price determination

PRICE DETERMINATION

Market demand for goods and services

Demand is defined as the quantity of a good or service consumers are willing and able to buy at a given price in a given time period.

EFFECTIVE DEMAND:

Only when the consumers' desire to buy something is backed up by willingness and an ability to pay for it do we speak of demand. To emphasize this point economists use the term effective demand. There are an unlimited number of human wants and needs - but in the market place these can only be bought / purchased if there is sufficient purchasing power.

THE RATIONAL CONSUMER

Economists assume that in deciding what to buy, consumers will tend to act rationally in their own self-interest. This means that they will choose between different goods and services so as to maximize total satisfaction.

Clearly they will take into consideration

How much satisfaction they get from buying and consuming an extra unit of a good or service

The market price that they have to pay to make this purchase

THE LAW OF DEMAND

The law of demand is that there is an inverse relationship between the price of a good and the demand for a good. As prices fall we see an expansion of demand. If prices rise we expect to see a contraction of demand.

Price in rupees Q D of cds

(Apples) (Apples)

10 500

15 400

20 300

A demand curve shows the relationship between the price of an item and the quantity of that item demanded over a certain period of time. For normal goods, more will be demanded as the price falls.

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CONDITIONS OF DEMAND

Many non price factors affect the total demand for a product - when these change, the demand curve can shift.

A movement along the curve occurs following a change in the price of the good itself, everything else held constant (sometimes called the "ceteris paribus" assumption)

Changes in demand due to change in price:

Increase in QD due to decrease in price of that product (extension).

Decrease in QD due to increase in price of that product (contraction).

What causes a shift in the demand curve?

A shift in the demand curve means that either more or less will be demanded at each and every ruling price in the market. Using the diagram above, the initial demand curve is D1. An outward shift in demand takes the curve to D2 (rise in demand). On the other hand inward shift in demand takes curve to D3( fall in demand)

Essentially - shifts in demand are caused by changes in the willingness and ability of consumers to buy a particular product at a given price. The factors discussed below are those that most commonly affect the market demand for a given product:


Non price factors effecting demand

i) Changing price of a substitute (positive relation with demand)

Substitutes are goods in competitive demand and act as replacements for another product. For example, a rise in the price of petrol should cause a substitution effect away from petrol towards CNG or other substitutes. A fall in the monthly rental charges of cable companies or cellular services provider might cause a decrease in the demand for PTCL. Consumers will tend to switch to the cheaper brand or service provider.

ii) Changing price of a complement (negative relation with demand)

A complement tends to be bought together with another good. Two complements are said to be in joint demand. Examples include: fish and chips, DVD players and DVD's, success and hard work, and so on. A rise in the price of a complement to Good X should cause a fall in the demand for X.

iii) Change in the income of consumers (positive relation with demand)

Most of the things we buy normal goods, that is, more is bought when income rises. When an individual's income goes up, their ability to purchase goods and services increases, and this causes an outward shift in the demand curve. When incomes fall, there will be a decrease in the demand for most goods.

iv) Change in tastes and preferences

Tastes can often be volatile leading to a change in demand. An example would be demand for chicken and chicken products during the “bird flue’ crisis. Advertising is designed to changes the tastes and preferences of consumers and thereby causes a change in demand.

v) Changes in interest rates (negative relation with demand)

Many goods are bought on credit using borrowed money and therefore the demand for them may be sensitive to the rate of interest charged by the lender. Therefore if the SBP decides to raise interest rates - the demand for many goods and services may fall. Examples of "interest sensitive" goods include household appliances, electronic goods, new furniture, and motor vehicles. The demand for new homes is affected by changes in mortgage interest rates. At higher interest rates people will also tend to save more so there will be a clear decrease in demand facilities and luxuries.

Exceptions to the law of demand

Do consumers always buy more of something when the price falls? Some economists claim there are two exceptions:

GEFFEN GOODS: These are highly inferior goods that people on low incomes spend a high proportion of their income on. When price falls, they are able to discard the consumption of these goods (having already satisfied their demand) and move onto better goods. Demand may fall when the price falls. These tend to be very basic foods such as rice and potatoes.

OSTENTATIOUS CONSUMPTION: Some goods are luxurious items where satisfaction comes from knowing the price of the good. A higher price may be a reflection of quality and people on high incomes are prepared to pay this for the "snob value effect". Examples would include perfumes, designer clothes, and fast cars.


Market supply

Supply is the quantity of a good or service that a producer is willing and able to supply onto the market at a given price in a given time period. Normally as the market price of a commodity rises, producers will expand their supply onto the market.

There are three main reasons why supply curves for most products slope upwards from left to right giving a positive relationship between the market price and quantity supplied.

