product, they are
casting votes in favour of production and supply of the commodity.
4. Consumers take an upper hand in deciding what is to be producedi.e. there is consumer
sovereignty where a consumer takes a leading role in determining allocation of resources.
ASSUMPTIONS OF PRICE MECHANISM
1. It assumes existence of a free enterprise economy where resource allocation is determined by
the interaction of market forces of demand and supply.
2. There is no government intervention/ interference as far as pricing and output policies of
the producers are concerned.
3. There are many buyers and sellers, hence no monopoly to influence market conditions.
4. Producers aim at profit maximization and they produce commodities whose price is high.
5. Consumers aim at utility maximization and thus they buy from the cheapest source.
6. There is free entry and exit in the market i.e. when super normal profits are earned, firms are free
to join the industry and when profits are exhausted, inefficient (high cost) firms leave the industry.
7. There is consumer sovereignty in the market i.e. consumers have an upper hand in deciding what is to
be produced by “casting votes” to commodities as they buy.
8. It assumes no wastage of resources because producers only supply what consumers want at
a particular time.
9. There is perfect mobility of factors of production, so resources go where the price is high.
10. There is perfect knowledge about market conditions by both sellers and buyers for instance
consumers know the price and qualities of the products on the market.
Price mechanism responds to the basic economic questions by providing appropriate answers to
these questions. These questions are;

- What to produce?
- How to produce?
- When to produce?
- Where to produce?
- How much to produce?
- For whom to produce?
THE ROLE OF PRICE MECHANISM IN THE ALLOCATION OF RESOURCES
NB
We consider the functional role of price mechanism in the allocation of resources i.e. we focus
on what price mechanism does in the process of allocating resources in an economy.
1. It guides on what to produce.
The producers are induced to produce and supply a commodity at a high price in order to
make profits.
2. It determines where to produce/ it determines the location of the production unit.
Producers always locate their production units in areas where demand for the goods is high
and consumers are ready to buy at a price that enables them to make a profit.
OR
Producers decide to locate their business firms in areas with the lowest costs of production. The aim
is to maximise profits through minimising costs.
3. It determines when to produce.
Producers always produce more of a good at that time when demand for it is high so as to make
profits.
4. It determines how much to produce.
Demand dictates the quantity of goods that producers supply on the market. This checks the danger
of over production and wastage is avoided.
5. It determines for whom to produce/ it determines the distribution of goods and services.
Producers supply goods to those consumers who are able to buy at the prevailing market price.
OR
Producers supply goods to those consumers who have effective demand.
6. It determines how to produce/ it determines the type of technology to be used in production.
Producers employ cheap but efficient techniques of production. The aim is to maximise profits
through minimising costs.
7. It guides consumers when making choice of which goods to buy.
Holding other factors constant, consumers buy more units of a commodity whose price is low and
fewer units of a commodity whose price is high.
8. It ensures efficient allocation of resources.
Resources are allocated to producing those goods with the highest prices. Producers get the incentive
to supply goods at high prices in order to get high profits.
9. It determines income distribution.
Income is distributed among producers depending on the price at which they supply and sell their
goods. Therefore, producers who supply goods at high prices earn more incomes than those who
supply goods at low prices.
10. It provides an incentive for economic growth.
This arises where high prices encourage high production of goods and services. As more goods and
services are produced, economic growth is attained.
11. It ensures production of better quality products because of competition among producers.
Producers compete for the available market in order to supply their goods. Due to this competition,
better quality goods have to be produced so that producers maintain and increase the level of demand
for their goods.
IMPLICATIONS OF PRICE MECHANISM

POSITIVE IMPLICATIONS (MERITS)
NB:
Here we focus on the positive outcomes/ desirable outcomes (good things) which arise from price
mechanism.
1. It promotes consumer sovereignty.
Individual households make their own decisions since the consumers influence what is to be
produced. The goods and services which consumers demand for are the ones produced and supplied.
The consumer becomes a king in influencing productive activities.
2. It ensures efficiency of firms.
Firms strive for efficient operations so as to survive competition and sell at high prices since high
prices lead to high profits. This enables producers to expand their scale of production and become
more efficient
3. It encourages competition which leads to production of better quality goods and services.
Consumers are more willing to pay a high price for high quality goods. Therefore producers strive to
get the high prices by improving the quality of commodities.
4. The profit motive encourages innovations and inventions (research).
Due to the profit motive, producers develop new and better techniques of production. The improved
methods of production result into increased output of better quality which is sold at high prices. This
enables producers to get more profits.
5. It avails a wide variety of goods and services to consumers.
Price mechanism generates competition among producers. This gives rise to a greater variety of goods
and services in an economy. Consumers are able to exercise choice and their standard of living is
improved.
6. It leads to efficient allocation and utilization of resources.

