04.

THEORIES OF DEMAND AND SUPPLY

DEMAND

The concept of demand

Is the willing and ability of a person to purchase/buy goods or services at a given
price level in a given period of time. Or

Is a full description of how the quantity demanded changes as the price of the good
changes.

Factors Influencing Demand for a Commodity:

They are many factors on which the demand for a commodity depends. They are
called determinants of demand. They are discussed as under:

1. Income of the consumer:

A consumer’s demand is influenced by the size of his income. With increase in the
level of income, there is increase in the demand for goods and services. A rise in
income causes a rise in consumption. As a result, a consumer buys more. For most of
the goods, the income effect is positive. But for the inferior goods, the income effect
is negative. That means with a rise in income, demand for inferior goods may fall.

2. Price of the commodity:

Price is a very important factor, which influences demand for the commodity.
Generally, demand for the commodity expands when its price falls, in the same way
if the price increases, demand for the commodity contracts. It should be noted that it
might not happen, if other things do not remain constant.

3. Changes in the prices of related goods:

Sometimes, the demand for a good might be influenced by prices changes of other
goods. There are two types of related goods. They are substitutes and complements.
Tea and Coffee are good substitutes. A rise in the price of coffee will increase the
demand for tea and vice versa. Bread and butter are complements. A fall in the price
of bread will increase the demand for butter and vice versa.

4. Tastes and preferences of the consumers:

Demand depends on people’s tastes, preferences, habits and social customs. A
change in any of these must bring about a change in demand. For example, if people
develop a taste for tea in place of coffee, the demand for tea will increase and that
for coffee will decrease.

5. Change in the distribution of income:

If the distribution of income is unequal, there will be many poor people and few rich
people in society. The level of demand in such a society will be low. On the other
hand, if there is equitable distribution of income, the demand for necessaries
commonly consumed by the poor will increase and the demand for luxuries

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consumed by the rich will decrease. However, the net effect of an equitable
distribution of income is an increase in the level of demand.

6. Price expectations:
Expectations of people regarding the future prices of goods also influence their
demand. If people anticipate a rise in the prices of goods in future due to some
reasons, the demand for goods will rise to avoid more prices in future. Contrarily, if
the people expect a fall in price, the demand for the commodity will fall.

7. State of economic activity:

The state of economic activity is major determinant influencing the demand for a
commodity. During the period of boom, prosperity prevails in the economy.
Investment, employment and income increase. The demand for both capital goods
and consumer goods increase. But in period of depression demand declines due to
low investment and low income.

Demand schedule
Is a list showing the quantities of a good that consumers would choose to purchase
at different prices, with all other variables held constant.

Price (per bottle)Tshs Quantity (bought per month)

1 7500
2 6000
3 5000
4 4000
5 3500

Demand Curve:

Market demand schedule

This is the horizontal summation of the list of goods and services different
consumers are willing and able to buy at certain price level. It involves only the
horizontal summation of quantities bought by different people

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Demand function
Is the mathematical relationship between the quantity demanded and factors
affecting demand

It is expressed as
Qdx=f(Px, Py, Y,T,P e.t.c)

Where; Qdx=quantity demanded of good X

f=function of
Px=price of good X
Py=price of related goods i.e. good Y
Y=income of the consumer
P=population
The linear equation representing the demand function is; Qdx=a-bPx

Where; a=factor remaining constant for the law of demand to operate

b=slope (negative)

The Law of Demand

How does a change in price affect quantity demanded? You probably know the
answer to this already: When something is more expensive, people buy less of it.

The law of demand states that, “when the price of a good rises and everything else
remains the same, the quantity of the good demanded will fall”.

“everything else remains the same”

• That’s an important phrase in the wording of the Law of Demand

• The quantity demanded of a consumer good such as ice cream depends on
– The price
– The prices of related goods
– Consumers’ incomes
– Consumers’ tastes

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 – Consumers’ expectations about future prices and incomes
– Number of buyers, etc
• The Law of Demand says that the quantity demanded of a good is inversely
related to its price, provided all other factors are unchanged

Reasons for a negative slope of demand curve

Carefully explain why a typical demand curve slopes downwards?

