Welcome to Price Determination!
Ever wondered why a bottle of water costs £1 in a supermarket but £5 at a music festival? Or why the price of strawberries drops in the summer? That is exactly what we are going to explore. This chapter is the heart of Microeconomics. We are looking at how buyers and sellers interact in a competitive market to decide on a price. Don't worry if it seems like a lot of graphs at first—once you see the "logic" behind the lines, it becomes much easier!
1. Demand: What Consumers Want
Demand is the quantity of a good or service that consumers are willing and able to buy at a given price. The "able" part is important—you might want a Ferrari, but if you can't afford it, you aren't part of the "effective demand" for it!
The Demand Curve
The demand curve usually slopes downwards from left to right. This shows an inverse relationship: as the price goes up, the quantity demanded goes down.
Example: If the price of your favourite chocolate bar doubles, you’ll probably buy fewer of them.
Shifts vs. Movements
This is a classic trap for students!
• Movements: A change in the Price causes a movement along the curve. We call this an extension or contraction of demand.
• Shifts: If anything other than price changes, the whole curve moves left or right.
Memory Aid: Why does Demand shift? (PIRATES)
Use the PIRATES mnemonic to remember what shifts the demand curve:
P - Population (more people = more demand)
I - Income (higher income = more demand for normal goods)
R - Related goods (price of substitutes or complements)
A - Advertising (better ads = more demand)
T - Tastes and fashions
E - Expectations of future price changes
S - Seasons (ice cream in summer!)
Key Takeaway: Price changes cause movements along the line; PIRATES cause the whole line to shift.
2. Supply: What Firms Offer
Supply is the quantity of a good or service that firms are willing and able to sell at a given price. Firms are motivated by profit. Higher prices usually mean higher profits, which gives firms an incentive to produce more.
The Supply Curve
The supply curve slopes upwards. As price increases, quantity supplied increases.
Analogy: Imagine you sell old clothes online. If the "going price" for a T-shirt is £1, you might not bother. If it jumps to £20, you'll go through your whole wardrobe to find more to sell!
Memory Aid: Why does Supply shift? (PINTSWC)
P - Productivity (more efficient workers = more supply)
I - Indirect taxes (like VAT or Sugar Tax make it dearer to produce)
N - Number of firms (more shops = more supply)
T - Technology (better machines = faster production)
S - Subsidies (money from the government to help firms)
W - Weather (huge for farming!)
C - Costs of production (wages, raw materials, electricity)
Key Takeaway: Under perfect competition, the supply curve is actually the firm's Marginal Cost curve. This just means firms will only supply an extra unit if the price covers the cost of making that extra unit.
3. Finding the "Sweet Spot": Market Equilibrium
Equilibrium happens where the Demand curve and the Supply curve cross. This is the market-clearing price. At this price, everyone who wants to buy at that price can, and everyone who wants to sell at that price can. There is no waste!
Disequilibrium: When things are out of balance
1. Excess Supply (A Glut): If the price is above the equilibrium, firms want to sell more than people want to buy. To get rid of the unsold stock, firms must lower the price.
2. Excess Demand (A Shortage): If the price is below the equilibrium, people want to buy more than is available. This "scarcity" allows firms to raise the price.
Quick Review Box:
• Equilibrium: Demand = Supply
• Excess Demand: Price rises towards equilibrium
• Excess Supply: Price falls towards equilibrium
4. Elasticity: How "Stretchy" is the Market?
Elasticity measures how much consumers or firms respond to a change in price or income.
Price Elasticity of Demand (PED)
The formula is:
\(PED = \frac{\% \Delta Quantity Demanded}{\% \Delta Price}\)
• If the answer is more than 1, it is Elastic (consumers are very sensitive to price).
• If the answer is less than 1, it is Inelastic (consumers will buy it anyway, like petrol or habit-forming goods).
Total Revenue Rule
This is a favorite exam topic!
• If demand is Inelastic, raising the price increases total revenue.
• If demand is Elastic, raising the price decreases total revenue.
Income (YED) and Cross-Price (XED) Elasticity
• YED measures how demand changes when Income changes.
Positive YED = Normal Good (you buy more as you get richer).
Negative YED = Inferior Good (you buy less as you get richer, e.g., value-brand noodles).
• XED measures how the price of Good A affects the demand for Good B.
Positive XED = Substitutes (Coke and Pepsi).
Negative XED = Complements (Printers and Ink Cartridges).
Price Elasticity of Supply (PES)
This shows how quickly firms can increase production if prices rise.
\(PES = \frac{\% \Delta Quantity Supplied}{\% \Delta Price}\)
Factors that make supply Inelastic:
• No spare capacity (factory is full)
• Low stocks (nothing in the warehouse)
• Hard to switch production (a farm can't turn into a tech hub overnight!)
5. Interrelated Markets
Markets don't exist in a vacuum. A change in one often affects another.
• Joint Demand: Goods bought together (e.g., Fish and Chips). If the price of fish rises, demand for chips might fall.
• Competitive Demand: Goods that are substitutes (e.g., Apple vs Samsung).
• Composite Demand: A good that has multiple uses (e.g., Land can be used for housing or farming). If we use more for houses, the supply for farming falls.
• Derived Demand: Demand for a factor of production depends on the demand for the final product.
Example: Nobody wants a "bricklayer" for the sake of it; we demand bricklayers because we demand houses.
• Joint Supply: When one product is a by-product of another.
Example: If you produce more Beef, you automatically produce more Leather.
Final Key Takeaway: Always look at the "big picture." If the price of electricity goes up, it affects the cost of production for almost every firm, shifting Supply to the left across hundreds of markets!