AF1605 Introduction to Economics

Topic 2: The Price Mechanism

Lecturer: Chau Tak Wai

School of Accounting and Finance

v Demand

v Supply

v Market Equilibrium

v Price Ceiling and Price Floor

v Consumer Surplus and Producer Surplus

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v In the market economy most of the decisions are guided by the
price signal from the market.

v We are interested in how prices and quantity transacted are

determined.

v There are two forces that determine the market price:

v Demand
v Supply

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v Demand for a particular commodity (goods or services) reflects the decisions
of consumers on how much they would like to buy under different
situations.
It can be expressed as a function of various related factors:
Qd = f (own price, x1, x2, x3, …)

v Quantity demanded is the amount of a commodity that people are willing

and able to buy at a specific price and the values of other factors during a
specified period.

v Demand-Supply analysis highlights the relationship between quantity and

price of the good under study.

v A demand curve/schedule (or simply demand) is the relationship between

the quantity demanded and the price of a commodity when all other
factors influencing the buying plans remain the same.

v Law of demand
v Holding other factors constant, quantity demanded is inversely related
to its price.
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v Law of demand
v Holding other factors constant, quantity demanded is inversely
related to its price.
v That means, the demand curve is downward sloping.

v Why?

v Substitution Effect: People would buy more the goods that become
relatively cheaper and buy less of the goods that become relatively
more expensive.
v Example: if chicken gets cheaper relative to pork, people will buy
more chicken and less pork to satisfy their needs for eating meat.

v Income effect: You need to spend more money to buy the same
amount of goods when price of a good increases. -> a lower
purchasing power of money -> buy a lower quantity.
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v Demand can be illustrated by a demand schedule or a demand curve.

A change in price due to a non-

demand factor
ÞMovement along the demand
curve
Þ a change in quantity demanded

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v Quantity demanded at a specific price represents how many units of
the commodity the consumers are willing and able to buy at that
price, given the values of other factors.

v In the example above, the consumer is willing to buy 2 units when

the price falls to $1.

v Put it in another way, the consumer will buy the second unit only
when the price falls to $1, but not higher.

v That means, the maximum marginal willingness to pay (or marginal

benefit) of the second unit is $1.

v $1 is also called the reservation price of the second unit of this

commodity for this consumer.
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Individual Demand and Market Demand
v Individual demand is the relation between quantity
demanded and price for one individual consumer.
v Market demand is the sum of the demands of all
consumers in a market.
v The market demand curve is the horizontal sum of the
demand curves of all consumers in the market.
v We add up quantities at each given price.

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 Shift of the demand curve Þ
v A shift of demand curve (or a change in demand
simply a change in demand) is a
change in the quantity that people
plan to buy when any factors
other than the price of the
commodity changes.

v When demand decreases, the

demand curve shifts leftward from
D0 to D1.

v When demand increases, the

demand curve shifts rightward
from D0 to D2.

v Caution: Don’t call a change in

quantity demanded due to a
change of own price only a change
in demand. 9
v Change in prices of related goods
v Change in expected future prices
v Change in income
v Change in expected future income and credit
v Change in preferences
v Change in number of buyers

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v Price of related goods
v A substitute in consumption is a good that can be consumed in place of
another good. For example, MTR and bus are substitutes.
v A complement in consumption is a good that is consumed with another
good. For example, digital camera and SD cards are complements.

Demand for the good

If price of substitute increases Increases
If price of complement increases Decreases

v Expected future prices

v A rise in the expected future price of a good increases the current
demand for that good.