A demand curve is the graphical representation of the demand schedule for a commodity. It is the

graphic statement of an individual buyer's reaction on amount demanded at a given price in the given
point of time. A demand curve has got a negative slope. It slopes downwards from left to right.
A demand curve shows the maximum quantities per unit of time that consumers will buy at various
prices. In the words of Richard Lipsey "The curve which shows the relation between the price of a
commodity and the amount of that commodity the consumer wishes to purchase is
called Demand Curve.

(1) Law of diminishing marginal utility:

A consumer always equalises marginal utility with price. The law states that a consumer
derives less and less satisfaction (utility) from the every additional increase in the stock of a
commodity. When price of a commodity falls the consumer's price utility equilibrium is
disturbed i.e. price becomes smaller than utility.

The consumer in order to restore the new equilibrium between price and utility buys more of
it so that the marginal utility falls with the rise in the amount demanded. So long the price of
a commodity falls, the consumer will go on buying more amount of it so as to reduce the
marginal utility and make it equal with new price.
Thus the shape and slope of a demand curve is derived from the slope of marginal
utility curve.

(2) Income effect:

Another cause behind the operation of law of demand is income effect. As the price of a
commodity falls, the consumer has to buy the same amount of the commodity at less amount
of money. After buying his required quantity he is left with some amount of money.

This constitutes his rise in his real income. This rise in real income is known as income effect.
This increase in real income induces the consumer to buy more of that commodity. Thus
income effect is one of the reasons why a consumer buys more at falling prices.

(3) Substitution effect:

When the price of a commodity falls, it becomes relatively cheaper than other commodities.
The consumer substitutes the commodity whose price has fallen for other commodities which
becomes relatively dearer.

For example with the fall in price of tea, coffees. Price being constant, tea will be substituted
for coffee. Therefore the demand for tea will go up.

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(4) New consumers:

When the price of a commodity falls many other consumers who were deprived of that
commodity at the previous price become able to buy it now as the price comes within their
reach. For example the units of colour TV. increases with a remarkable fall in price of it. The
opposite will happen with a rise in prices.

(5) Multiple use of commodity:

There are some commodities which have multiple uses. Their uses depend upon their
respective, prices. When their prices rise they are used only for certain selected purposes.
That is why their demand goes down.
For example electricity can be put to different uses like heating, lighting, cooling, cooking etc.
If its price falls people use it for other uses other than that. A rise in price of electricity will
force the consumer to minimise its use. Thus with a fall and rise in price of electricity
its demand rises and falls accordingly.

Exceptions of Law of Demand

Sometimes, we find that with a fall in the price demand also falls and with a rise in
price demand also rises. These cases are referred to as exceptions to the general law
of demand. The demand curve in these cases will be an upward sloping. Some of
these exceptions are:
1. Giffen goods or Inferior goods.
2. Prestige goods
3. Speculation
4. Price Illusion

These different types of exceptions are described in brief explanation as follows:-

 Inferior goods:
Some goods like potato, bread, vegetable oil etc. are called inferior goods. In
the case of these goods when their price falls, the real income or the
purchasing power of the consumer increases, this purchasing power is used
to buy other superior goods. Such inferior goods are named as 'Giffen goods'.
An Irish economist Sir Robert Giffen observed this tendency of the
individuals in the 19th century.

 Expectations and speculations:

When people expect a rise or fall in price in the near future, the law of
demand does not hold good. If a price rise is expected by next week, then
they will buy more now itself though at present the prices are quite high.
 Prestige (luxury, ostentation) goods:
Rich people like to show off their economic status. So they buy prestige goods
like color T.V., diamond, car, phones, and laptops even at a higher price.

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  Price illusion:
There are certain consumers those who are always guided by the price of the
commodity. They always believe that higher the price, better the quality.
Hence they purchase larger quantities of high priced goods.
 Ignorance:
Sometimes due to ignorance of existing market price, and people buy more at
a higher price.
 Fear of serious shortage in the future:

Interrelated Demand

The demand for one product is affected by changes in the market for other related
products. The demand for all products is related because all products compete for
the scarce budget, the increase in the price of one product can affect all other
purchases.

