Chapter 2: The Price System and the Microeconomic

The Price Mechanism

The price mechanism is the means of allocating resources in a market economy. It follows three main functions:

  1. Rationing
  2. Signaling
  3. Transmission of preferences.


Demand is the quantity of product that the consumers are willing and are able to buy at various prices per period of time.

  • Notional demand: it is speculative and not always backed by to ability to pay.
  • Effective demand: it is supported by the ability to pay.


Demand Curve

The above figure shows the inverse relationship between price and quantity of goods is demanded.  The demand curve is downward sloping because when the price falls, the quantity demanded increases.

Factors influencing Demand

 The following factors may influence demand:

  1. Price
  2. Changes in Taste
  3. Income
  4. Change in distribution of income
  5. Changes in marketing strategy
  6. Changes in law
  7. Fashion


Supply is the quantity of product that the producers are willing and are able to sell at the particular time period.

                            Supply Curve

The above supply curve slows the relationship between the quantity supplied and the price of the product.

Changes in the price causes changes in the quantity supplied. The slope is upward.

Factors influencing Supply

The following factors may influence supply:

  1. Price of goods
  2. Change in the price of other products
  3. Change in Law
  4. Government Policy
  5. Subsidy

Price Elasticity of Demand

Price elasticity of demand (PED) is the measurement of the responsiveness of the quantity demanded to change in the price of product.

PED=(%change in quantity demanded of a product)/(%change in price of that product)

PED Graph

PED affects the gradient of demand curves.

  • The inelastic goods have vertical demand curve.
  • The perfectly elastic goods have horizontal demand curve.

Income elasticity of Demand

Income elasticity of demand (YED) is the measurement of the responsiveness of the quality demanded to the change in income.

YED=(%change in quantity demanded)/(%change in income)

For YED:

  • A negative YED indicates an inferior goods i.e. goods that are demanded less.
  • A YED of 0 indicates a necessity goods.
  • A positive YED between 0 and 1 indicates normal goods
  • A positive YED, greater than 1, indicates a superior goods i.e. goods which are highly in demand.

Cross Elasticity of Demand

Cross elasticity of demand (XED) is the measurement of responsiveness of quantity demanded of one product to change in price of another relatable product.

XED=(%change in quantity demanded of product A)/(%change in price of product B)

Elasticity of Supply

Price elasticity of supply (PES) is measurement of responsiveness of the quantity supplied to a change in the price of the product.

PES=(%change in quantity supplied)/(%change in price)

PES will always be positive because when the price of good increases, more will be supplied.

  • A PES greater than 1 is elastic
  • A PES less than 1 is inelastic.

Interaction of Demand and Supply

Equilibrium is the situation when demand and supply come together and fix the price in the market. The equilibrium position is affected by the shift in demand curve, a shift in supply curve or the combination of both.

Consumers and Producers Surplus

  • Consumer Surplus: The difference between the market price and the maximum price the consumer is willing to pay. It is the amount that the consumer benefits.
  • Producer Surplus: The difference between the price a producer is willing to accept and what is actually paid.