Price mechanism enables producers to allocate the scarce resources in the production of those goods
needed by the consumers. Producers allocate more resources to those goods whose demand is high
and fewer resources are allocated to those goods whose demand is low.
7. It leads to increased employment opportunities.
As prices of goods rise (increase), producers supply more of those goods. Producers expand their scale
of production and more people get employed in production units.
8. It promotes incentive for hard work among producers leading to increased production.High
prices of goods motivate or encourage producers to work hard and supply more goods to consumers.
This promotes economic growth in the country.
9. It reduces the costs of administration due to limited or no government intervention.
The forces of demand and supply guide the allocation of resources without government interference
using price controls. The government does not incur costs of enforcing minimum and maximum
prices.
10. It helps to reward the various factors of production in the factor market.
Factors which enable production of goods with high demand and prices are paid higher rewards.
However, those factors whose output has low demand and low prices are paid low rewards.
11. It encourages flexibility in production.
Producer use the price and profit signals to change from less profitable to more profitable economic
activities. For example a coffee farmer may change from the growing of coffee to the growing of
vanilla should the price of vanilla become higher than that of coffee.
12. It encourages arbitrage which benefits producers.
Producers transfer goods from areas with low prices to sell them in areas with high prices. This
benefits producers because they earn more revenue from sales and subsequently make higher profits.
NB:

Arbitrage is the practice of transferring goods from areas with low prices to areas with high prices in
order to gain from the difference in prices. For example if a bag of in Jinja costs shs 120,000 and it
costs shs 150,000 in Kampala, a trader may transfer bags of sugar from Jinja and sells them in
Kampala so that he gains from that difference in price.
NEGATIVE IMPLICATIONS / DEMERITS/ DEFECTS/ WEAKNESSES/

SHORTCOMINGS/ DISADVANTAGES OF PRICE MECHANISM
NB:
Here we focus on those undesirable outcomes or bad things associated with price mechanism.
1. It leads to consumer exploitation by producers due to ignorance or market imperfections.
Price mechanism assumes that a consumer has perfect knowledge about the market conditions.
However, many consumers are not aware of price changes and new goods on the market and thus they
are exploited by profit – hungry producers.
2. It leads to emergence of monopoly and its negative consequences.
Price mechanism creates private monopoly because of excessive competition which forces inefficient
firms out of production and efficient firms take over the market. The monopoly firms restrict output in
order to charge high prices. They also supply low quality goods due to absence of competition in the
market. This leads to exploitation of consumers.
3. It promotes income inequality.
Efficient producers whose goods are highly demanded receive higher incomes than the inefficient
producers. Therefore the efficient producers get access to most of the resources in the economy. This
creates income disparity with its associated disadvantages of exploitation of the poor by the rich.
4. It encourages divergence between social costs and private benefits.
Price mechanism does not consider the negative effects inflicted on the society as producers exploit
the natural resources. Private investors benefit through profit maximization without taking into
account social costs. For example when forest trees are cut down to get timber, there is a danger of
deforestation and its negative impact on the environment, pollution created by private enterprises,

over exploitation of resources. Unfortunately, these social costs are not considered under price
mechanism.
5. It leads to unemployment.
This is due to automation (use of capital intensive techniques of production) and out competition of
inefficient firms making people who were employed in those firms to lose jobs. The unemployed
people experience low standards of living.
6. It leads to economic instabilities like inflation, price fluctuations and balance of

payments problems.
This is due to absence of government intervention.
7. It leads to underutilization of resources.
Price mechanism creates excess capacity in certain cases. Producers abandon production of those
goods which are not highly demanded. This leaves some resources to be idle or underutilized.
8. It leads to wastage of resources due to wasteful competition.
Price mechanism brings about stiff or cut-throat competition among private investors. Excessive
competition among producers leads to resource wastage.
9. It fails to allocate resources in priority sectors i.e. it does not provide public and merit goods/
it ignores socially profitable ventures.
Price mechanism is not used to provide public goods such as public hospitals, roads and schools. The
provision of such socially desirable goods is done by the government.
10. It does not respond quickly or adjust quickly to structural changes in an economy.
Price mechanism does not respond to circumstances requiring rapid structural changes such as
privatization, modernization of agriculture, liberalization of trade, alleviating effects of natural
disasters, etc. Such rapid structural changes call for government intervention.
11. It leads to distortion of consumer choices through persuasive advertising.

As private investors try to capture market for their goods, they undertake persuasive advertisements.
As a result, many consumers end up buying goods which they would not have bought and thus their
choices are distorted.
12. Foreign dominance of an economy is prominent most especially if the economy is open.
13. It leads to disappearance of cheap goods from the market because private individuals only venture
in activities that enable them maximize profits.
14. It makes government planning difficult since it is associated with a number of uncertainties.
METHODS/ WAYS OF INTERFERING WITH PRICE MECHANISM

1. Use of taxation policies.
For instance adoption of Progressive taxation policy helps in redistributing income in an economy
because the tax rate increases with increase in the tax payer’s income i.e. it takes a higher proportion
of income of the rich than the poor hence narrowing the gap between the rich and the poor. Taxation
can also be used to influence resource allocation whereby for sectors government wants to promote,
no taxes are levied on their activities while for sectors and activities that government finds less
desirable, high taxes are levied on them.
2. Provision of public goods by the government.
For example the provision of better transport network in form of roads helps in the movement of
goods from areas where they are in plenty to those areas where goods are scarce. Hence shortages of
goods created through the market forces of demand and supply are solved or checked.
3. Encouragingthe setting up of consumer protection associations.