Complementary demand goods

The products are used in conjunction with one another. A shift in demand for one
product will shift the demand curve of its complementary product as well e.g. DVD
players and DVDs.

Composite demand goods

Demand arises from several sources, and an increase in demand for products for use
in one sector will decrease the availability of the products for use in another sector
e.g. electricity for domestic or commercial uses.

Derived demand goods

Demand for one product is derived from the demand for another product. This is
akin to Complementary Demand, but different in that for Derived Demand, one good
is involved in the production process of the other product e.g. cars and the steel
used to make cars.

Substitute demand goods

Are two goods that could be used for the same purpose. If the price of one good
increases, then demand for the substitute is likely to rise.

ELASTICITY OF DEMAND

Elasticity of demand refers to the sensitiveness or responsiveness of demand to

changes in price. Price elasticity of demand is usually referred to as elasticity of
demand.

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Different elasticities of demand measures the responsiveness of quantity demanded
to changes in variables which affect demand so:
1. Price elasticity of demand- measures the responsiveness of quantity demanded by
changes in the price of the good
2. Income elasticity of demand – measures the responsiveness of quantity
demanded by changes in consumer incomes.
3. Cross elasticity of demand – measures the responsiveness of quantity demanded
by changes in price of another good

Price Elasticity of Demand

It is the ratio of proportionate change in quantity demanded of a commodity to a
given proportionate change in its price. Price elasticity of demand (EP) is, thus,
given by:
Ped= Percentage Change in Quantity Demanded
Percentage Change in Price

Ped=∆Q×P
∆P Q
Where, Q = quantity demanded of a commodity; P= Price.

Example, quantity demanded originally is 100 at a price of $2. There is a rise in price
to $3 resulting in a fall in demand to 75. Calculate the price elasticity of demand

Types of Elasticity of Demand: Price elasticity of demand is classified under the

following five sub heads:

1. Perfectly elastic demand: It refers to the situation where the slightest rise in price
causes the quantity demanded of a commodity to fall to zero and at the present level
of price people demand infinitely large quantity of the commodity. The coefficient of
elasticity of demand is infinite.

2. Perfectly inelastic demand: It refers to the situation where even substantial

changes in price do not make any change in the quantity demanded, i.e., for any
change in the price, the demand remains constant. The coefficient of elasticity of
demand is zero.

3. Relatively elastic demand: Here, a small proportionate change in the price of a

commodity results in a larger proportionate change in its quantity demanded. The
coefficient of elasticity of demand is greater than unity.

4. Relatively Inelastic demand: A larger proportionate change in the price of a

commodity results in a smaller proportionate change in its quantity demanded. The
coefficient of elasticity of demand is greater than zero, but less than unity.

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5. Unitary elastic demand: It refers to a situation where a given proportionate
change in price is accompanied by an equally proportionate change in the quantity
demanded. In other words, a given proportionate fall in the price is followed by an
equally proportionate increase in demand and vice versa. The co efficient of
elasticity of demand is unity.

Measurement of Elasticity of Demand: Price elasticity of demand can be measured

by two methods. They are:

1. Point price elasticity, this measure elasticity of price at only one point or at a
single point.
2. Arc elasticity of demand, this measure elasticity between two points

Quiz 1. If the demand for butter rose by 2% when the price of margarine rose by 8%,
then the cross price elasticity of demand of butter with respect to the price of
margarine will be 0.25, they are substitutes

Quiz 2. If a 4% rise in the price of bread led to a 3% fall in the demand for butter, the
cross-price elasticity of demand for butter with respect to bread would be -0.75,
they are complementary

Elasticity and Total sales (revenue)

Total sale = P*Q
We normally check with only three kinds i.e. inelastic, elastic and unitary

Total revenue (TR) = Price x Quantity; when the demand curve is inelastic, TR
increases as the price goes up, and vice versa; when the demand curve is elastic, TR
falls as the price goes up, and vice versa, and for unitary things remain as they are

Factors Influencing the Elasticity of Demand

The elastic or inelastic nature of the demand for a commodity is determined by the
following factors.

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 1) Degree of necessity: Other things being equal, the demand for necessities is
inelastic or less elastic than that for comforts and luxuries. The reason is simple. The
necessities must be bought whatever be the price because no one can live without
them. The demand for a necessity without a substitute is less elastic than the
demand for a necessity with a substitute. For example, the demand for salt is less
elastic than that for paddy.