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v Income

Effect of increase in income

Normal good Demand for the good increases
Inferior good Demand for the good decreases

v Normal goods: most goods

Inferior goods: low-quality goods that serve basic functions, e.g. rice.
People switch to better-quality goods when they are richer.

v Expected future income

v Demand will increase for normal goods when income is expected to
increase in the future.
v Smoothing effect: people tend to spread increase in future
consumption to now
v It has the greatest effect on the demand for big ticket, durable items
such as houses and cars.
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v Preferences
v People’s preferences may change due to changes in information,
trends or situation
Examples: preference towards surgical masks, alcohol swab
increased sharply under COVID-19.

v Number of buyers
v The greater the number of buyers in a market, the larger is the
demand for any good.
v Example: Larger population

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v Supply for a particular commodity (goods or services) reflects the
decisions of producers/firms on how much they would like to produce/sell
under different situations.
It can be expressed as a function of various related factors:
Qs = f (own price, z1, z2, z3, …)

v Quantity supplied is the amount of a commodity that people are willing

and able to sell at a specific price and the values of other related factors
during a specified period.

v Demand-Supply analysis highlights the relationship between quantity and

price of the good under study.

v A supply curve/schedule (or simply supply) is the relationship between

the quantity supplied and the price of a commodity when all other
factors influencing the selling plans remain the same.

v Law of supply
v Other things remaining the same, quantity supplied is positively
related to the price.
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v Supply can be illustrated by a supply schedule or a supply curve.
A change in price due to a non-supply
factor Þ
Movement along the supply curve Þ
a change in quantity supplied

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v Quantity supplied at a specific price represents how many units of
the commodity the sellers are willing and able to sell at that price.

v In the example above, the seller is willing to sell 2 units when the
price rises to $1.5.

v Put it in another way, the seller will sell the second unit only when
the price rises to $1.5 but not for lower.

v That means, the minimum marginal willingness to receive to sell of

the second unit is $1.5.

v $1.5 is also called the reservation price of the second unit of this
commodity for this seller.

v The supply curve is upward sloping because the reservation price

increases when more output is produced.

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Individual Supply and Market Supply

v Individual supply describes the relationship between

price and quantity supplied for one seller.
v Market supply is the sum of the supply of all the
sellers/producers in a market.
v The market supply curve is the horizontal sum of the
supply curves of all sellers/producers in the market.
v We add up quantities at each specific price.

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 Shift of the supply curve Þ
v A shift of supply curve (or simply a a change in supply
change in supply) is a change in the
quantity that sellers plan to sell when
any factors other than the price of
the commodity changes.

v When supply decreases, the supply

curve shifts leftward from S0 to S1.

v When supply increases, the supply

curve shifts rightward from S0 to S2.

v Caution: Don’t call a change in

quantity supplied due to a change of
own price only a change in supply.

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v Change in prices of related goods
v Change in prices of resources and other inputs
v Change in expected future prices
v Change in productivity
v Change in number of sellers

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 Factors for a Shift in Supply Curve
v Price of related goods
v A substitute in production output is a good that can be produced in
place of another good (using similar inputs and technology).
v Example: luxury cars and ordinary cars are substitutes in production in
an automobile factory.

v A complement in production output is a good that is produced along

with another good. (By-products / joint supply)
v Example: cream is a complement in production of skim milk in a dairy;
Chicken legs and chicken wings; different layers of oil being refined.
Supply of the good
If price of substitute increases Decrease
If price of complement increases Increase

v Please distinguish substitutes in production vs substitutes in

consumption. Similarly for complements.
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 Factors for a Shift in Supply Curve
v Unexpected increase or decrease in output
v An unexpected increase in output increases the supply
Example: good harvest of agricultural products.
v An unexpected decrease in output decreases the supply
Example: bad harvest of agricultural products; destruction of output due to
a natural disaster.
v Input prices
v Input prices influence the (marginal) cost of production.
Supply of the good
If input prices increase Decrease
If input prices decrease Increase
v If there is an unexpected decrease in inputs, input price would increase,
which would lead to a decrease in supply of the output.

v Productivity (Technology)
v An increase in productivity (improvement in technology) lowers the
(marginal) cost of production and increases the supply.
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 Factors for a Shift in Supply Curve

v Expected future prices

v A rise in the expected future price of a good decreases the
current supply for the good. (Either keeping more inventories or
shifting the production to the future.)

v Tax and subsidies on sellers

v Tax decreases supply.
v Subsidy increases supply.

v Number of sellers
v The greater the number of sellers in a market, the larger is
the supply. (Recall horizontal summation)

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 Self Assessment

v When people expect that the future price of tissue paper will
increase, which of the following about the current market is
true?

v A. Demand increases and supply is unchanged.

v B. Demand is unchanged and supply decreases.

v C. Demand increases and supply increases.

v D. Demand increases and supply decreases.