These help in sensitizing the consumers about the ways in which they can be exploited by profit –
hungry traders. The consumers are educated on how they can safeguard themselves against buying
expired goods and adulterated goods as well as other forms of exploitation by traders.
4. Anti-monopoly legislation
Government enacts laws aimed at checking monopoly powers of private producers or investors. This
is aimed at reducing consumer exploitation associated with monopoly firms.
5. Setting up regulatory bodies to minimize social costs.
Such bodies set laws which govern exploitation of resources, laws that protect wetlands, laws that
enforce proper disposal of industrial wastes, etc. A case in Uganda is The National Environment and
Management Authority (NEMA) that was set up to protect the environment.
6. Setting up and strengthening bureau of standards.
A bureau of standards is in charge of inspecting goods being produced to ensure that certain quality
specifications are fulfilled before goods are put on the market. A certification mark is given for goods
that fulfill the required quality standards and this protects the health of consumers.
7. Licensing.
The government puts certain restrictions on the licensing of traders such that licenses are given to
only those traders or enterprises approved by the licensing department. This checks the carrying out of
illegal or illicit trade.
8. Planning for the economy.
Economic development plans are drawn up by the government to guide the allocation of resources in
both the private public sector. The aim is to avoid misallocation of resources associated with price
mechanism.
9. Subsidization of firms especially those providing essential and merit goods.

The government offers subsidies to firms to produce essential goods and services so that the
consumers are able to get such goods and services at lower prices.
10. Adoption of price legislation policy/ control.
Price controls are taken to even out fluctuations in prices. The government can either set a maximum
price to protect consumers or a minimum price to protect producers depending on the economic
situations at that time.
11. Setting up government owned firms to compete with private monopolies.
Government can set up non-profit making enterprises which are vital to the society. Such enterprises
can compete with the private producers thus reducing on consumer exploitation.
12. Carrying out nationalization of private enterprises.
This is done to ensure that all essential goods and services are produced and supplied by nationalized
enterprises at fair prices.
13. Rationing of scarce commodities.
It involves direct action by the government to distribute the scarce commodities to the public at fixed
prices in limited quantities. This is done in periods when goods are scarce in order to reduce consumer
exploitation by the traders. For example in 1986 – 1987, the government of Uganda used this policy
by rationing the supply of essential goods like sugar, salt, soap to consumers through local councils.
14. Controlling/ fighting inflation.
The government through the central bank uses a restrictive monetary policy to reduce the amount of
money in circulation. This reduces the purchasing power of households/ public. Consequently,
aggregate demand falls and prices become stable.
15. Use of buffer stocks.
A buffer stock is a system or scheme which buys and stores stock in times of plenty and releases the
stocks in times of scarcity. The buffer stock is managed by the government and it helps in stabilizing
prices of goods on the market.

REASONS FOR GOVERNMENT INTERFERENCE IN PRICE MECHANISM
Due to the weaknesses or defects of price mechanism, government interferes in the allocation of
resources through the forces of demand and supply for the reasons below;
1. To reduce consumer exploitation by the profit – hungry business community.
This arises due to consumer ignorance/ market imperfections. The profit – hungry traders exploit
consumers through over charging, sale of fake products, product adulteration, sale of expired goods
etc. Such trade malpractices call for government intervention through setting up and strengthening the
bureau of standards.
2. To control monopoly power in an economy where consumer preference is ignored.
The government intervenes by imposing heavy taxes on the profits of monopolists. The aim is to fight
the dangers associated with private monopolies such as overcharging of consumers and production of
poor quality goods.
3. To reduce income inequality.
The government intervenes through progressive taxation so as to reallocate resources and attain equity
in income distribution.
4. To minimise social costs that arise as private investors pursue their private gains.
Such costs include over exploitation of resources, pollution of the environment, deforestation among
others. The government intervenes by setting up regulatory bodies that enact laws geared to protecting
the environment by regulating the actions of firms during resource exploitation.
5. To reduce unemployment which arises as inefficient firms are outcompeted.
The government intervenes by subsidising the inefficient firms to enable them lower their production
costs and survive the stiff competition. This guards against unemployment.
6. To reduce economic instabilities like inflation i.e. to stabilize the economy.

The government intervenes through price controls to ensure stability in prices of goods and
incomes of producers.
7. To cater for the provision of public goods.
Goods such as public roads andnational security cannot be provided through the market forces
of demand and supply hence a need for government interference.
8. To encourage production and consumption of merit goods.
These include education, medical care and safe water. A case in Uganda is the funding of
the Universal Primary and Secondary Education by the government.
9. In order to plan for rapid structural changes in the economy that cannot be handled by
price mechanism.
Structural changes such as rehabilitation of basic infrastructure after periods of war, privatization
and modernization of agriculture call for government interference.
10. For purposes of avoiding duplication of activities.
The government intervenes by setting up one public enterprise to run an activity. This avoids wastage
of resources.
11. To control distortion of consumer choices.The government intervenes by legislating prices of

commodities so as to avoid consumer exploitation by the producers in form of persuasive advertising.
12. To encourage investment in areas that may appear risky.
13. To provide goods needed by the poor.
In some cases, government subsidises such goods so that they become affordable to the poor people
in the economy. The aim is to improve the quality of life of the poor people.
LIMITATIONS OF PRICE MECHANISM