2) Proportion of consumer’s income spent on the commodity: The demand for a

commodity on which the consumer spends only a small proportion of his income is
less elastic. For instance, even if the price of salt or match-box rises by 100 per cent,
the demand for them may not decline substantially.

3) Existence of substitutes: The demand for a commodity is more elastic, if it has a

number of good substitutes. A small rise in the price of such a commodity will
induce the consumers to go for its substitutes, assuming that their prices do not rise.

4) Several uses of the commodity: The demand for a commodity is said to be more
elastic, if it can be put to a variety of uses. A fall in the price of electricity will result
in the substantial increase in its demand.

5) Time: The elasticity of demand varies with the length of time. In general, demand
is more elastic for longer period of time. For instance, if the price of kerosene rises,
it may be difficult to substitute it with cooking gas within a very short time. But if
sufficient time is given, people will make adjustments and use firewood or cooking
gas instead of kerosene

6) Habit

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Income Elasticity of Demand
It may be defined as the ratio of proportionate change in the quantity demanded of
commodity to a given proportionate change in income of the consumer

Income Elasticity, Ei = Percentage Change in Quantity Demanded

Percentage Change In Income

Symbolically, Ei = Δ Q × Y
ΔY Q

Where, Q = Quantity demanded; Y-income

Example, consumer’s income rises from Tshs. 1000 to Tshs. 1200 his purchase of the
good X (say, rice) increases from 25 kgs per month to 28 kgs, then his income elasticity
of demand for rice is 0.60

Interpretation of income Elasticity of Income

(1). Normal products (positive income elasticity): if income rises, demand rises.

(2). Inferior products (negative income elasticity): if income rises, demand falls.

Cross Elasticity of Demand

The quantity demanded of a particular good varies according to the price of other
goods. A rise in price of a good such as beef would increase the quantity demanded
of a substitute such as pork. On the other hand a rise in price of a good such as
tennis racket would lead to a fall in quantity demanded of a complement such as
tennis ball.
Cross elasticity of demand is a measure of how much the quantity demanded of one
good responds to a change in the price of another good. The formula for calculating
the cross elasticity of demand for good is X:

Ex = %∆ in quantity demanded of good x

%∆ in price of another good y

Ex=∆Qx X Py
∆Py Qx

Example, when the price of commodity X increased from 200/= to 400/= the quantity
demanded of commodity Y increased from 10kg to 15kg. Calculate cross elasticity of
demand.

Two goods, which are substitutes, will have a positive cross elasticity. Two goods,
which are complements, will have a negative cross elasticity.

Practical application of concept of elasticity of demand (importance)

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 i. In price determination, inelastic goods high prices and elastic goods low
prices
ii. In imposition of taxation, inelastic goods high tax rate and elastic goods low
tax rate
iii. In determination of tax incidence, means who pays large proportion of tax i.e.
if inelastic consumer and for elastic producer
iv. In devaluation, devaluation will successful if the elasticity of export and
import will be elastic
v. Price discrimination by monopoly, for discrimination to be successful the
elasticity between the two market should be different

Change in demand Versus Change in quantity demanded

Using an example of your own, distinguish between shifts of demand and

movements along a demand curve.

Change in demand is a shift of a demand curve in response to a change in some

variable other than price.

A change in any determinant of demand—except for the good’s price—causes the

demand curve to shift. We call this a change in demand. If buyers choose to purchase
more at any price, the demand curve shifts rightward—an in- crease in demand. If
buyers choose to purchase less at any price, the demand curve shifts leftward—a
decrease in demand.

Change in quantity demanded is a movement along a demand curve in response to a

change in price.

A change in a good’s price causes us to move along the demand curve. We call this a
change in quantity demanded. A rise in price causes a leftward movement along the
demand curve—a decrease in quantity demanded. A fall in price causes a rightward
movement along the demand curve—an increase in quantity demanded

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SUPPLY

Supply refers to the amount of a product that producers and firms are willing to sell
at a given price when all other factors being held constant.