When the market price rises (for example following an increase in consumer demand), it becomes more profitable for businesses to increase their output.

Higher prices send signals to firms that they can increase their profits by satisfying demand in the market. When output rises, a firm's costs may rise, therefore a higher price is needed to justify the extra output and cover these extra costs of production

Higher prices makes it more profitable for other firms to start producing that product so we may see new firms entering the market leading to an increase in supply available for consumers to buy For these reasons we find that more is supplied at a higher price than at a lower price.

The supply curve shows a relationship between the price of a good or service and the quantity a producer is willing and able to sell in the market.

Change in supply due to change in price( movement along the curve)

Non price determinants of supply (shift in supply curve)


i) Costs of production (negative relation with supply)

A fall in the costs of production leads to an increase in the supply of a good because the supply curve shifts downwards and to the right. Lower costs mean that a business can supply more at each price. For example a firm might benefit from a reduction in the cost of imported raw materials. If production costs increase, a business will not be able to supply as much at the same price - this will cause an inward shift of the supply curve. An example of this would be an inward shift of supply due to an increase in wage costs.

ii) Changes in production technology (positive relation with supply)

Technology can change very quickly and in industries where the pace of technological change is rapid we expect to see increases in supply (and therefore lower prices for the consumer)

iii) Government taxes and subsidies (taxes have positive & subsidies negative relation)

Government intervention in a market can have a major effect on supply. A tax on producers causes an increase in costs and will cause the supply curve to shift upwards. Less will be supplied after the tax is introduced.

A subsidy has the opposite effect as a tax cut. A subsidy will increase supply because a guaranteed payment from the Government reduces a firm's costs allowing them to produce more output at a given price. The supply curve shifts downwards and to the right depending on the size of the subsidy.

iv) Climatic conditions

For agricultural commodities such as coffee, fruit and wheat the climate can exert a great influence on supply. Favorable weather will produce a bumper harvest and will increase supply. Unfavorable weather conditions such as a drought will lead to a poor harvest and decrease supply. These unpredictable changes in climate can have a dramatic effect on market prices for many agricultural goods.

v) Change in the price of a substitute

A substitute in production is a product that could have been produced using the same resources. Take the example of barley. An increase in the price of wheat makes wheat growing more attractive. This may cause farmers to use land to grow wheat and less to grow barley. The supply of barley will shift to the left.

vi) The number of producers in the market

The number of sellers in a market will affect total market supply. When new firms enter a market, supply increases and causes downward pressure on the market price. Sometimes producers may decide to deliberately limit supply by controlling production through the use of quotas. This is designed to reduce market supply and force the price upwards. The entry of new firms into a market causes an increase in market supply and normally leads to a fall in the market price paid by consumers. More firms increase market supply and expand the range of choice available.


Equilibrium market price

A price at which consumer is willing and able to buy and producer is willing and able to produce and sell is known as market price. At this price level QD = QS so there will be no surplus or deficit of commodities in the market. It is also known as clearing or equilibrium price.

Equilibrium means a state of equality between demand and supply. Without a shift in demand and/or supply there will be no change in market price.

In the diagram below, the quantity demanded and supplied at price P1 are equal.

At any price above P1, supply exceeds demand and at a price below P1, demand exceeds supply. In other words, prices where demand and supply are out of balance are termed points of disequilibrium. Changes in the conditions of demand or supply will shift the demand or supply curves. This will cause changes in the equilibrium price and quantity in the market.

Changes in Market Demand and Equilibrium Price

The demand curve may shift to the right (increase) for several reasons:

A rise in the price of a substitute or a fall in the price of a complement An increase in consumers’ income or their wealth Changing consumer tastes and preferences in favour of the product A fall in interest rates (i.e. borrowing rates on bank loans or mortgage interest rates) A general rise in consumer confidence and optimism A decrease in direct tax rate.


The outward shift in the demand curve causes a movement (expansion) along the supply curve and a rise in the equilibrium price and quantity. Firms in the market will sell more at a higher price and therefore receive more in total revenue.

The reverse effects will occur when there is an inward shift of demand. A shift in the demand curve does not cause a shift in the supply curve! Demand and supply factors are assumed independent of each other although some economists claim this assumption is no longer valid

Changes in Market Supply and Equilibrium Price

The supply curve may shift outwards if there is

A fall in the costs of production (e.g. a fall in labour or raw material costs) A government subsidy to producers that reduces their costs for each unit supplied Favourable climatic conditions causing higher than expected yields for agricultural commodities A fall in the price of a substitute in production An improvement in production technology leading to higher productivity and efficiency in the

production process and lower costs for businesses The entry of new suppliers (firms) into the market which leads to an increase in total market

supply available to consumers

The outward shift of the supply curve increases the supply available in the market at each price and with a given demand curve, there is a fall in the market equilibrium price from P1 to P3 and a rise in the quantity of output bought and sold from Q1 to Q3. The shift in supply causes an expansion along the demand curve.