In this case, we focus on those factors that slow down or distort the effective allocation of resources
through the price mechanism. A student needs to be well versed with the assumptions of price
mechanism.
1. Government intervention/ interference.
In most economies, government interferes with the inter-play of market forces through price controls
and taxation policies. This discourages some producers and they reduce the amount of goods supplied
on the market. In this case, supply does not match with the consumers’ demand and price mechanism
is distorted.
2. Ignorance of the producers and consumers.
Generally, producers and consumers do not have perfect knowledge of the market conditions. Some
producers tend to supply goods without judging the condition in the market. Consumers too are not
always aware of the availability of certain products and their prices. This creates slow response
between demand and supply hence limiting price mechanism.
3. Existence of monopolies
There are many monopolies who tend to be price makers. They always restrict output in order to
charge high prices and exploit consumers. They do not supply goods according to the demand by the
consumers and this distorts the use of price mechanism in the allocation of resources.
4. Limited entrepreneurial skills.
Poor organization of factors of production and failure to take risks limits producers from responding
to consumers demands. Producers fail to supply those goods needed by consumers and this slows
down the operation of price mechanism.
5. Under developed infrastructure.
A poor road network limits the supply of goods to areas where they are needed. Consumers may
desire to buy goods but are not accessible due to poor transport and distribution network.

6. Inability to forecast future trends.
Failure of producers to anticipate increased demand in future gives rise to low output and this leads to
scarcity of goods. Alternatively, over production can occur where producers anticipate increased
demand yet actual demand is low. This creates a gap between demand and supply hence price
mechanism is distorted.
7. Limited capital.
Inadequate supply of real and money capital leads to low output. This makes producers to supply less
than what is required by consumers. As a result, shortages of goods arise on the market hence limiting
the operation of price mechanism.
8. Limited skilled labour.
The existence of few people with the necessary and relevant skills makes supply not to respond to the
demand of consumers because of fewer volumes of goods being suppliedhence limiting the effective
operation of price mechanism.
9. Immobility of factors of production.
Some factors of production do not move with ease from one place of work to another or from one
geographical area to another. Therefore producers may fail to increase output hence supply does not
respond to demand thus limiting the operation of price mechanism.
10. Irrationality of producers and consumers.
Price mechanism assumes that producers and consumers are rational which is not always true. Many
producers and consumers are not guided by a calculating mind.
11. Reliance on imported goods.
This makes local consumers to have little influence on prices, quality, designs, etc of such imported
goods.
12. Band wagon effect.
Many people consume certain commodities because they have seen others consuming them. Therefore
price mechanism may not operate since such consumers are not rational.
PRICE LEGISLATION
Price legislation is where the government fixes prices of commodities that is either maximum price
to protect consumers or minimum price to protect producers.
OR
Price legislation is the deliberate government act of fixing price either above or below the
equilibrium and it becomes illegal to sell below or above respectively.
Price control or legislation takes two major forms namely;
1. Maximum price legislation.
2. Minimum price legislation.
MAXIMUM PRICE LEGISLATION
This is the setting/ fixing of prices of commodities by the government below the equilibrium
price above which it becomes illegal to sell or buy a commodity. It protects consumers.
The result of maximum price legislation is a maximum price/ price ceiling.
Maximum price/ price ceiling
Refers to the price set by the government below the equilibrium price above which it becomes
illegal to sell or buy a commodity. It protects consumers.
Illustration

OPe = equilibrium price
OQe = equilibrium quantity demanded or supplied
OPc = maximum price/ price ceiling
It should be noted that no seller is allowed to sell above OPc which is the maximum price.
MERITS OF MAXIMUM PRICE LEGISLATION
1. Protects consumers from exploitation by producers through over charging.
2. Controls monopoly power since monopoly to a greater extent is a price maker.
3. Avails commodities to all groups of people in the economy. A maximum price makes the
commodity affordable to all people and therefore more units are bought.
4. Reduces income inequality because it reduces the profits of producers and expenditures of consumers.
5. Controls inflation because the price is set below the equilibrium price and it is illegal to sell or buy
above it.
6. Widens consumers’ choice thereby improving on peoples’ standards of living.

7. Helps to increase on aggregate demand thus stimulating investment and economic growth.
8. Discourages production of harmful products such as alcohol, cigarettes, marijuana, etc and
this benefits the entire society.
9. Discourages importation of expensive commodities and encourages exports. This increases the
foreign exchange earnings of the country.
DEMERITS
1. Discourages entrepreneurship development since it reduces the profit margins of producers.
2. Results into shortages of commodities since the legislated prices tend to be less attractive to
producers.
3. Leads to trade malpractices such as black marketing, hoarding of commodities, smuggling hence
reducing the supply of goods and services in the market.
4. Results into production at excess capacity as a number of resources are not put into use.
5. It leads to rationing. This is because it creates scarcity of goods and as a result, the government is
forced to restrict the consumption of scarce commodities on the basis of first come first serve hence
leading to problems like long queues and nepotism.
6. It leads to increased government expenditure due to high administrative costs incurred by the
government to employ the scouts and enforcement officials to visit all parts of the country so as to
ensure that goods are sold at the legislated prices.
7. It leads to unemployment due to reduced levels of investment
8. Deflation may arise and this if not checked may lead to economic depression.
NB:
Rationing is the government act of selling scarce commodities to households in

fixed quantities at fixed prices on the basis of first come first serve.