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 Market Equilibrium

v Market equilibrium occurs

when the quantity demanded
equals the quantity supplied at
the market equilibrium price.

v Market equilibrium occurs at

the intersection of the demand
curve and the supply curve.

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v If market price is above the
equilibrium level, price will fall
until the surplus (excess
supply) is eliminated.
v If market price is below the
equilibrium level, price will rise
until the shortage (excess
demand) is eliminated.
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v Increase in demand with supply v Decrease in demand with supply
unchanged will cause increases in unchanged will cause decreases in
equilibrium price and quantity. equilibrium price and quantity.

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v Increase in supply with demand v Decrease in supply with demand
unchanged will cause a decrease in unchanged will cause an increase in
equilibrium price and an increase in equilibrium price and a decrease in
equilibrium quantity. equilibrium quantity.

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v Increase in demand + Increase in v Decrease in demand + Decrease in
supply supply
→ Equilibrium quantity will increase → Equilibrium quantity will decrease
→ Equilibrium price is uncertain → Equilibrium price is uncertain

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v Increase in demand + Decrease in v Decrease in demand + Increase in
supply supply
→ Equilibrium price will increase → Equilibrium price will decrease
→ Equilibrium quantity is uncertain → Equilibrium quantity is uncertain

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v 1. Identify which factor(s) has changed that shifts either
curve.

v 2. Determine how this shifts which curve(s).

v 3. Draw the demand-supply diagram.

v 4. Determine the change in equilibrium price and

equilibrium quantity.

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v What is the effect of African swine fever on the market of pork?
(Assume that it does not affect the quality of pork available in the
market.)

v 1. Factor changed?
v Unexpected decrease in output. Why?

v 2. How curves are shifted?

v Supply curve shifts to the left (Supply decreases)

v 3. Draw a demand-supply diagram

v 4. Determine the change in equilibrium price and equilibrium quantity

v Equilibrium price increases and equilibrium quantity decreases.

v Reminder: Do not say that supply decreases, then demand decreases.

v It is only a movement along the demand curve, and it reduces the
quantity demanded unless there are other factors changing the
demand.
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v More schools in Hong Kong go for online teaching this September in full
scale (which is more intense than before). How does it affect the market
for broadband internet service?

v 1. Factor changed?

v 2. How curves are shifted?

v 3. Draw a demand-supply diagram

v 4. Determine the change in equilibrium price and equilibrium quantity

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v A price ceiling or price cap is a government regulation that places an
upper limit on the price at which a commodity can be traded.

v An example is a price ceiling on housing rent control.

v Trading above the price ceiling is illegal.

v There will be no effect on the market equilibrium if the price ceiling is

set at a level which is above the equilibrium price.

v The price ceiling is effective if it is set below the market equilibrium

price.

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v If the price ceiling is set at a
level which is below the
equilibrium price, there will be
shortage (excess demand) in
the market.

v Possible outcome:
v Queuing
v Rationing

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v With a rent ceiling of $400 per month,
3,000 units of housing are available.

v Someone is willing to pay $625 per

month for the 3,000th unit of housing.

v Buyers may compete/search in some

ways that spend an extra $225 for the
housing.

v Black market: some illegal transactions

can take place

v Rent may be as high as $625 per month

in the black market if:
-the black market cannot induce more
sales in the market, and
-Those who value less than $625 resell to
those who are the most willing to pay, or
the sellers is willing to search harder to
find a renter who are most willing to pay.
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v A price floor is a government regulation that places a lower limit on
the price at which a commodity can be traded.

v An example is a minimum wage in labor markets.

v Trading below the price floor is illegal.

v There will be no effect on the market equilibrium if the price floor is

set at a level which is below the equilibrium price.

v The price floor is effective if it is set above the market equilibrium

price.

