The price theory
The price theory is the basis of exchange in economics. It is the study of price and its determinants. Prices are relative values of goods and services at a particular time.
In a market, buyers and sellers exchange goods or services at a price – where money is always used as a medium of exchange. Historically most transactions took place via a barter system. Barter suffers from the problems of double coincidence of wants.
How is price determined in the market?
- Forces of demand and supply
- Haggling a(process of bargaining)
- Sales auction
- Fixing prices by treaties
- In some countries, prices can be fixed by government. The government can set a pricefor certain products (price ceiling). Any company selling above may be punished.
Equilibrium Price (market clearing price)
Equilibrium is a state of rest when there is no reason for anything to change unless disturbed by an outside shock.
The equilibrium price is the price that equates the quantity supplied and quantity demanded. Under the market mechanism, there is a tendency, in a free market, for prices to change until the market clears (at a market clearing price) – that is, until the quantity supplied equals quantity demanded.
There is not always an equilibrium. Sometimes there can be a shortage or even a surplus.
A shortage is a situation in which the quantity demanded exceeds quantity supplied. During a shortage, consumers trying to obtain goods they require outcompete each other by paying higher prices for the goods; and this will entice producers to produce more.
There is also a surplus – a situation in which the quantity supplied exceeds quantity demanded.
ELASTICITY
Elasticity is useful in explaining relationships between two variables. It is independent of the units, such as quantity or price units in which the variables are measured. It can simply be referred to as the responsiveness of dependent variables to independent variables.
The knowledge of elasticity of either supply and/or demand is particularly useful to decision makers – whether in government or private sector. For example if we are informed that the demand elasticity of fresh fish fillets to the EU is 2, then it means that a 1% price rise causes a 2% fall in quantity demanded.
Here we are saying that the elasticity is -2 as the price causes a fall in quantity demanded (The minus sign is always committed). The more elastic the demand and supply curves, the greater will be the decline or fall in sales.
Importance of elasticity
Elasticity and government taxation: The size of the elasticity for a product will indicate the extent to which aproduct’s sales may fall when a tax is imposed. The more elastic the demand and supply curves, the greater the decline in sales. Government tax revenue equals the amount of the tax multiplied by the after tax quantity of sales. Noting this therefore, the government will experience the lowest loss in tax revenue when it imposes a tax on goods with low demand and supply elasticity. And vice versa.
Elasticity can also be inelastic. Inelastic demand elasticity means that, whether you increase or reduce the price of such a product, its demand will not necessarily increase or fall. An example is salt. Households will not buy more salt simply due to a fall in its price. They will continue to buy that amount that they need for use.
Elasticity of supply: degree of responsiveness of quantity supplied to factors (variables) which influence the quantity supplied. The independent variables that influence quantity supplied include price of the commodity, price of other commodities such as substitutes, price and cost of factors of production, level of technology, government policy on that particular commodity (taxation, subsidization etc.), demand, and number of producers, and the goals of firms in the sector.
Elasticity of demand: degree of responsiveness of quantity demanded to the independent variables which influence quantity demanded. The factors that influence quantity demanded include the price of the commodity, income levels of the potential consumers and the prices of other commodities such as substitutes.
Price elasticity of supply: The supply curve normally slopes upwards from left to right – from point O of the quantity supplied and price curves. Price elasticity of supply can be referred to as unit elasticity of supply, elastic supply, and inelastic supply.
Price elasticity of demand
This explains the relationship between quantity demanded and the changes in the price of the commodity.
Income elasticity of demand
This measures how demand responds to a change in income. It is always positive for a normal good but negative for an inferior good. The quantity demanded of an inferior good falls as income rises. Normal goods can be divided into luxury or superior goods and essential or basic goods.
Essential goods have an elasticity of less than one. Demand for basic goods such as soap, beans, etc. rises at a slower rate than income. Income elasticity of demand for luxuries is greater than unity. Quantity demanded of luxuries such as dishwashers, luxury cars, etc. rises more than proportionately with income.
Please note the following:
An income elasticity of demand which is greater than 1 (>1) means that there is more demand for the quantity demanded. There is a bigger proportionate increase in quantity demanded.
When there is an increase in income, there can happen the following;
- An increase in demand for the commodity in question
- A decrease in demand
- No change in quantity demanded of a commodity in question
For most goods (luxuries and essential commodities) income elasticity of demand will be positive.
Income elasticity: income elasticity is greater than one. Quantity demanded will change proportionately more than a change in income (ceteris paribus). It is income that is a key determinant of quantity demanded here. So an increase in consumers income will result in an increase in quantity
demanded. Whereas a fall in consumers income will lead to a decrease in quantity demanded. This applies to normal goods.
Income inelasticity: a situation where income elasticity of demand is less than one but greater than zero. A percentage change in income leads to less percentage change in quantity demanded. We can say the following:
- For inferior goods, the quantity demanded decreases as incomes increase.
- For normal goods, as the income increases, the quantity demanded also increases.
- For necessities, as income rises, the quantity demanded remains constant. Salt is a common example.
Importance of income elasticity
- Income elasticity is helps to estimate future demand. It should help producers plan future output. As income increases, the producers should increase supply.
- Knowing the income elasticity of necessities, inferior goods, luxuries and non – essential goods helps investors decide where to put their money to gain future market.
Cross elasticity of demand.
Is the measure of the degree of responsiveness of quantity demanded of a commodity (say meat) to changes in prices of other commodities (say chicken, rice, beans, etc.). It describes the complementary or substitute relationship between two commodities. A cross elasticity of demand of – 0.1 for milk with respect to the price of sugar indicates that a 10% rise in the price of sugar is associated with a 1% fall in the demand for meat.
CONSUMER BEHAVIOR AND INDIVIDUAL’S CONSUMPTION CHOICES
Consumption: the process by which goods and services are put to final use by people. People refers to two groups of individuals – the customer who pays for the good or services; and the consumer who is the ultimate user of the good or services that have been purchased by the
customer. Sometimes, the customer is at the same time the consumer. The importance of consumption is that it is the indicators for what quantities the market wants – or will require in the future.
From Adam Smith onwards, much of economic discourse has assumed that everything about the successful functioning of the economy is anchored in the final demand for goods and services. Adam Smith, in 1770s, said that “Consumption is the sole end and purpose of all production and the welfare of the producer ought to be attended to, only so far as it may be necessary for promoting that of the consumer”.
The consumer as sovereign: traditional economics approach therefore views the consumer as sovereign. Consumer sovereignty is the belief that consumer satisfaction – consumers’ needs and wants – determine the nature of all economic activities in an economy. Each consumer behaves in a rational manner to maximize his/her self-interest in order to maximize satisfaction. Consumer’s needs and wants determine the shape of all economic activities in an economy. Economic activities are there to satisfy consumer choices. S/he dictates what the market has to deliver – so that s/he consumes it. The consumer is a king.