ASSIGNMENT
Outline the objectives of maximum price legislation.
MINIMUM PRICE LEGISLATION
Is the fixing/ setting of pricesof commodities by the government above the equilibrium price
below which it becomes illegal to sell or buy a commodity. It protects producers.
The result of minimum price legislation is a minimum price/ price floor.
MINIMUM PRICE/ PRICE FLOOR
Refers to the price set by the government above the equilibrium price below which it becomes
illegal to sell or buy a commodity. It protects producers.
Illustration
OPe = equilibrium price
OQe = equilibrium quantity demanded or supplied
OPc = minimum price/ price floor

MERITS OF MINIMUM PRICE LEGISLATION
1. Protects producers from exploitation by consumers through under charging. This basically applies to
producers of agricultural goods. The buyers are not allowed to get produce from farmers at a price
below the legislated price.
2. Increases output levels because it encourages more production in an economy hence economic growth
and development.
3. Enables producers to realize stable incomes since it minimizes price fluctuations.
4. Minimizes consumption of harmful products such as alcohol, cigarettes, marijuana, etc. This is
because the price is set above the equilibrium price hence making the products unaffordable by
consumers.
5. Increases government revenue because the government is in position to charge reasonable taxes on
profits received by producers.
6. May help an economy to offset economic depression or recession since it tends to activate
investments/ production in the economy.
7. Minimizes smuggling of goods to other countries since producers are satisfied with home prices.
8. Increases employment opportunities as a result of increased production of commodities and trade in

the economy.
9. Promotes research due to the high profits received by the producers which leads to production of
better quality products hence better standards of living.
DEMERITS
1. Causes surplus output because of excess production hence wastage of resources.
2. Leads to increased costs of productionsince it is a high price and mainly set for primary
products which form a major part of raw materials especially for agro – based industries.
3. A minimum price in form of minimum wage makes labour expensive forcing producers to opt for
alternative methods of production instead of hiring expensive labour e.g. some producers start using
more machines compared to men. This results into technological unemployment.
4. Leads to storage problems due to unmanageable surplus.
5. Leads to reduction in social welfare because of high costs of living.
6. Leads to over exploitation of resources which leads to exhaustion of some non-renewable resources
like minerals.
7. Leads to smuggling of goods into the country making government to lose a lot of revenue required to
meet its expenditure needs.
8. It is inflationary since there is no maximum. A minimum price makes it only illegal to set a lower
price but sellers can set any price above it.
9. Widens income disparities between producers and consumers since it increases the profits of
producers and expenditure of consumers.
10. It encourages dumping of commodities to other countries. Dumping has negative effects on the
recipient country such as closure of local firms due to their out competition, under utilization of local
resources among others.
11. Farmers are discouraged in the long run in case the government fails to buy the surplus output.
NB:
1. Dumping refers to the selling of a commodity in the external market at a lower price
than the one charged in the local market.
2. Price support is where the government buys the surplus output on the market
arising from the fixing of the minimum price.
ASSIGNMENT
1. Outline the objectives of maximum price legislation?
2. Under what circumstances may government employ a price control policy?
3. Examine the effects of price control in an economy.
4. Why may the use of price controls be avoided in an economy?

CIRCUMSTANCES UNDER WHICH GOVERNMENT MAY EMPLOY A
PRICE CONTROL POLICY
A price control policy may be employed under the following circumstances.
1. When consumers are being exploited. In this case, the government fixes a maximum price.
2. When there is existence of monopoly and its consequences → maximum price.
3. When essentials of life are unaffordable to consumers → maximum price
4. When there is need to reduce income inequality → maximum price
5. When producers are being exploited → minimum price
6. When there is desire to attain higher levels of output (economic growth) → minimum price
7. When there is need to maintain industrial peace → minimum price
8. When there is need to stabilize producers’ incomes → minimum price
9. When there is need to offset an economic depression/ recession → minimum price
10. When government wants to discourage production and consumption of harmful products → both
11. When there are price instabilities → both.
EFFECTS OF PRICE CONTROLS
POSITIVE EFFECTS
1. Maximum price protects consumers from exploitation by producers through over charging.
2. Maximum price controls monopoly power.
3. Maximum price avails commodities to all groups of people in the economy.
4. Maximum price reduces income inequalities.
5. Maximum price widens consumers’ choice

6. Maximum price helps to increase on aggregate demand
7. Maximum price discourages importation of expensive commodities and encourages exports.

This increases the foreign exchange earning of the country.
8. Minimum price protects producers from exploitation by consumers through under payment.
9. Minimum price increases output levels.
10. Minimum price enables producers to realize stable incomes.
11. Minimum price increases government revenue.
12. Minimum price may help an economy offset an economic depression or recession.
13. Minimum price increases employment opportunities.
14. Minimum price promotes research.
15. Price control maintains price stability
16. Price control checks on the production and consumption of harmful products.
17. Price control eliminates trade malpractices such as black marketing, smuggling of goods, etc.
NEGATIVE EFFECTS
1. Maximum price discourages entrepreneurship development.
2. Maximum price results into shortages.
3. Maximum price results into production at excess capacity.
4. Maximum price leads to unemployment due to reduced level of investments.
5. Minimum price causes surplus output hence wastage of resources.
6. Minimum price leads to increased costs of production.
7. Minimum price leads to storage problems due to unmanageable surplus.
8. Minimum price leads to reduction in social welfare because of high costs of living.