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v If the price floor is set at a level
which is above the equilibrium
price, there will be surplus (excess
supply) in the market.

v e.g. Minimum wage which is set

at a level above the equilibrium
wage may cause unemployment.

v Possible outcome:
v Sellers need to compete or
search harder that incur more
costs.

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v At the minimum wage of $10 per
hour, 3,000 jobs are available.

v Someone is willing to take the

3,000th job for $5 per hour.

v Workers are willing to spend

resources (time or even money)
on job search that is worth the
equivalent to lowering their wage
rate by $5 per hour.

v If there is a black market (illegal

hiring), the wage can be as low as
$5.

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 Examples of Price Floor
Statutory Minimum Wage (SMW) has come into force since 1 May 2011.
With effect from 1 May 2019, the SMW rate will be raised from $34.5 to
$37.5 per hour. Local low-skill workers
The Minimum Allowable Wage (MAW) for foreign domestic helpers (FDHs)
in Hong Kong is currently set at HK$4,520 per month.
Local domestic helpers but
not those from overseas.

Do you know why and how it

works?

Who are the HK government trying to protect in the above two cases
of price regulations?

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v A quota is a government regulation
that places an upper limit on the
quantity at which a commodity can
be traded.
v The motive is to either restrict the
quantity it can be sold because it is
somewhat harmful (like carbon
emission that leads to global
warming, or cigarettes), or to raise
the market price to help existing
sellers (e.g. restricting the size of
imports).
v It is effective when the quota is set
below the market equilibrium
quantity.
v The supply curve is vertical once it is
above the original supply curve.
v The market price is then higher than
the original equilibrium price.
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§ Can the price ceiling help the buyers?
§ In what sense yes and in what sense no?

§ Can the price floor help the sellers (e.g. workers for
minimum wage)?
§ In what sense yes and in what sense no?

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a) What is the market equilibrium price?
b) If there is a price ceiling at $1300, how large is the excess demand or
excess supply? 46
v Consumers and producers/sellers can enjoy a surplus when they engage in
market transaction of a commodity.

v Recall: a consumer can enjoy a surplus if one has a higher value for the units
of commodity one buys than the price one needs to pay to buy them.

v Similarly, a producer can enjoy a surplus if one can sell the units of the good
at a price higher than the (marginal) cost they need to pay in producing
them.

v Then, how can we measure them more exactly?

v Can we measure them using information about the demand and supply
curves?
v If so, how?

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v Consider the following case with
discrete price and quantity.
Price Quantity Unit Value
v Consider the demand schedule for ($) demanded (Marginal
Lillie. Benefit) ($)

v Note that she starts to buy the first 10 0

unit only when the price falls to $9, 9 1 1st 9
but not higher, so her maximum
8 2 2nd
willingness to pay for the first unit is
$9, which is her value (marginal 7 3 3rd
benefit) for the first unit. 6 4 4th
It is also called the reservation price
for the first unit. 5 5 5th

v Similarly, for the second unit, she is

willing to buy only when the price
falls to $8, so her value or marginal
benefit for the second unit is $8.
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v As a result, the demand
schedule/curve reflects the
value/marginal benefit for the last
unit of purchase.
Price Quantity Unit Value
v The demand schedule/curve is the ($) demanded (Marginal
marginal benefit curve for the Benefit) ($)
consumer(s).
10 0
v Then, what is the consumer surplus? 9 1 1st 9
v Definition: Consumer surplus is the 8 2 2nd 8
marginal benefit from a good or 7 3 3rd 7
service in excess of the price paid
for it for a particular unit, summed 6 4 4th 6
over each unit consumed. 5 5 5th 5
$

