TOPIC 1

Market Mechanism

1.1The algebra of demand, supply and equilibrium

1.2Application of demand, supply and equilibrium
with respect to government intervention
1.3Elasticities of demand & supply and its
application (Theoretical & calculation)
 Market Mechanism
A Market
Consists of buyers and sellers of a good or
service.

Market/Price mechanism
Describes how the forces of demand and
supply determine (relative) prices of goods
and services which ultimately determines
the productive resources (e.g. labor and
capital) are allocated in the economy.
 Market Mechanism

Law of Demand

States that when the price of a product

falls, quantity demanded will increase, vice
versa, ceteris paribus.

A demand curve slopes downwards showing

the inverse/negative relationship between
price & quantity demanded.
Market Mechanism
A Demand Curve
 Market Mechanism

Why a Demand Curve Slopes Downwards

2 reasons:
Substitution effect
When price of a good decreases, consumer will
substitute the lower priced good for the more
expensive ones.
Income effect
When price decreases, consumer’s real income
(or purchasing power) increases, so he/she
tends to buy more.
 Market Mechanism
Demand Function
Quantity demanded (QD) is expressed as
a mathematical function of price (P). The
demand function can be written as:
                  QD = a - bP
where
◦ a is the horizontal intercept of the equation
◦ (-b) is the slope of the function
Example: QD = 10 – 4P
 Market Mechanism
Factors that Shift Demand Curves
 Market Mechanism

Law of Supply

States that when the price of a product

rises, firms offer more quantities for sale,
ceteris paribus.

A supply curve slopes upwards showing the

direct/positive relationship between price &
quantity supplied.
Market Mechanism
A Supply Curve
 Market Mechanism

Why a Supply Curve Slopes Upwards

3 reasons:
Profit Motivated
Attract new producers to enter the market
More output increase costs of production
 Market Mechanism
Supply Function
Quantity supplied (QS) is expressed as a
mathematical function of price (P). The
supply function can be written as:
Qs = a + bP
where
◦ a is the horizontal intercept of the equation
◦ (+b) is the slope of the function
Example: QS = –2 + 8P
 Market Mechanism
Factors that Shift Supply Curves
Market Mechanism
Market Equilibrium

QD = Q S

E
 Market Mechanism

Market equilibrium
When the supply and demand curves
intersect, the market is in equilibrium of
which the quantity demanded and quantity
supplied are equal. 
The corresponding price is the equilibrium
price or market-clearing price, the quantity is
the equilibrium quantity.
 Market Mechanism

Changes in Equilibrium Price & Quantity

Show the effect on equilibrium price & quantity
due to changes described below:

Case 1: An increase in Demand

Case 2: An increase in Supply
Case 3: A decrease in Demand
Case 4: A decrease in Supply
 Market Mechanism
Excess Demand & Supply
 Market Mechanism

Changes in Equilibrium Price & Quantity

Show the effect on equilibrium price & quantity
due to changes described below:

Case 1: An increase in Demand

Case 2: An increase in Supply
Case 3: A decrease in Demand
Case 4: A decrease in Supply
 Market Mechanism
I Market Equilibrium Algebraic
Express algebraically the market demand and
supply curves as shown below:

QD = 10 – 4P
QS = –2 + 8P

Base on the DD & SS functions, determine the

equilibrium price and quantity.
 Market Mechanism
II Shifts in Demand & Supply, & Equilibrium
Assume a shift in the demand curve (D to D’)

is shown with the new DD function as:

QD’ = 16 – 4P
whereas the supply curve does not change i.e.
QS = –2 + 8P
Determine the new equilibrium price & quantity.
 Market Mechanism
II Shifts in Demand & Supply, & Equilibrium
Assume a shift in the supply curve (S to S’)
is shown with the new supply function as:
QS’ = -16 + 4P
whereas the demand curve does not change
i.e. QD = 10 – 4P
Determine the new equilibrium price & quantity.
 Market Mechanism
Consumer Surplus

Definition
• The amount consumers are willing to pay
MINUS amount they actually pay.
• The area below the demand curve and
above the price the consumer pays.
 Market Mechanism
Consumer Surplus

Triangle Area = Base x Height x ½

10 Triangle Area = 4000 x (10-5) x 1/2

Supply
CS =
Equilibrium Triangle Area
Price = $5

2 D

Equilibrium Quantity = 4000

22
 Market Mechanism
Producer Surplus

Definition
• The difference between what the sellers are
willing to receive and what they actually get.
• The area above the supply curve and
below the price the consumer pays.
 Market Mechanism
Producer Surplus

Triangle Area = Base x Height x ½

10 Triangle Area = 4000 x (5-2) x 1/2

Supply

5
PS = Triangle
Area

2
D

4000
24
 Market Mechanism
Consumer & Producer Surplus

10

Supply

CS

PS

2
Demand
Qe=4000 Quantity
Q
25
 Market Mechanism
1.2: Application of Demand, Supply and
Equilibrium with respects to
Government Market Intervention

How government intervene:

