Chapter 2

The Market Mechanism

Learning Outcomes: At the end of this chapter, students are expected to:
1. Illustrate the circular flow model for microeconomics and identify the
product market and factor market
2. Describe the market and distinguish the law of demand and law of
supply
3. Illustrate differences in the demand and supply function, schedule,
and curve
4. Analyze the determinants of demand and determinants of supply
5. Compute and explain the equilibrium price and equilibrium quantity
and illustrate effect of government intervention through its price ceiling
and price support
6. Classify and explain four kinds of elasticity
7. Identify and give example of product with different elasticities

CIRCULAR FLOW FOR MICROECONOMICS

Figure 2.1
Circular Flow Diagram

Source:

19
 Figure2.1 in the upper loop is a flow model showing the exchange between businesses
(producer) and households (consumer) in the resource market. The households, as shown, are
the providers of inputs/resources (land, labor, capital, and entrepreneurs); hence, the households
receive payment from businesses called money income. The outflow of money from the
businesses in exchange for the inputs/resources is called cost of production as businesses
make the payment.
On the other hand, the lower loop shows the exchange of output between businesses and
households in the product market. Businesses produce goods and services which households
demand to satisfy their wants. Businesses provide the goods and services and the households
pay for these goods and services, which is shown by the outflow of money from the households.
The money that households pay for the goods is called expenses of the consumer while this
same money received by businesses is called the revenue of the producer.

DEFINITION OF MARKET

Markets bring together buyers and sellers, whether these are the product market or the
resource market . A market exists as long as there are buyers and sellers who agree on the
price, hence transaction takes place. The agreed- upon price is called the market price or
equilibrium price.

Figure 2.2
3 Elements of the Market

Buyers Sellers

Transaction Equilibrium price

Take note that a market does not exist in a definite place only, it can exist anywhere as
long as there are buyers and sellers who agree on the price. A market exists even without a face-
to- face contact because even by phone or by mail alone there can be a market like the on-line
market.

THE LAW OF DEMAND

The law of demand states that “the higher the price of the good, the lesser the quantity
demanded” of that good or “as price declines, quantity demanded increases” all other things
constant or equal. This law can be presented in 3 ways: as a demand function, a demand
schedule and as a demand curve.

The Demand Function is expressed in terms of a mathematical equation as follows:

Qd = 100 - 2 P
where Qd is quantity demanded and P is the price

The above function shows that Qd is dependent on P, or this shows that there is an
inverse relation between Qd and P; as price increases, Qd declines.

The Demand Schedule is expressed in a tabular form, this is done thru substitution in the given
demand function and can be represented as follows:

20
 Table 2.1
Demand Schedule

Price per kilo of Quantity Demanded

rice (in pesos) of Rice (in kilos)

20 60

25 50

30 40

35 30

40 20

The table above shows the inverse relationship of price and quantity demanded; that as
the price gets higher the quantity demanded gets lower.

The Demand Curve is a line plotted on the graph which represents the demand schedule; see
Figure 2.3.

Figure 2.3
Demand Curve

Fig. 2.3 shows the demand curve representing Qd = 100-2P. Notice that the demand
curve is downward sloping which reflects an inverse relation between quantity demanded and
price. At point A, the quantity demanded is 20 units and the price is P40.00 and as price goes
down to P35.00 at point B, quantity demanded increases from 20 to 30 units.

21
DETERMINANTS OF DEMAND

1. Income – (direct relation to demand for normal goods and inverse for inferior goods)
. An increase in income increases the demand for a normal good; if the product is
an inferior good , an increase in income deceases the demand for it.
Normal goods are goods whose demand increases as income increases.

Inferior goods are goods whose demand increases as income declines like that
of eggs, sardines and dried fish.

2. Tastes and preferences. (direct relation to demand) If one’s taste is in favor of the
product, the higher will be the demand; if one’s taste does not favor the good, the lower
will be its demand.

3. Prices of related goods and services. For substitute goods like rice and bread , the
relation of this determinant to demand is direct. As price of rice increases , the
demand for bread will increase. For complementary goods like bread and butter, the
relationship is inverse; as the price of bread increases the demand for butter will
decrease.

4. Buyer's expectations about future prices (direct relation to demand). If price is

expected to increase, people tend to buy more, hence demand increases. This leads
people to resort to panic-buying because they try to avoid the future increase in prices.

5. Number of Buyers(direct relation to demand). The more the number of buyers, the
higher the demand.

Change in Quantity Demanded vs Change in demand

A change in quantity demanded occurs when there is a change in the price of the good itself.
Figure 2.4 below shows that an increase in price from P30 to P35 results to a decrease in
quantity demanded from 40 units to 30 units, represented by a movement along a given demand
curve from point c to point b.