9. Minimum price leads to over exploitation of resources.
10. Minimum price causes inflation since there is no maximum.
11. Minimum price widens income disparities between producers and consumers.
12. Price controls encourage trade malpractices such as black marketing, smuggling, etc.
13. Price controls call for establishment of marketing boards which leads to exploitation of consumers.
14. Price controls lead to misallocation of resources due to distortion of price mechanism.
15. It is expensive for the government to enforce price controls.
REASONS FOR AVOIDANCE OF PRICE CONTROLS
1. Fear of causing trade malpractices such as smuggling, black marketing, etc. Maximum price
legislation leads to smuggling of goods to other countries while minimum price legislation leads to
smuggling of goods into the country.
2. Fear of raising costs of production which arise out of high costs of raw materials resulting from
minimum price legislation.
3. Fear of causing unemployment resulting from maximum price legislation which forces firms to close
down as they cannot cover their average costs.
4. To avoid unmanageable surpluses and storage problems in case of a minimum price.
5. To avoid discouraging entrepreneurs through tampering with their profit margins in case of a
maximum price.
6. To avoid high administrative costs on these price controls e.g. price support.
7. To avoid unnecessary distortion of the price mechanism which may lead to misallocation of resources.
8. Fear of reducing social welfare of the people due to high cost of living caused by minimum price
legislation.
9. To avoid underutilization of resources in case of a maximum price.

10. Fear of causing shortages of goods and services resulting from maximum price legislation
which discourages production.
AGRICULTURE IN RELATION TO DEMAND AND SUPPLY
The nature of demand and supply in the agricultural sector tends to be unstable and this in turn tends
to make prices of agricultural products fluctuate more often compared to the prices of industrial
products or manufactured goods.
AGRICULTURAL PRICE FLUCTUATIONS
Agricultural price fluctuations refer to instabilities or changes in prices of agricultural products over
a given period of time.
CAUSES OF AGRICULTURAL PRICE FLUCTUATIONS
1. Divergence between planned output and actual output.
When the actual output of farmers is greater than the planned output, over production arises leading to
a fall in prices for the planned output. However where actual output is less than the planned output,
there is shortage on the market hence causing the prices to increase.
2. Long gestation period of agricultural products.
The long gestation period of some crops makes supply to be inelastic. Before harvesting season, there
is a shortage of agricultural products in the market and this leads to an increase in prices. However
after harvesting, supply of agricultural products is increased on the market and this leads to a fall in
prices being offered to producers.
NB:
Gestation period is the time it takes before new supplies of goods reaches the market
for example maize takes 3-4 months while mushrooms take 1 month.
3. Low income elasticity of demand for agricultural commodities.

The demand for agricultural products is not influenced by changes in income i.e. changes in income
have minimal impact on the demand for agricultural products. During seasons of high supply, surplus
is created on the market and this leads to a fall in prices. However, a fall in supply leads to an increase
in prices.
4. Low price elasticity of demand (inelastic demand) for agricultural commodities.
The demand for agricultural products is inelastic such that even if prices change, consumers demand
almost the same quantities. This implies that change in supply is not followed by change in demand
hence leading to continuous change in price levels i.e. surplus output pushes the prices downwards
and shortages push the prices upwards.
5. Changes in the costs of production.
Farmers incur costs of production in form of buying seeds, fertilizers, farm equipments, hiring tractor
services etc. When they incur high costs of production, they increase the prices for their products and
when they incur lower costs of production, they reduce the prices hence price fluctuations.
6. Perishability of agricultural products hence difficult to store.
Most of the agricultural products are perishable and thus cannot be stored for future use. This causes
prices to fall during harvesting periods because farmers tend to sell all their produce. On the other
hand during non-harvesting periods, there is severe shortage because little or nothing was stored
during the harvesting period and consequently prices go up.
7. Bulkiness of agricultural products hence difficult to transport.
Agricultural products are bulky and this makes them difficult to transport from production areas to
market centres. This leads to a fall in prices at the production centres and a rise in prices at the market
centres.
8. Lack of co-operation among producers of agricultural products.
Presence of many farmers competing amongst themselves makes it hard to regulate output in order to
stabilize prices. When producers enjoy high prices of products in one season, many farmers are
attracted to grow the same crop in the coming season. This results into massive output leading to a fall

in prices. When producers make losses, many farmers are discouraged and stop growing the crop.
This results into shortages in the next season forcing prices to rise.
9. Heavy dependence on nature/ effects of changes in natural factors like weather, soils, etc
which affect output levels.
Unfavourable climatic factors like prolonged droughts, floods, pests and diseases in some seasons
result into low output leading to an increase in the price of agricultural products. On the other hand,
favourable climatic conditions lead to greater output by the farmers resulting into declining prices of
agricultural products.
10. Substitution of agricultural raw materials with artificially made raw materials by
developed countries/ high competition from synthetic/ artificial fibres.
Some agricultural products like cotton face stiff competition from synthetic fibres like nylon, silk,
polyester, etc. Where buyers prefer synthetic fibres to natural fibres, the price of natural fibres falls.
However, when the demand for synthetic fibres declines, buyers resort to natural fibres and their
prices increases.
11. Introduction of raw material saving techniques by developed countries (major buyers).
Raw material saving innovations have tended to interfere with planning output in the agricultural sector
thereby causing instabilities in supplies and hence instabilities in prices of agricultural products.
12. Weak bargaining position of LDCs on the world market/ external determination of prices
The major buyers (MDCs) dictate the prices of agricultural products like coffee, cotton, tea etc. As a
result, LDCs cannot secure stable prices for their products because the major buyers increase and
decrease the prices since they are more or less price makers in the foreign markets hence price
fluctuation.
13. Agricultural products are only minor inputs in the manufacturing sector.
The agricultural products used as inputs in the production of industrial products form a small part. E.g.
in the manufacturing of cars, agricultural products are only used in the making of tyres making their
demand inelastic.
14. Poor surplus disposal system/ machinery.

