Session 2 - Price Theory: Demand & Supply (Prof. A.T.

F)

Outline
• Determination of price
• Theory of Demand
• Theory of Supply
• How the price mechanism works
• Equilibrium & changes in equilibrium
• Advantages & shortcomings of price mechanism
• Govt. intervention in market & consequences
 Determination of Price
• Planned economy – Price is fixed by government
• Market economies –
For goods & services supplied by pvt. sector- price
gets determined through the free interaction of
demand & supply.
Demand comes from buyers (consumers)
Supply comes from sellers (suppliers/ firms)

For goods & services supplied by Govt. – Price is

fixed by government. ‘An affordable price’.
 Theory of Demand
• Demand = Desire to buy + ability to buy i.e.
want+ purchasing power
• Factors determining demand
(1) Its own price (law of demand)
When price falls, quantity demanded increases
When price rises, quantity demanded decreases
Diagram – It is a movement along the demand curve
* Chain of causation
Increase in Qty
↓ Price
Demanded
Individual Demand Curve Market Demand Curve
 Factors other than Own Price as
Determinants of Demand
• Prices of related goods (substitutes & complements)
• Population (size, age distribution, sex composition)
• Weather, climate, seasonal factor
• Advertising
• Income
• Tastes/preferences
• Taxes (on consumer income)
• Access to credit
(Diagram– Entire Demand curve shifts either to the right or to the left

Chain of Causation
Change in any
Increase (Decrease)
factor other than
its own price In demand
Changes in Demand
 Theory of Supply
• Definition of supply
• Factors determining supply
1. Its own price (law of supply)
• When price falls, quantity supplied decreases
When price rises, quantity supplied increases
(Diagram – it is a movement along the supply curve)
• Chain of causation

↑ in Price ↑ in Qty
Supplied
Individual Supply Curve Market Supply Curve
 Factors (other than own price) as
Determinants of Supply
• Prices of other goods (final goods)
• Prices of factor inputs
• Technology
• Time
• Govt. policy (taxes on producer; subsidies to producer)
• Goals of firm
• Weather
(Diagram – Entire supply curve shifts)
• Chain of causation

Change in any factor Increase (Decrease)

other than its own price In Supply
Changes in Supply
 Price Mechanism
• Definition: Price mechanism is a system of resource
allocation based on the free interaction of D&S forces
• How price mechanism works (determination of
equilibrium)
• Shifts of demand curve & effect on equilibrium price
• Shifts of supply curve & effect on equilibrium price
• Shifts of both D&S & effect on price
Market Equilibrium
Changes in Demand & Effect on Equilibrium
Changes in Supply & Effect on Equilibrium
 Shifts of Both Demand & Supply Curves
& Effect on Price
Effect on Price level is indeterminate
If the % change in D > % change in S, price will rise
If the % change in S > % change in D, price will fall
If the % change in D & S are equal, equilibrium P will
Not change Simultaneous Increase in Demand & Supply
Price / Unit
Rs

S0

S1

P0

D1

D0
0 Q0 Q1
Qty /(units)
 Role (functions) of Price Mechanism
• Allocative function: It allocates scarce resources
among competing uses (e.g. to grow carrot or to grow
beetroot); it then allocates goods produced among
competing buyers- “who gets what”
• A communication function: it gives signals to the
producer (what to produce) and to the consumer
(what to buy)
• Incentive function: market price covers the costs of
producer, and also gives him a profit
 Price Mechanism - Advantages
• Automatic regulator of the economy. It is an “invisible hand”
that guides the economy. It provides answers to the basic
questions facing an economy –
what to produce, how to produce & for whom to produce.
• Freedom of choice to consumers & producers
Concept of consumer sovereignty ( “consumer is king”)
• Price Fixing by Govt. & adverse consequences
- Maximum Retail Price =(Price ceiling)
- Minimum Price = (Price Floor)
Govt. intervention leads to distortions in the market.
 Maximum Price Fixing By Govt. (price ceiling)
It is to benefit consumers. But adverse consequences
• D > S and a black market can emerge
• Rationing scheme has to be introduced & supervised by
govt. officials. It results in higher administrative cost
• Welfare loss to society (deadweight loss)

Minimum Price Fixing by Govt. (floor price)

It is to benefit producers (Guaranteed Minimum price)
But adverse consequences
• S > D. Price has to fall sharply to clear MKT of excess
supply. To prevent this, govt. stores the excess. Hence,
higher administrative cost. Price stabilization scheme of
Govt.
• Deadweight loss
• At times, farmers destroy excess crop to prevent fall in P
 Price Mechanism – Shortcomings
• Inequality in income distribution – goods will be produced for
those who have money
• Market failure – “public goods” will not be produced
Public goods have 2 distinct features (in contrast to economic
goods)
- Non excludability – goods are consumed collectively & no
one can be excluded from its consumption
- Non rivalry (non-diminishability) - consumption by one does
not reduce its benefits to a subsequent user
• “Merit goods” (health, education) : under-produced
• Externalities are ignored by a firm when pricing its product. It
considers only the private costs incurred in producing the good
and not the harmful costs to society when producing same.
Negative Production Externality Negative Consumption Externality

Costs &
Costs &
Benefits MPC = MSC
Benefits MSC

C A
MPC
B
B

A
C

MPB
MPB = MSB
MSB

0 Q1 Q0 Qty 0 Q1 Q0 Qty

Q0 – Q1: Over Production

Q0 – Q1: Over Consumption
ABC: Welfare Loss
ABC: Welfare Loss
 Externalities

Price
ST = Supply curve after Tax

D ST

S S = supply curve

Tax
PT

ST D
S
O
QT Q Quantity