Price System and the Micro Economy

The Price System and the Micro Economy

• Markets provide a mechanism for buyers and sellers to establish prices for goods, services, and factors of production.

The Function of Prices

• Prices serve three basic functions in any market.
• Signalling function: Prices indicate surpluses or shortages.
• Rationing function: Prices allocate resources among alternative uses.
• Incentive function: Prices encourage producers to adjust their supply.

Demand and Supply Curves

• Law of Demand: There is an inverse relationship between price and quantity demanded for most goods and services.
• Demand Curve: Illustrates the relationship between the quantity of a product individuals are willing and able to purchase at different prices over time, assuming all other factors are constant (ceteris paribus).

Individual and Effective Demand

• An individual's demand is the quantity they're willing and able to buy at various prices over a period.
• Effective demand occurs when an individual is both willing and able to purchase a product.

Market Demand

• Market demand is the total demand for a product, found by summing the quantity demanded by each individual at every price.

Other Influences on Demand - Conditions of Demand

• Various conditions influence individual demand at each price, shifting the demand curve.

Income

• Normal Good: Demand rises with income and falls when income decreases.
• Inferior Good: Demand falls as income rises, and rises as income decreases.

The Price of other goods

• Substitutes: Alternative goods; if the demand for one increases, the demand for the other decreases.
• Complements: Goods consumed together; if the demand for one increases, the demand for the other also increases.

Tastes

• Individuals tend to purchase preferred items.
• Product appeal influences demand.
• Tastes and preferences can be shaped through advertising and promotion.

Expectations of Future Prices

• Products with investment potential are bought in anticipation of future price increases and profitable resale.
• Expectations of rising prices can drive an increase in current demand.

Size, Age and Gender Distribution of the Population

• Overall demand for goods and services fluctuates with population changes.
• Specific demographics influence demand patterns for particular goods and services.

Distribution of Income

• A more even income distribution typically increases demand for most normal goods.
• Uneven distribution impacts demand for necessities and luxury items.

Shifts of the Demand Curve

• Changes in conditions of demand enable individuals to purchase more or less at each price point, and shift the demand curve.
• Increased ability to buy shifts the demand curve to the right, whereas decreased ability shifts it to the left.

Movements Along the Demand Curve

• Price increases cause an upward movement along the curve, resulting in decreased demand.
• Price decreases cause a downward movement, increasing demand.

Supply

• Supply is the quantity of a good or service producers are willing and able to sell at different prices over a period.
• Law of Supply: The quantity supplied usually increases with price increases and decreases with price decreases.

Market Supply

• Market supply is the total quantity offered by all producers at each price.

Other Influences on Supply - Conditions of Supply

Costs of Production

• Supply decreases as production costs increase, and vice versa.

Availability of resources

• Supply increases as more resources become available, and vice versa.

Climate

• Adverse weather can reduce the ability to produce and supply certain goods.

Technology

• Technology can lead to new products or lower production costs, enabling firms to produce more at each price.

Government regulation

• Regulations can impact a producer's costs and, consequently, product supply.

Tax and Subsidies

• VAT and GST increase production costs, reducing supply, while subsidies lower costs and enable more supply.

Price of Other Goods the Producer Could Supply

• A product's supply varies inversely with the price of alternative products that could be produced.

Shifts of the Supply Curve

• When supply conditions change a shift in the entire supply curve results.
• Increased ability to supply shifts the curve to the right.
• Decreased ability to supply shifts the curve to the left.

Movements Along the Supply Curve

• Price increases generate an upward movement along the supply curve, expanding supply.
• Price decreases cause a downward movement, contracting supply.

Market Equilibrium and Disequilibrium

Market Equilibrium

• Equilibrium is the price point where there is no tendency for change given existing demand and supply conditions where demand equals supply.

Market Disequilibrium

• Disequilibrium happens when demand does not equal supply, leading to price changes.
• Price increases if demand exceeds supply.
• Price decreases if supply exceeds demand.

Determinants of the Equilibrium Market Price

• To find equilibrium price, demand and supply schedules and curves are combined.

Shifts of Demand and Supply on Equilibrium Price

An increase or decrease in demand

• Increased demand shifts the demand curve to the right, resulting in a new, higher equilibrium price.
• Decreased demand shifts the demand curve to the left, resulting in a new equilibrium price.

An increase or decrease in supply

• Increased supply shifts the supply curve to the right, creating a new equilibrium.
• Decreased supply shifts the supply curve to the left and leads to a new equilibrium.

Elasticity of Demand and Supply

Price Elasticity of Demand (PED)

• PED measures how responsive demand is to a change in price.

Calculation of the Price elasticity of demand

• PED is calculated by dividing the percentage change in quantity demanded by the percentage change in price.

Interpreting the figure for PED

• PED ranges from zero to infinity.
• Elastic Demand: PED > 1
• Inelastic Demand: PED < 1

Point Elasticity of Demand

• Point elasticity measures elasticity at a specific price or point on a demand curve, useful for straight-line demand curves.
• Point elasticity is calcualted by dividing the top segment of the demand curve above the chosen point by the bottom segment below the point.

Classifications of Point Elasticity

Perfectly Elastic Demand

• Perfectly Elastic Demand: a tiny price change causes an infinite change in quantity demanded (horizontal line).

Perfectly Inelastic Demand

• Perfectly Inelastic Demand: quantity demanded does not change regardless of price change (vertical straight line).

Unitary Elasticity of Demand

• Unitary Elasticity of Demand: any price/quantity combination yields the same total revenue (rectangular hyperbola).

Factors Affecting PED

Time

• Demand becomes more elastic over longer time periods.

Number of Sustitutes

• More substitutes lead to more price-elastic demand.

Degree of Necessity

• Demand is more inelastic for necessities and more elastic for luxuries.

Durability and Perishability

• Durable goods tend to have more elastic demand than perishable goods.

Proportion of Income Taken by the Product

• Demand becomes more elastic as the proportion of income spent on a product increases.

Importance of PED

• Producers use PED to decide on pricing and the government uses it to determine the impact of taxes.

Price Elasticity of Demand and Indirect Taxes

• Indirect taxes are taxes on expenditure levied on producers but possibly passed to consumers through higher prices.

• Ad Valorem Tax: Percentage tax

• Specific Tax: Fixed amount per unit.

Income Elasticity of Demand

• Measures the responsiveness of demand to changes in consumers' income.

Calculation of the Income elasticity of demand

• Income elasticity is calculated by dividing the percentage change in quantity demanded by the percentage change in income.

Classifications of Income elasticity

• Income Elastic: >1
• Unitary Income Elasticity: =1