Fig. 2.4
Change in Quantity Demanded

22
 Change in demand. A change in demand is represented by a shift of the demand curve
to the right or to the left which is caused by a change in any of the determinants of demand .

Let us assume that there is an increase in income, other things remaining constant ; the
demand for a normal good increases which is shown by a shift of the demand curve to the right:
D to D1. Conversely, if income declines, the demand curve will shift to the left from D1 to D .

Figure 2.5
Change in Demand

LAW OF SUPPLY

The law of supply states that as the price of a good increases, quantity supplied
increases, all other things constant or equal. This can be represented by a function, a schedule
or by a curve.

Supply Function: Given the supply function as follows:

Qs = -20 + 2P
where Qs is quantity supplied P is the price

The above function shows that there is a direct relation between price and quantity
supplied as shown by the positive coefficient of price which is +2.

Supply Schedule: The above supply function: Qs = -20 + 2P can be expressed in tabular form
and through substitution in the supply function; the table/schedule is shown as:
Table 2.2
Supply Schedule
Price of Rice Quantity Supplied
of Rice

20 20,000

25 30,000

30 40,000

35 50,000

40 60,000

23
 The illustration above shows that if the price is P20.00, sellers would sell 20,000kilos of
rice, and if the price increases to P25.00, Qs increases to 30,000 kilos; further increases to
60,000kilos at price P40.

Supply Curve: The line plotted on the graph is the supply curve of the given supply schedule.

Figure 2.6
Supply Curve

As price increases from P20.00 to P25.00, Qs also increases from 20,000 to 40,000 kilos
of rice which shows that there is direct relation between price and quantity supplied, all other
things remaining constant or equal.

Change in Quantity Supplied

A change in quantity supplied occurs when there is a change in the price of the good.
In Figure 2.7, increasing the price from P20.00 to P25.00 (from point h to point i) increases
quantity supplied from 20,000 to 30,000 kilos of rice. A change in quantity supplied is reflected
by a movement from one point to another point along a given supply curve and this movement is
due to a change in price of the good.

Fig. 2.7
Change in Quantity Supplied

24
Change in Supply

Figure 2.8
Change in Supply

A change in supply occurs whenever any of the non-price determinants of supply

changes. An increase in supply is represented by a shift in the supply curve to the right, a shift
from S to S1. Alternatively, a decrease in supply is represented by a shift of the supply curve to
the left , a shift from S1 to S.

Determinants of Supply

Aside from the price of the product there are other factors that determine or affect its
supply.
1. Cost of production (inverse relation to supply). An increase in the production cost
discourages producers to produce more, hence a decrease supply.
2. Technology (direct relation to supply). An improved technology encourages producers
to produce more, hence an increase in supply.
3. Subsidy (direct relation to supply). An increase in government subsidy for fertilizers
used by farmers encourages them to plant more, hence increases supply for their
products.
4. Price of competing products (inverse relation to supply). Consider palay and corn
as competing products for farmers. An increase in the price of corn will decrease the
supply of palay since farmers will plant corn rather than palay to take advantage of
the increase in the price of corn.
5. Price expectations (inverse relation to supply) If the price of rice is expected to
increase, businessmen tend to hoard rice, hence supply decreases.
6. Number of sellers(direct relation to supply). The more the sellers in the market, the
higher the supply.

MARKET EQUILIBRIUM

We can now combine our analysis of demand and supply and see how the market clears
or how a market equilibrium is attained. The market clears when supply matches demand leaving
no surplus or shortage in the market. The term equilibrium means that all forces in the market are
in balance. Market equilibrium is attained when demand is equal to supply.

Finding the equilibrium price and quantity in tabular form

25
 Table 2.3
Demand and Supply Schedule

Quantity Quantity
Demanded Price per Supplied Shortage or
Kilo Surplus
(in kilos) (in kilos)

60,000 20 20,000 Shortage

50,000 25 30,000 Shortage

40,000 30 40,000 Equilibrium

30,000 35 50,000 Surplus

20,000 40 60,000 Surplus

The above table shows that the equilibrium price can be determined by comparing Qd and
Qs. The equilibrium price (Pe) is P30.00 and equilibrium quantity (Qe) is 30,000 units. Any price
above P30.00, Qs >Qd would create a surplus in the market.

Finding the equilibrium price and quantity through graphical analysis

Figure 2.9
Equilibrium Price and Quantity

In Figure 2.9, the intersection of the demand curve and supply curve at point E indicates
that the equilibrium price is P30.00 and equilibrium quantity is 40,000 units.

26
 A surplus is the excess of quantity supplied over quantity demanded. For example, at
P40, quantity demanded in the market is 20,000 units, but producers have produced and offered
60,000 units. The difference brings a surplus of 40,000 units. The surplus would push down price
as sellers would compete to enable them to sell their product, and in so doing, reduce quantity
supplied and increase quantity demanded until equilibrium is achieved.