• Tax
• Maximum/Ceiling Price
• Minimum/Floor Price
 Market Mechanism
Tax
• Indirect Taxes such as sales tax, custom
duties are examples of specific taxes.
• When the government imposes a sales tax of
RM10 per unit in the market. The effect of
sales tax will shift the supply curve to the
left.
• Why?
• Effects on price and quantity, incidence of tax
 The effect of a sales tax on the market
for a good Supply after tax
Price

Supply

Price buyers Size of tax

pay

Price
without tax

Price sellers
receive

Demand

0 Quantity Quantity Quantity

with tax without tax
Copyright © 2004 South-Western
 The effect of a sales tax on the market
for a good
Supply after tax

Price

Price A Supply
Qe ’
buyers = PB
pay
B
Price C Qe
without tax = P1
E
Price D
sellers = PS
receive F

Demand

0 Q2 Q1 Quantity

Copyright © 2004 South-Western

 Market Mechanism
Tax
• Based on the diagram:
Without tax
Consumer surplus (CS) = A + B + C
Producer surplus (PS) = D + E + F
Total Surplus = CS + PS
= A+ B +C +D+ E +F
 Market Mechanism
Tax
• Based on the diagram:
With tax
Consumer surplus (CS) = A
Producer surplus (PS) = F
Tax revenue =B+D
Total Surplus =A+B+D+F
The tax causes total surplus to fall by
=C+E
 Market Mechanism
Tax
• What is the area C + E?
C + E is called the deadweight loss(DWL)
of the tax, the fall in total surplus that
results from a market distortion, such as a
tax.

The costs to the society due to market

inefficiency i.e. any deficiency caused by an
inefficient allocation of resources.
 Market Mechanism
Maximum or Ceiling Price

Definition
• A legal ceiling price set by the government agency
below the equilibrium price so as not to allow the
price to increase further.
• The main reason is to protect the consumers so
as to enable them to obtain some essential goods.
• However the consequence of this action is it leads
to a shortage of the goods in the market.
 Market Mechanism
Maximum or Ceiling Price
Figure 1: Maximum / Ceiling Price
Price of sugar
D S

Pmax

Qd > Qs
shortage

S D
Qs Qd Quantity
 Market Mechanism
Maximum or Ceiling Price
 Advantages and Disadvantages of Ceiling Price
Advantages Disadvantages
1. Poor people can afford to 1. Shortage of the goods in the
buy the essential goods. market.

2. Consumers are able to 2. Black market arises

obtain the basic goods.
3. Applicable during war time or 3. Need to ration the goods to
emergency situations. ensure consumers get the
goods. Unfair to those
consumers who are willing to
pay the price.
4. Unfair to the sellers who have
to sell a lower price.
 Market Mechanism
Maximum or Ceiling Price

What will be the welfare impact of the ceiling

price? Explain using a diagram the impact on:

Consumer Surplus

Producer Surplus

Deadweight Loss
 Market Mechanism
Minimum or Floor Price

Definition
• A legal floor price set by the government
agency above the equilibrium price so as not to

allow the price to fall further.

• Main reason is to protect producers’ income.
• However the consequence of this action is it
leads to a surplus of the goods in the market.
 Market Mechanism
Minimum or Floor Price
Figure 2: Minimum / Floor Price
Price of paddy
D S

Pmin
Qs > Qd
surplus

S D
Qd Qs
Quantity
 Market Mechanism
Minimum or Floor Price
 Advantages and Disadvantages of Floor Price
Advantages Disadvantages
1. To protect producer’s 1. Unfair to consumers for having to
incomes. pay more for the good.

2. A surplus can be stored for 2. Results with a surplus of the

good.
future shortages.
3. In the case of government 3. However government needs to
implementing minimum ‘buy up’ the surplus to maintain
wage can prevent workers the high price thus tax revenue
will finance the purchase.
from being exploited. Unfair to the taxpayers.
4. A good strategy during 4. Producers can become
election to win votes. inefficient in producing the goods.
 Market Mechanism
Minimum or Floor Price

What will be the welfare impact of the floor

price? Explain using a diagram the impact on:

Consumer Surplus

Producer Surplus

Deadweight Loss
 Market Mechanism
Elasticity & its Application
Concept
refers to the degree of responsiveness of
the quantity of a good in relation to
changes in price or income.
4 basic types of elasticity:
Price elasticity of demand
Price elasticity of supply
Income elasticity of demand
Cross elasticity
 Market Mechanism
Price Elasticity of Demand
Definition
Measures how responsive is the quantity
demanded of a good to a change in the price
of the good.