Developing countries are faced with a problem of poor infrastructure such as underdeveloped
transport facilities making it difficult to transport the surplus to areas of scarcity. This leads to a fall in
prices in the areas where there is surplus output and a rise in prices in areas of scarcity.
EFFECTS OF AGRICULTURAL PRICE FLUCTUATIONS ON AN ECONOMY
1. Price fluctuations lead to fluctuations in farmers’ incomes.
Incomes of farmers increase when prices increase and they decrease when the prices decrease.
2. Price fluctuations result into fluctuations in government revenue.
This is because government receives most of the revenue from taxing income and/ or property.
Therefore fluctuation in income means fluctuation in tax revenue.
3. Fluctuations in prices of major export crops lead to instability in export earnings.
In seasons when export prices increase, export revenue for the government increases. However in
seasons when export prices fall, export revenue also declines. This causes unstable export earnings
from one season to another.
4. Government planning based on expected earnings from the agricultural sector

becomes difficult.
When prices are fluctuating, it is not easy to predict what is to be earned from selling agricultural
products. This complicates planning by the government in case the plans are to be financed by
incomes from the agricultural sector/ agricultural exports.

5. Farmers get discouraged/ frustrated.
This leads to subsistence production hence a decline in economic growth and development.
6. Price fluctuations lead to rural urban migration with its negative consequences.
As incomes from agriculture become unreliable, the frustrated farmers (especially the young and
energetic) migrate to urban areas looking for better employment avenues/ opportunities.
Unfortunately, this migration is associated with many problems like open urban unemployment, high
crime rate, development of slums, gambling, etc.
7. Price fluctuations lead to instability in exchange rates.
As export prices of agricultural products increase, a country’s foreign exchange earnings are
improved. This results into greater foreign exchange inflow. This increased inflow of foreign currency
results into a fall in exchange rates in the country. However, a fall in export prices of agricultural
products creates a shortage of foreign currency in the country. This results into an increase in
exchange rates.
8. Price fluctuations lead to instabilities in balance of payments.
An increase in export prices of agricultural products in a given season results into an improvement in
the balance of payments position.On the hand, a fall in export prices of agricultural products in a
given season results into worsening of the balance of payments position.
9. Price fluctuations result into unstable/fluctuating terms of trade.
When prices of agricultural exports increase, the terms of trade improve (become better). However
when export prices decline, the terms trade deteriorate (become worse).
10. Investment in agriculture becomes uncertain.
This causes speculation as farmers regard investment in agriculture as a gamble and thus irrational use
of land.
11. Price fluctuations lead to seasonal unemployment in the sector.
Some farmers may decide not to produce in a particular season because of the miserable prices
obtained in the past season. Such farmers become seasonally unemployed.
12. Price fluctuations worsen income inequalities.
A decline in prices of agricultural products in some seasons makes farmers to earn less income
than individuals employed in other sectors like the industrial sector, service sector, etc.
ASSIGNMENT
Why is there need to stabilize agricultural products?
POSSIBLE WAYS OF STABILISING AGRICULTURAL PRICES
1. Through operation of the buffer stock policy.
A buffer stock policy is one whereby the government through the market boards buys the surplus
output from farmers, stores it and sells it during periods of scarcity. This helps to iron out fluctuations
in supply, prices and incomes.
2. By use of the stabilization fund policy.
A stabilization fund policy is the deliberate attempt by the government of paying the producers less than
the market price when prices and incomes are high and putting the realized difference into a fund and later
using the fund to pay the producers higher prices than the market price when prices and incomes are low to
avoid fluctuations in prices and incomes as would be dictated by the market forces.
3. Improving on storage facilities/ system
For example use of fridges to ensure proper storage of highly perishable products like milk, fish,
tomatoes etc. This stabilizes supply and hence prices and incomes of agricultural producers.
4. Improving on transport system.
This involves construction of feeder and main roads linking production centres and market centres. A
better transport system evens out surpluses by easing transportation of goods from production centres
(areas of plenty) to market centres (areas of scarcity) thereby stabilizing prices of agricultural
products.
5. Modernizing agriculture/ improvement in technology and carrying out extensive research.