Factors affecting supply

Innumerable factors and circumstances could affect a seller's willingness or ability
to produce and sell a good. Some of the more common factors are:

Good's own price: The basic supply relationship is between the price of a good and
the quantity supplied. Although there is no "Law of Supply", generally, the
relationship is positive, meaning that an increase in price will induce an increase in
the quantity supplied.

State of technology. If there is a technological advancement in one good's

production, the supply increases. Other variables may also affect production
conditions. For instance, for agricultural goods, weather is crucial for it may affect
the production outputs.

Expectations: Sellers' are concerning future market conditions can directly affect
supply. If the seller believes that the demand for his product will sharply increase in
the foreseeable future the firm owner may immediately increase production in
anticipation of future price increases. The supply curve would shift out.

Price of inputs: Inputs include land, labor, energy and raw materials. If the price of
inputs increases the supply curve will shift left as sellers are less willing or able to
sell goods at any given price. For example, if the price of electricity increased a seller
may reduce his supply of his product because of the increased costs of production.

Number of suppliers: The market supply curve is the horizontal summation of the
individual supply curves. As more firms enter the industry the market supply curve
will shift out driving down prices.

Government policies and regulations: Government intervention can have a

significant effect on supply. Government intervention can take many forms
including environmental and health regulations, hour and wage laws, taxes,
electrical and natural gas rates and zoning and land use regulations.

Supply schedule

Is a table which contains values for the price of a good and the quantity that would
be supplied at that price. If the data from the table is charted, it is known as a supply
curve.

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Market supply schedule

Is the list of all goods and services that many producers are willing and able to offer
at a certain price level. It involves the horizontal summation of quantities supplied
at a certain price level.

Supply curve

The curve is generally positively sloped. The curve depicts the relationship between
two variables only; price and quantity supplied. All other factors affecting supply are
held constant. However, these factors are part of the supply equation and are
implicitly present in the constant term.

The Law of Supply

The law of supply is a fundamental principle of economic theory which states that,
all else equal, an increase in price results in an increase in quantity supplied. In
other words, there is a direct relationship between price and quantity: quantities
respond in the same direction as price changes. This means that producers are
willing to offer more products for sale on the market at higher prices by increasing
production as a way of increasing profits

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Supply function

The supply function is the mathematical expression of the relationship between

supply and those factors that affect the willingness and ability of a supplier to offer
goods for sale. An example would be the curve implied by Qs=f (Px ;) where P is the
price of the good and the semicolon means that the variables to the right are held
constant when quantity supplied is plotted against the good's own price.

Qsx=a+bPx

Change in supply versus Change in quantity supplied

Change in supply is the shift of the supply curve caused by a change in one of the
supply determinants. A change in supply is caused by any factor affecting supply
EXCEPT price.

Change in quantity supplied is the movement along a given supply curve caused by a
change in supply price. The only factor that can cause a change in quantity supplied
is price. A related, but distinct, concept is a change in supply.
A change in quantity supplied is a change in the specific quantity of a good that
sellers are willing and able to sell. This change in quantity supplied is caused by a
change in the supply price. It is illustrated by a movement along a given supply
curve.

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Exceptional supply curve
In some situations the slope of the supply curve may be reversed.  
Regressive Supply.  In this case, the higher the price within a certain range, the
smaller the amount offered to the market.  This may occur for example in some
labor markets where above certain level, higher wages have disincentive effects as
the leisure preference becomes high.  This may also occur in undeveloped peasant
economies where producers have a static view of the income they receive.  Lastly
regressive supply curves may occur with target workers. Or
Is a graph showing a situation in which, as "real" wages increase beyond a certain
level, people will substitute leisure (non-paid time) for paid work-time and thus
higher wages lead to less labor-time being offered for sale

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Interrelated Supply
This show the relationship between supply of commodities as a result of the change
in the price or supply of related commodity

Competitive supply
Good that can be produced using the same factors of production. These commodities
compete in the use of resource in their production

Joint Supply
An economic term referring to a product that can yield two or more outputs.
Common examples occur within the livestock industry: cows can be utilized for
milk, beef and hide; sheep can be utilized for meat, wool and sheepskin. If the supply
of cows increases, so will the supply of dairy and beef products.