𝐶𝑆 = $(𝑀𝐵! − 𝑃)
!"#

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v As a result, the demand
schedule/curve reflects the
value/reservation price for the
last unit of purchase.
Price Quantity Unit Value Consumer
v The demand schedule/curve is the ($) demanded (Benefit) Surplus
($) for this
marginal benefit curve for the
unit
consumer(s).
10 0
v In this case, suppose the market 9 1 1st 9
price is $6. What is the consumer 8 2 2nd 8
surplus for this consumer? 7 3 3rd 7
6 4 4th 6
v Lillie will buy up to 4 units. 5 5 5th 5

v Summing up the consumer

surplus for each unit, her
consumer surplus is $6. 50
v Consider the price and quantity are
continuous/infinitely divisible. (Adjustment
can be arbitrarily small. e.g. possible to have
4.9999.)

v Note: quantity is in thousands here as it is

measured for the whole market.

v There is a consumer who is willing to buy the

10 thousandth unit only when the price falls
to $10 (but not for $10.01).

v Thus, the consumer who is willing to buy the

10,000th has a value (marginal benefit) of $10
for it.

v This means the marginal benefit for the 10

thousandth unit in the market is $10.

v The demand curve is then the marginal

benefit curve.
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v Recall: Consumer surplus is the
marginal benefit from a good or service
in excess of the price paid for it for a
particular unit, summed over the
quantity consumed.
v Each unit of quantity is now very small.
Essentially, it is the area between the
demand curve and the horizontal line at
the market price.
v In this example, consumer surplus is the
green area: CS = [(20 – 10) x 10]/2= $50
thousand.

v This is also equivalent to the total

benefit enjoyed by the consumers (area
below the demand curve from 0 to ten
thousand) minus the expenditure they
need to pay (blue area). 52
v Producers can earn a surplus when they
can sell at a price higher than their cost
of producing the unit.
v We will provide more details in Topic 4
and 5.
v You may use a similar logic: when the
quantity supplied is n when the price is p,
then the producer is only willing to sell
the nth unit when the price rises to p.

v This means the firm can only cover its

cost in producing the nth unit when the
price is p. Thus, the marginal cost of
producing the nth unit is p.
v Thus, the supply curve is also the
marginal cost curve.
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v Definition: Producer surplus is the price of a
good in excess of the marginal cost of
producing it at a particular unit, summed
over each unit produced.
$
𝑃𝑆 = $(𝑃 − 𝑀𝐶! )
!"#

v In the continuous case here, it is essentially

the area between the supply curve and the
horizontal line representing the market price.

v From the diagram, it is the blue area. PS =

[(10 – 2) x 10 thousand ]/2 = $40 thousand.

v It is also equivalent to the total revenue

received (price x quantity) minus the total
variable cost incurred (pink area).
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v Using the supply schedule on Price Quantity Unit (Marginal) Producer
the right with discrete price ($) supplied Cost ($) Surplus for
and quantity, what is the total this unit
producer surplus for this 2 0
seller if the market price is 3 1 1st
$6? 4 2 2nd
v A. 3 5 3 3rd
6 4 4th
v B. 6 7 5 5th

v C. 10

v D. 18

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v Summary

v Discrete case: quantity change by integer, usually information given in the

form of a table of numbers.

v Continuous case: quantity can change in very very small unit, usually
information given in the form of equations.

Discrete Case Continuous Case

Consumer Surplus $ The area between the demand
𝐶𝑆 = $(𝑀𝐵! − 𝑃) curve and horizontal line for
!"# market price
Producer Surplus $ The area between the supply
𝑃𝑆 = $(𝑃 − 𝑀𝐶! ) curve and the horizontal line
!"# for market price

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v Demand
v Demand and Quantity demanded
v Factors that shifts the demand curve

v Supply
v Supply and Quantity supplied
v Factors that shifts the supply curve

v Market Equilibrium
v Equilibrium price and equilibrium quantity
v A 4-step approach for demand-supply analysis

v Price Ceiling and Price Floor

v Consumer Surplus and Producer Surplus

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