When quantity demanded is higher than quantity supplied, there is a shortage of the
product. At price P25.00, buyers demand 50,000 units but producers are willing to sell only 30,000
units, hence a shortage of 20,000 units. The shortage in the market is due to a lower price and
would drive prices up as buyers would compete among themselves to get hold of the available
product and in so doing, may increase Qs and decrease Qd until Qs = Qd.

Price ceiling vs Price Support

A price ceiling is also called a price control. It is the maximum legal price fixed by the
government on consumer goods like rice, oil , sugar, etc. to keep prices from further rising.

For the government to be successful in its program of protecting the consumers through
price fixing, it must be able to assure a continuous supply of the goods by price monitoring.

A price support or floor price is the minimum price regulated by the government on
producer goods to keep prices from further decline.

The most prevalent use of price floors is seen thru the prices set by the government for
agricultural products usually palay and corn. The government usually attempts to stabilize or
raise farm incomes by maintaining the prices of farm commodities above their equilibrium values
using its power to alter the price.

As a result of the price floor, there is usually a surplus for agricultural products. The
problem of a surplus can only be solved if the government commits to buy from the farmers
whatever is not bought by traders.

Price Elasticity of demand and of supply

In general, elasticity measures the degree of responsiveness of the dependent variable;

Quantity Demanded (Qd) or Quantity Supplied (Qs) to independent variable; either price, income
or price of related goods all other things constant or equal.

Price elasticity of demand (Ep) measures the degree of responsiveness of quantity demanded
to changes in the price of the good itself, other things constant.

Price elasticity of supply (Es) measures the degree of responsiveness of quantity supplied to
changes in the price of the good itself, other things constant.

Income elasticity of demand (Ey) measures the degree of responsiveness of quantity

demanded to changes in consumers income, other things constant. The coefficients can be
positive or negative depending on the type of product. For a normal good, income elasticity of
demand is positive and for an inferior good, this is negative.

27
Cross Elasticity of demand (Ec) measures the degree of responsiveness of quantity demanded
to changes in the price of related goods, other things constant. It is positive when the goods and
services under study are substitutes and is negative when the goods are complementary.

Formula:
∆Q Q2 – Q1
% ∆Q Q1 Q1
Ep = ----------
= ---------- = ----------
% ∆P ∆P P2 – P1
P1 P1
Illustrative example: P₁= 10, Q₁= 20, P₂= 5, Q₂= 50

∆Q 50 – 20 1.5
% ∆Q Q1 20
Ep = ---------- = ---------- = ---------- = ----------------- = -3
% ∆P ∆P 5– 10 5
P1 10

Interpreting the price elasticity of demand

Quantity demanded can be very responsive, not so responsive or does not respond to
changes in the price of the good itself. This is determined by the value of the price elasticity of
demand (Ep).

Economists, however, consider the absolute value of price elasticity of demand (Ep) and
price elasticity of supply (Es) for interpretation purposes.

1. Elastic or Relatively Elastic: Ep > 1 , or when %∆Q > %∆P

Fig. 2.10
Relatively Elastic Demand

A relatively elastic demand curve has a flatter demand curve. To increase total revenue
(TR), sellers may decrease the price. Examples of products are those luxury items like clothes
and bags , shoes .

2. Unitary or Unit Elastic Demand: Ep = 1 ; %∆Q=%∆P

28
 Fig. 2.11
Unitary Demand

Demand is unitary if the price elasticity coefficient is equal to one. Total Revenue remain
constants even sellers increases or decreases the price

3. Inelastic or Relatively Inelastic Demand: Ep < 1 ; %∆P>%∆Q

Figure 2.12
Relatively Inelastic Demand

A relatively inelastic demand is a steep curve as shown above. To increase total revenue,
price must be increase. Example of products are basic goods like sugar, rice and salt.

Figure 2.13
Perfectly Elastic and Perfectly Inelastic Demand

Perfectly Inelastic Demand Perfectly Elastic Demand

Ep = 0, (vertical demand curve) Ep = ∞ (demand cure)

29
 A Perfectly Inelastic (PI) demand is a vertical demand curve whose Ep = 0. It
shows that at any price, quantity demanded remains constant. example can be an anti-rabies
vaccine, regardless of price if one is bitten by cat, if doctor prescribe a certain dosage it
needs to be bought because it is a matter of life and death.

A perfectly elastic demand (PE) is a horizontal demand curve, its Ep = ∞ which shows
that at any quantity bought or sold, the price remains constant just like the demand curve for the
firm under pure competition.

Course Materials:
Read: Payumo, C., et al, (2012), Understanding Economics
Watch: https://www.youtube.com/watch?v=g9aDizJpd_s Supply and Demand: Crash course

Supply and Demand: Crash course

30