The equilibrium price and quantity in a market will change when there shifts in both market supply and demand. Two examples of this are shown in the next diagram:


In the left-hand diagram above, we see an inward shift of supply (caused perhaps by rising costs or a decision by producers to cut back on output at each price level) together with a fall (inward shift) in demand (perhaps the result of a decline in consumer confidence and incomes). Both factors lead to a fall in quantity traded, but the rise in costs forces up the market price.

The second example on the right shows a rise in demand from D1 to D3 but a much bigger increase in supply from S1 to S2. The net result is a fall in equilibrium price (from P1 to P3) and an increase in the equilibrium quantity traded in the market.

Price elasticity of demand

A responsive change in quantity demanded due to change in price.

PED = % change in demand of good X / % change in price of good X

If the PED is greater than one, the good is price elastic. Demand is responsive to a change in price.

If the PED is less than one, the good is inelastic. Demand is not very responsive to changes in price.


If the PED is equal to one, the good has unit elasticity. The percentage change in quantity demanded is equal to the percentage change in price. Demand changes proportionately to a price change.

If the PED is equal to zero, the good is perfectly inelastic. A change in price will have no influence on quantity demanded. The demand curve for such a product will be vertical.

If the PED is infinity, the good is perfectly elastic. Any change in price will see quantity demanded fall to zero. This demand curve is associated with firms operating in perfectly competitive markets

How to use concept of PED

Businesses can use the concept of price elasticity of demand when they decide to change the prices of their products. If the product is price elastic (> 1), business can increase its revenues by decreasing the prices of its products, as responsive increase in QD will be greater than the decrease in Price.

The Demand for facilities and luxuries are normally elastic (e g cell phones, branded clothes etc)

A relatively elastic demand curve

On the other hand if product is price inelastic (< 1), business can increase its profits by increasing the prices of its products, as responsive decrease in QD will be less than the increase in P of that product.

Price elasticity of demand for basic necessities are inelastic (e.g. life saving drugs, food, clothing etc).

A relatively inelastic demand curve


A unitry elastic deand curve

Factors that determine the value of price elasticity of demand

1. Number of close substitutes within the market - The more (and closer) substitutes available in the market the more elastic demand will be in response to a change in price. In this case, the substitution effect will be quite strong.

2. Luxuries and necessities - Necessities tend to have a more inelastic demand curve, whereas luxury goods and services tend to be more elastic. For example, the demand for opera tickets is more elastic than the demand for urban rail travel. The demand for vacation air travel is more elastic than the demand for business air travel.

3. Percentage of income spent on a good - It may be the case that the smaller the proportion of income spent taken up with purchasing the good or service the more inelastic demand will be.

4. Habit forming goods - Goods such as cigarettes and drugs tend to be inelastic in demand. Preferences are such that habitual consumers of certain products become de-sensitized to price changes.


Price elasticity of supply

Price elasticity of supply measures the relationship between change in quantity supplied and a change in price. The formula for price elasticity of supply is:

The value of elasticity of supply is positive, because an increase in price is likely to increase the quantity supplied to the market and vice versa.

DETERMINENTS OF ELASTICITY OF SUPPLY

The elasticity of supply depends on the following factors

SPARE CAPACITY: How much spare capacity a firm has - if there is plenty of spare capacity, the firm should be able to increase output quite quickly without a rise in costs and therefore supply will be elastic

STOCKS: the level of stocks or inventories - if stocks of raw materials, components, and finished products are high then the firm is able to respond to a change in demand quickly by supplying these stocks onto the market - supply will be elastic

EASE OF FACTOR SUBSTITUTION: Consider the sudden and dramatic increase in demand for petrol canisters during the recent fuel shortage. Could manufacturers of cool-boxes or producers of other types of canister have switched their production processes quickly and easily to meet the high demand for fuel containers?

If capital and labour resources are occupationally mobile then the elasticity of supply for a product is likely to be higher than if capital equipment and labour cannot easily be switched and the production process is fairly inflexible in response to changes in the pattern of demand for goods and services.

TIME PERIOD: Supply is likely to be more elastic, the longer the time period a firm has to adjust its production. In the short run, the firm may not be able to change its factor inputs. In some agricultural industries the supply is fixed and determined by planting decisions made months before, and climatic conditions, which affect the production, yield.

Economists sometimes refer to the momentary time period - a time period that is short enough for supply to be fixed i.e. supply cannot respond at all to a change in demand.


Market price and Govt intervention:


price determination

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