Elasticity = % change in quantity demanded

% change in price
= ∆Q/Q
∆P/P
 Market Mechanism
Price Elasticity of Demand
Classification of Price Elasticity of Demand
Perfectly inelastic demand
Inelastic demand
Unitary elastic demand
Elastic demand
Perfectly elastic demand
 Market Mechanism
Price Elasticity of Demand
Determinants of Price Elasticity of Demand
Availability of Close Substitutes: the more
substitutes a good has, the more elastic its
demand.
Necessities versus Luxuries: luxuries are more
price elastic.
Time Horizon: goods tend to have more elastic
demand over longer time horizons.
Habit
 Market Mechanism
Price Elasticity of Demand
Elasticity Along a Straight-Line Demand Curve
$10 Elasticity declines along
demand curve as we move
9 toward the quantity axis
8 Ed > 1
7
6
Price

Ed = 1
5
4
3 Ed < 1
2
1 Ed = 0
0 1 2 3 4 5 6 7 8 9 10 Quantity
 Market Mechanism
Price Elasticity of Supply
Definition

Measures how responsive is the quantity

supplied of a good to a change in the price
of the good.

Elasticity = % change in quantity supplied

% change in price
= ∆Q/Q
∆P/P
 Market Mechanism
Price Elasticity of Supply
Classification of Price Elasticity of Supply
Perfectly inelastic supply
Inelastic supply
Unitary elastic supply
Elastic supply
Perfectly elastic supply
 Market Mechanism
Price Elasticity of Supply

Determinants of Price Elasticity of Supply

Ease of substitutability of a resource.
Time Horizon: supply is usually more inelastic
in the short run than in the long run.
Durability versus perishability of a good.
 Market Mechanism
Notes: Measuring Price Elasticities

Calculating Price Elasticity of Demand & Supply

Price elasticity can be measured at an interval
(or arc) along demand, or at a specific point
on the demand curve
◦ If the price change is relatively small, a point
calculation is suitable
◦ If the price change spans a sizable arc along
the demand curve, the interval calculation
provides a better measure
 Market Mechanism
Notes: Measuring Price Elasticities
Computation of Elasticity at a Point
When calculating price elasticity at a point on
demand, multiply the slope of demand
(Q/P), computed at the point of measure,
times the ratio P/Q, using the values of P and
Q at the point of measure
Method of measuring point elasticity depends
on whether demand is linear or curvilinear
Formulae:
 = (Q/P).P/Q
 Market Mechanism
Price Elasticity of Demand
Example of Calculation
QD = 10 – 4P
QS = –2 + 8P

Calculate the price elasticity of demand & price

elasticity of supply when the market is in
equilibrium.
 Market Mechanism
Income Elasticity of Demand

Definition
Measures the responsiveness of a change in
quantity demanded towards a change in
income.
Y Elasticity=% change in quantity demanded
% change in income
= ∆Q/Q
∆Y/Y
 Market Mechanism
Income Elasticity of Demand
• Types of Goods
1. Normal/Necessity/Luxury Goods
Demand rises as income rises (+ve coefficient)
Goods consumers regard as necessities tend to

be income inelastic.
Examples include food, fuel, clothing & utilities
However, luxuries goods tend to be income
elastic.
Examples include sports cars, furs, & jewellery.
 Market Mechanism
Income Elasticity of Demand

2. Inferior Good/Giffen Good

Goods whose demand decreases with an
increase in income.
It means that there exists an inverse
relationship between income and the demand
for these goods (negative coefficient).
Example of goods low quality goods such as
lower grade rice.
 Market Mechanism
Cross Elasticity of Demand
Definition
Measures the responsiveness of demand
of one good to a change in the price of a
related good–either substitute or complement.
Complementary goods will have a negative
coefficient.
Substitute goods will have a positive
coefficient.
Cross Elasticity = % ∆ in Qty Dd for Good A
% ∆ in Price of Good B
 Market Mechanism
Application of Elasticity

I. Elasticity and Total Revenue (TR)

TR = Price (P) x Quantity (Q)

If P goes down Q goes up, what happens to TR?

If P goes up Q goes down, what happens to TR?

The question for a producer is to increase TR,

should he reduce or raise the price?
 Market Mechanism
Application of Elasticity

Depends on the price elasticity of demand

for the good.
When DD is elastic, should or price to TR?
Show diagram.
When DD is inelastic, should or price to
TR? Show diagram.
 Market Mechanism
Application of Elasticity

II. Agriculture Production

During bad crop years, prices rise and

quantity falls (but not that much) so total
revenue to farmers goes up.
During good crop years, prices fall and
quantity increases (but not that much) so
total revenue to farmers goes down.
Show diagrammatically.
 Market Mechanism
Application of Elasticity

III. Government to Impose Tax

Depends on the price elasticity of DD &
SS of the good in order to increase their
revenue from tax.
When DD is elastic, SS is inelastic.
When DD is inelastic, SS is elastic.
Show diagrams.
 Problem
Exercise 1
Consider a market whose supply and demand
curves are given as:
P= 4QS and P= 12 - 2QD
i. Calculate the equilibrium price and quantity.
ii. How will the equilibrium price and quantity
in this market be affected if a tax of 6 per
unit of output is imposed on sellers? The
new supply function is P = 6+4QS.
iii. Find the price elasticity of demand & supply
at the equilibrium point.
Exercise 2
Jan 2014: Solve question 1