This not only improves on the quality of agricultural products but also leads to a reduction in their
gestation period. For example use of hybrid seeds with a short gestation period, taming nature through
irrigation, etc. All these stabilize supply leading to stable prices over time.
6. Setting up agro-based industries.
Agro-based industries add value onto agricultural products. This helps to improve on the quality and
prices of agricultural products.
7. Joining international commodity agreements.
International commodity agreements like international coffee agreement help to fix prices and quotas
for the buyers and sellers of commodities to avoid fluctuations of prices on the world market resulting
from excess supply.
8. Diversifying agriculture.
It is important to note that many developing countries depend on only one or two crops for export. As
a result, fluctuations in the output or prices of the crop(s) may cause considerable instability in exports
and incomes of those countries. To reduce the effects of dependence on one or a few crops, there is
need to produce a variety of crops so that failure of one can be compensated for by the successful
harvest of the other(s).
9. Development of forward (future) markets/ contract trade
This involves producers and buyers signing agreements specifying the amount, quality and price of a
given commodity to be supplied in the future. In this way, changes in supply do not affect the price
agreed upon hence stability in prices of agricultural products. Future trade can be arranged for both
local and foreign trade.
10. Through price legislations.
The government of the concerned economy can carry out price controls by fixing prices of selected
commodities.
11. Formation of co-operatives to control supply.
Co-operatives help to educate the farmers about the use of better farming methods, looking for market
for the farmers’ output, regulating supply through a quota system, improving the bargaining abilities
of farmers with buyers, etc. All these actions help to stabilize the prices of agricultural products.
12. Strengthening regional economic integration.
This improves the bargaining power of member states for their agricultural exports on the world
market.
13. Diversifying and expanding the markets for agricultural products.

This involves extending and widening markets for agricultural products. It is done by searching for
new buyers from other developing countries in Asia and in other parts of Africa.
14. Re-sale price maintenance system.
It is important to note that greater fluctuations are at times caused by middlemen and if prices at
which consumers are to buy are set in advance by the primary producers, instability in prices may be
minimized.
15. Subsidising farmers/ providing tax incentives to farmers/ stabilising costs of production.
This involves reducing taxes on farm inputs or provision of subsidies to farmers on farm inputs. This
helps to stabilise costs of production and ensure stable supply and prices.
16. Providing affordable credit to farmers to buy necessary inputs.
This involves providing low interest loans to farmers through the local SACCOs and commercial
banks to enable purchase of farm inputs. This leads to stable supply of agricultural products and thus
stable prices.
EFFECT OF A CHANGE IN SUPPLY UNDER CONDITIONS OF INELASTIC DEMAND
With inelastic demand, small change in supply can have a large impact on changing price.
Illustration
From the diagram above, it can be observed that a small increase in supply (represented by a shift of
the supply curve to the right from S1S1 to S2S2) leads to a big fall in price from P2 to P1. Note that a
fall in supply has a similar but opposite effect.
THE COBWEB THEORY
The cobweb theory is an economic model that attempts to explain the occurrence of price fluctuations
in certain types of markets.
The cobweb theory is based on a time lag between supply and demand decisions. Since agricultural
marketsare characterised by a time lag between planting and harvesting, the cobweb model can be
applied to explain the occurrences of agricultural price fluctuations.
Because of this time lag, the output produced in a particular season is determined by the prices of the
previous season.
Illustration of the cobweb model (Convergent cobweb)
From the above illustration, initially the equilibrium quantity supplied is OQoand the equilibrium
price is OPo.
Assuming there is a shock in an economy for instance an unexpectedly bad weather, this will result in
a fall in the amount of the commodity supplied on the market from OQo to OQ1 (A shortage is
created). This results into an increase in the price of the commodity from OPo to OP1. This increase
in the price above equilibrium attracts new farmers to plant the same crop and also makes the old
farmers to plant more. Because of the time lag between planting and harvesting, much will be
supplied in the next season i.e. output increases from OQ1 to Q2 (There is surplus output). This forces
the farmers to reduce the prices of their products from OP1 to OP2. This fall in price discourages
some farmers and they stop growing the crop and even those who remain in production end up
planting less. This results into less output put on the market the next season (Quantity OQ3 is supplied
which is less than demand) again forcing prices to rise from OP2 to OP3. This process will go on until
equilibrium is reached after a number of oscillations.
From the illustration, it can be observed that the fluctuations spiral inwardly meaning that the forces
of demand and supply work out to restore the equilibrium conditions. This is a case where demand is
more elastic than supply (The supply curve is steeper than the demand curve)

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“COPY THE NOTES, DIAGRAM AND CALCULATIONS WILL BE DRAWN WHEN SCHOOL

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9. Resale price maintenance.

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OPe is the equilibrium price.

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THE LAW OF DEMAND

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5. Behaviour/presence of low income earners.

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DECREASE IN QUANTITY DEMANDED

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ABNORMAL/ REGRESSIVE/ EXCEPTIONAL DEMAND CURVES

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4. Speculation (future price expectations)

From the diagram above, the following can be observed.

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THE LAW OF DIMINISHING MARGINAL UTILITY

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RELATIONSHIP BETWEEN MARGINAL UTILITY AND THE DEMAND CURVE

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Price consumers are willing to pay (shs) Units purchased

Taking 100 to be the equilibrium price, calculate the producer’s surplus.

Produce r' surplus=Actual revenue−Expected revenue

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6. Length of gestation period.

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THE SUPPLY CURVE

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From the diagram, supply remains constant in spite of price changes.

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FACTORS THAT CAUSE A CHANGE IN SUPPLY OF A COMMODITY

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CAUSES OF AN INCREASE IN SUPPLY

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INCREASE IN QUANTITY SUPPLIED

DECREASE IN QUANTITY SUPPLIED

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ILLUSTRATION OF THE EQUILIBRIUM CONCEPT