Section 2 A, E, F

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Madanhire
The Price Mechanism
• The price mechanism is a means of allocating resources in a market
economy.
• Resource allocation in a market economy is done through the interaction of
buyers and sellers in different markets
• A market is anywhere (not necessarily physical) where buyers and sellers to
exchange goods and services for money
• Examples: Food market, housing market, stock market etc
• Prices of goods and services are set by the market forces of demand
(buyers) and supply (sellers)
• These prices are always moving into and out of equilibrium, and can be
both efficient and inefficient in different ways and over different time
periods.
• However markets have the ability to readjust themselves back into
equilibrium through the ‘invisible hand’ as put forward by Adam Smith
Demand
• To an economist, demand refers to the quantity of a product that purchasers are
willing and able to buy at various prices per period of time, all other things being
equal.
• Definitions are of critical importance in Economics, so let us break this definition
down to understand in some depth what it means.
• Quantity: This refers to the numerical quantity of a product that is being
demanded.
• Product: This is a general term that simply refers to the item that is being traded.
It can be used for goods or services. We could also stretch this to include tradable
items like money or other financial assets such as shares.
• Purchasers: These are the buyers of the product and
are often referred to as ‘consumers’, although they may simply be intermediaries
in the supply chain, e.g., Nestlé purchasing large amounts of cocoa to be used in
the production of chocolate for sale to the final consumer. We can consider an
individual’s demand for a product or, more usefully, we can aggregate this to look
at the demand for the market as a whole.
• Willing to buy: Purchasers must want a product if they are going to enter into the
market with the intention of buying it.
• Able to buy: To an economist, the notional demand for a product, which emerges
from wanting it, must be backed by purchasing power if the demand is to become
Demand
• Various prices: Prices are crucial to the functioning of a market. Although many
things influence demand for a product, it is at the time of purchase, when we
have to hand over our money and pay the price that we really judge whether the
product is value for money – in other words, whether we really are willing and
able to buy it. As the price goes up, and provided no other changes have
occurred, more and more people will judge the product to be less worthwhile.
• Per period of time: Demand must be time related. It is
of no use to say that the local McDonald’s sold 20 Big Macs to consumers unless
you specify the time period over which the sales occurred. If that was per
minute then demand is high, but if that was per week then this would show
there is little demand for Big Macs in this particular market.
• Other things being equal: There are numerous potential influences on the
demand for a product. Understanding the connections between the various
influences is very difficult if many of these elements are changing
simultaneously. This is why it is necessary to apply the ceteris paribus
assumption referred to in Chapter 1.
The Demand Curve
• Demand curve: represents the relationship between the quantity
demanded and price of a product.
• Market demand: the total amount demanded by consumers.
• Demand schedule: the data from which a demand curve is drawn.
The Demand Curve
The Demand Curve
• The market demand curve in Figure 2.1 shows:
• An inverse or negative relationship between price and quantity
demanded. In other words:
• when price goes up, there is a decrease in quantity
• demanded
• when price goes down, there is an increase in quantity
• demanded.
• Changes in price cause a change in quantity demanded and we show
this by movements up and down the demand curve.
• A linear relationship – this demand curve has been drawn as a straight
line. However, it is perfectly acceptable for price and quantity
demanded to be related in a non-linear manner in the form of a type
of curve.
• A continuous relationship – we could look at the diagram and find out
at what price consumers would be willing and able to buy A time-
based relationship – the time period here is weekly.
• Other things being equal, ceteris paribus.
Factors influencing Demand
(i) Income
• The ability to pay is vital when considering the importance of effective
demand. For any individual, the demand for goods and services
invariably depends upon income.
• In general, there is a positive relationship between income and demand.
• An increase in the ability to pay usually leads to an increase in demand.
• Conversely, if the ability to pay falls then less is demanded.
• Goods and services that are characterised by this relationship are called
normal goods. Most products are like this and include things like cars,
restaurant meals, quality clothing, etc.
• For some products, however, there is a negative relationship, with less
being purchased as income rises.
• These are called inferior goods. Typical examples are poor quality
foodstuffs; as consumers become better-off, they are more likely to buy
less of these and, instead, purchase more fish, meat and premium priced
foods with their increased income.
Factors influencing Demand
(ii) Price and availability of related products
• Two particular categories can be identified. First, substitutes, which
are alternative goods and can satisfy the same want or need.
• Typical examples are Coca-Cola and Pepsi, both well-known brands of
cola. e in demand depends on the degree of substitutability
• An increase in the price of substitute A will lead to an increase in the
demand for the other substitute B and vice versa
• There is a positive relationship between the Price of good A and the
demand for its substitute good B
• Second, there are complements. These goods have a joint demand as
they enhance the satisfaction that consumers derive from another
product. Typical examples are cars
and petrol,
• An increase in the price of compliment A will lead to a decrease in the
demand for the other compliment B and vice versa
• There is a negative relationship between the Price of good A and the

Section 2 A, E, F

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Section 2 A, E, F

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