Elasticity of Supply

Elasticity of supply may also be defined as the ratio of the percentage change or the
proportionate change in quantity supplied to the percentage or proportionate
change in price

Es = proportionate change in supply/Proportionate change in price

= (change in quantity supplied/Original quantity supplied) × (Change in

price/Original
price)

Let Q = Original supply

ΔQ = Change of supply
P = Original price and
ΔP = Change of price, then

Es = (ΔQ/Q) / (ΔP/P) = (ΔQ/Q) × (P/ΔP) = (ΔQ/ΔP) × (P/Q)

Example: Suppose that the price of an article rises from $4 to $5 and as a result,
supply rises from 200 to 300. Then
Es = (100/1) × (4/200) = 2.

Types of Elasticity of Supply

Elastic Supply. When the proportionate change in quantity is greater than the
proportionate change in price. Elastic supply means that quantity changes by a
greater percentage than the percentage change in price. Es > 1

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Inelastic Supply. When the proportionate change in quantity is less than the
proportionate change in price. Inelastic supply means that quantity doesn't change
much with a change in price. Es < 1
Unitary Elastic Supply. When elasticity of supply is unitary, a change in price will
cause a proportionate change in quantity supplied. Es = 1
Perfectly Elastic Supply. Perfectly or infinitely elastic supply signifies that a fall in
price will completely cut off supply and a rise in price will cause an infinite
expansion of supply. Es = ∞
Perfectly Inelastic Supply. Perfectly inelastic supply means that changes in price will
not bring about any change in supply. Es = 0

Factors affecting elasticity of  supply

There are a few factors that determine how elastic supply (i.e. how responsive
quantity supply is to changes in prices) for a particular good is:

Time: Supply will be different in the short and long run with time. In the short run,
firms will only be able to increase input of labour to increase supply of commodities.
Supply change will be little because other factors of production may not be
increased in the same proportion as the change in price and may limit the supply.
However, in the long run a firm will increase the input of all factors of production
and thus the supply becomes more price elastic.

Availability of resources: If the economy is already using most of its scarce

resources, then firms will find it difficult to employ more (i.e. workers) and so
output will not be able to rise. The supply of most goods and services will therefore
be price inelastic, and vice versa.

Number of producers: If there are more producers, this means that the output can
be increased more easily. Thus supply is more elastic as a result.

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Ease of storing stocks: The type of good that a producer supplies will affect
elasticity. If goods can be stocked with ease and have a long shelf life, then supply
will be elastic. Otherwise the goods will be inelastic. For example, perishable goods
such as fresh flowers, vegetables have comparatively inelastic supply because it is
difficult to store them for longer periods.

Increase in cost of production as compared to output: In cases where there is a

significant increase in cost of production when price is increased, supply is inelastic.
This is because suppliers would have to make a significant investment in order to
increase the output. This would take time and some suppliers may be hesitant in
doing so.

Improvements in Technology: Some industries will have improvements in

technology that affects the price elasticity of supply. Improvements lead to goods
being more elastic (i.e. firms are more efficient in production- better machinery so
output is increased greater with increase in price) as compared to industries where
there are less improvements.

Stock availability of finished goods: In some industries where there is higher

inventory or stock of finished goods, the supplier can supply more as the price rises.
Thus, the price elasticity of supply for these goods will be elastic.

Economic Equilibrium

Equilibrium is a state in which there are no shortages and surpluses; in other words
the quantity demanded is equal to the quantity supplied.

Equilibrium price is the price prevailing at the point of intersection of the demand
and supply curves; in other words, it is the price at which the quantity demanded is
equal to the quantity supplied.

Equilibrium quantity is the quantity that clears the market; in other words, it is it is
the quantity at which the quantity demand is equal to the quantity supplied.

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Characteristics of the equilibrium or market clearing price:
– QD = QS
– No shortage
– No excess supply
– No pressure on the price to change
–
Algebraic Representation of Equilibrium
If we have following demand and supply functions,
Qd = 100 – 10 P Qs = 40 + 20 P
In equilibrium,
Qd = Qs
Therefore
100 - 10P = 40 + 20P
20P + 10P = 100 – 40
30P = 60 P = 60/30
P=2
Putting the value of price in any of demand and supply equation,
Q = 100 – 10x2 (or 40 + 20x2)
Q = 100 – 20
Q = 80
The equilibrium price is 2 and the equilibrium quantity is 80.

