ECONOMICS FOR

BUSINESS
Mr Tahir Nowaz

Class 3 – The Theory of Price Determination

Price Theory
Free-market economies are based upon the idea of
flexible prices i.e. Prices that will change to reflect the
true market conditions

The equilibrium price (the market clearing price)is the

one that occurs when demand equals supply

In command economies, prices are determined by the

state
Demand
The amount of a particular economic good or service
that a consumer or group of consumers are willing to
purchase at a given price.

The demand curve is downward sloping because

consumers are willing to buy more of a product the
cheaper the product is (assuming the quality does not
change).
The Demand curve
Supply
The quantity of a product that a producer is willing
and able to supply onto the market at a given price in a
given time period.

The supply curve is upward sloping. This is because

the higher the price of a good is, the more profit the
supplier will earn from selling it. Therefore he will
want to supply as much of that good as possible.
The Supply Curve
Price determination
The equilibrium price (or market price), is determined
when supply of a good equals the demand for that
good.

This is shown when the two curves cross each other

Equilibrium price
Changes in Supply & Demand
A change in supply leads to a shift in the supply
curve and a movement along the demand curve.
A change in demand leads to a shift in the demand
curve and a movement along the supply curve.
As you can see, price increases when:
 Demand increases or Supply decreases

Price decreases when:

Demand decreases or Supply increases

The Supply and Demand curves do not shift due to a

change in price. It is always due to an external factor.
Applications of the D&S Model
Draw the graphs for the following scenarios in the
market for apples, describe what happens to
equilibrium price and quantity:
1. People start finding worms in all their apples, so the
demand for apples fall
2. There is a very bad harvest this year, so farmers can
only produce half the usual amount of apples
3. Suppliers double the prices of their apples
4. The demand for apples increase, but the supply of
apples decrease
Elasticity
When a price of a good increases, the quantity
demanded and supplied will change. Elasticity
measures how much the quantity demanded/supplied
will change due to an increase in price.

Price Elasticity of Demand – the responsiveness of the

change in quantity demanded due to a change in price

Price Elasticity of Supply – the responsiveness of the

change in quantity supplied due to a change in price
The price elasticity of Demand
This is given by the following formula

If between -1 and 1, the good has inelastic demand (Increase

in price leads to an increase in revenue)
If -1< or >1, the good has elastic demand. (Increase in price
will lead to a fall in revenue)
If =1, the good has unitary elasticity (revenue will not change)
A good with inelastic demand
Examples: cigarettes, electricity, basic necessities
Good with elastic demand
Examples: plasma TV, suits, luxury items
Point elasticity of Demand
This is the elasticity of demand at a single point on a
demand curve
If the demand curve is curved rather than straight, it
will have different elasticity's at different quantities
demanded
Cross Elasticity of demand
The responsiveness of the demand for a good to a
change in the price of another good.
Two goods that complement each other show a
negative cross elasticity of demand: as the price of
good Y rises, the demand for good X falls.
E.g. salt and pepper, tennis racquets and tennis balls

These are called complement goods. Perfect

complements have a cross price elasticity of -1.
Two goods that are substitutes have a positive cross
elasticity of demand: as the price of good Y rises, the
demand for good X rises.
E.g. Apples and Oranges, cars and motorcycles

These are called substitute goods. Perfect substitutes

have a cross price elasticity of 1.
Two goods that are independent have a zero cross
elasticity of demand: as the price of good Y rises, the
demand for good X stays constant.

E.g. Apples and tennis racquets, cars and salt