Equilibrium can shift if

• Demand Curve Shifts.
• Supply Curve Shifts.
• Both Shift.

Quiz 1 What effect will each of the following have on the demand of product B
a. Product B become more fashionable
b. The price of substitute C falls

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 c. Incomes declines and product b is an inferior good
d. Consumers anticipate that the price of B will be lower in the near future
e. The price of complimentary product D falls

Quiz 2 Discuss, and illustrate with a graph, how each of the following events will
affect the demand for coffee:
a. A blight on coffee plants kills off much of the Brazilian crop.
b. The price of tea declines.
c. Coffee workers organize themselves into a union and gain higher wages.
d. Coffee is shown to cause cancer in laboratory rats.
e. Coffee prices are expected to rise rapidly in the near future.

Price Floor and Price Ceiling

Price Floors is the lowest legal price a commodity can be sold at. Price floors are
used by the government to prevent prices from being too low. The most common
price floor is the minimum wage--the minimum price that can be paid for labor.
Price floors are also used often in agriculture to try to protect farmers.

For a price floor to be effective, it must be set above the equilibrium price. If it's not
above equilibrium, then the market won't sell below equilibrium and the price floor
will be irrelevant.

A few crazy things start to happen when a price floor is set. First of all, the price
floor has raised the price above what it was at equilibrium, so the demanders
(consumers) aren't willing to buy as much quantity. The demanders will purchase
the quantity where the quantity demanded is equal to the price floor, or where the
demand curve intersects the price floor line. On the other hand, since the price is
higher than what it would be at equilibrium, the suppliers (producers) are willing to
supply more than the equilibrium quantity. They will supply where their marginal

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cost is equal to the price floor, or where the supply curve intersects the price floor
line.
As you might have guessed, this creates a problem. There is less quantity demanded
(consumed) than quantity supplied (produced). This is called a surplus. If the
surplus is allowed to be in the market then the price would actually drop below the
equilibrium. In order to prevent this, the government must step in. The government
has a few options:
 They can buy up the entire surplus
 They can strictly enforce the price floor and let the surplus go to waste. This
means that the suppliers that are able to sell their goods are better off while
those who can't sell theirs (because of lack of demand) will be worse off.
Minimum wage laws, for example, mean that some workers who are willing
to work at a lower wage don't get to work at all. Such workers make up a
portion of the unemployed (this is called "structural unemployment").
 The government can control how much is produced.
 They can also subsidize consumption. To get demanders to purchase more of
the surplus, the government can pay part of the costs. This would obviously
get expensive really fast.
Price ceiling

A price ceiling occurs when the government puts a legal limit on how high the price
of a product can be. In order for a price ceiling to be effective, it must be set below
the natural market equilibrium.

When a price ceiling is set, a shortage occurs. For the price that the ceiling is set at,
there is more demand than there is at the equilibrium price. There is also less
supply than there is at the equilibrium price, thus there is more quantity demanded
than quantity supplied.

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Price Mechanism

Price mechanism refers to the system where the forces of demand and supply
determine the prices of commodities and the changes therein. It is the buyers and
sellers who actually determine the price of a commodity.

Advantages of the price mechanism

 The idea of consumer sovereignty - consumers have the power to determine
what is bought and sold in the market.
 The freedoms of choice, property and enterprise can only be fulfilled in a
system with operation of the price mechanism.
 Prices are as low as possible and resources go to the most efficient use.
 The system operates without regulation.
 There is a constant striving to improve production methods and distribution
chains
 There is a strong incentive effect. People are encouraged to work hard and
get on in life as they have the freedom to try anything they want. This can
stimulate economic growth.
 It works automatically, is essentially costless, and requires no bureaucracy
to run it.

Disadvantages of the price mechanism

 Inequality of income and wealth
 Without government intervention, there will be under-provision of public
and merit good
 Unemployment
 Inflation
 Wastage on advertising
 When firms make decisions to maximize profits, only private costs are
considered; public costs and benefits are ignored

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