RI H1 Economics Lecture Notes 2 Price Mechanism and Its Applications

Year 5 H1 Economics 2018 Microeconomics Lecture Notes Price Mechanism and its Applications Raffles Institution 22 Economics Department RAFFLES INSTITUTION YEAR 5 H1 ECONOMICS 2018 PRICE MECHANISM AND ITS APPLICATIONS 1. Demand-Supply model 1.1 The Market System 1.2 The Price Mechanism 1.3 Market Equilibrium 1.4 Changes in Demand and Supply 2. Economic Efficiency and the Price Mechanism 2.1 Allocative Efficiency 2.2 Productive Efficiency 2.3 How desirable is the free market equilibrium 3. Demand Theory 3.1 The Definition of Demand 3.2 The Law of Demand 3.3 Factors Influencing Market Demand 3.4 Distinction btw changes in Quantity Demanded and changes in Demand 4. Supply Theory 4.1 Definition of Supply 4.2 The Law of Supply 4.3 Factors Influencing Market Supply 4.4 Distinction btw changes in Quantity Supplied and changes in Supply 5. The Labor Market: Application of Demand and Supply 5.1 Wage Determination 5.2 Non-Wage Determination of Demand and Supply of Labor 6. Elasticities of Demand and Supply 5.1 Price Elasticity of Demand (PED) 5.2 Price Elasticity of Supply (PES) 6. Government Intervention in the Market (Market Level Analysis) 6.1 Taxation 6.2 Subsidies 6.3 Applications of Elasticities of Demand & Supply to Primary Commodities and Manufactured Products 6.4 Problems with the Use & Application of Elasticity Concepts 6.5 Price Controls: Maximum Price/Minimum Price / Application to Factor Market 6.6 Quantity Controls – Quotas 6.7 Consequences of Government Intervention: Intended and Unintended Reference: Gillespie, Andrew. Foundations of Economics, 2nd Edition, New York: Oxford University Press Lecture Objectives: After this series of lectures and tutorials, students should understand how the demand and supply model can be applied in the real world context. They should be able to apply demand and supply analysis to various markets such as primary products, manufactured goods, housing, healthcare, education, and labour market (wages). @dream

Year 5 H1 Economics 2018 Microeconomics Lecture Notes Price Mechanism and its applications Raffles Institution 23 Economics Department 1. DEMAND-SUPPLY MODEL 1.1 The Market System In the free market system (free of government intervention), resources are allocated according to the market forces of demand and supply. It is the level of demand and supply of each factor of production or final good or service that determine their respective prices and quantities traded. A market is present wherever and whenever buyers and sellers interact. 1.2 The Price Mechanism • According to Adam Smith (1776) The Wealth of Nations, the price mechanism is the invisible hand that allocates resources, based on the self -interest of consumers and producers, which results in the right mix of goods and services for society. What are the main functions of the price mechanism? • It has 2 main functions which are i. Signalling (the allocative function) ii. Rationing (the distributive function) i. Signalling function: When the market price of a product or resource changes, it sends a contrasting message to consumers and producers about whether to enter or leave a market. Prices rise and fall to reflect scarcity and surpluses. Rising prices give a signal to consumers to cut back on the buying or even withdraw from a market completely. However, the higher price gives a signal to potential producers to enter a market. Resources move or reallocate to different industries due to this signalling function. The signalling function is associated with shifts in demand and supply curves. Changes in the price level convey information to buyers and sellers. Price movements signal either a shortage or surplus in a market. Consumers and producers have an incentive to respond to this information. Consumers adjust their quantity demanded. Producers adjust their quantity supplied. The shortage or surplus is cleared. Fig. 1: Overview of Signalling Recall: The price mechanism was previously defined as the system of allocating resources using price adjustments caused by market forces in a free market economy. Recall: Consumers have the objective of maximising utility (satisfaction) @dream

Year 5 H1 Economics 2018 Microeconomics Lecture Notes Price Mechanism and its applications Raffles Institution 24 Economics Department For example, if there is a bumper harvest for durians, then there is an increase in its supply and the price falls. This tells consumers that durian is relatively cheaper due to the surplus and the consumers will respond and increase their quantity of durian demanded. If wearable technology becomes more popular, the price of powerful computer chips will go up due to an increase in demand for faster devices. This tells chip producers there is a shortage in the market and profit motivated firms will put in more workers and increase the output of these chips. In terms of the labour market, a rise in the wage rate, which is the price of labour, provides a signal to the unemployed to join the labour market. ii. Rationing function: In a free market, prices will ration the good or resource to consumers or producers who are willing and able to pay for it. In other words, whenever there is a shortage, the market price will be higher and the effect is to discourage consumption and conserve resources. The greater the shortage, the higher the price and the more the good or resource is rationed to only those who wants it and can afford it at that higher price. This can be seen in the market for oil. As oil slowly runs out, its price will rise, and this discourages consumption and leads to more oil being conserved than at lower prices. 1.3 Market Equilibrium The meaning of “market” A market is a medium that allows buyers and sellers of a specific good, service or resource to interact in order to facilitate an exchange. It may either be a physical marketplace where people or resource owners and buyers come together to exchange goods and services in person, as in a bazaar or shopping centre or office workspace. It can also be a virtual market where buyers and sellers do not interact face to face, as in an online market. Note that markets for resources are just as important as goods markets in the study of economics. The meaning of “equilibrium”: A situation when quantity demanded and supplied are equal at a particular price level and there is no inherent tendency to change. Equilibrium Price and Output  The equilibrium price is the price at which the quantity demanded of a good is equal to the quantity supplied, i.e., the price at which the equilibrium quantity is traded.  Equilibrium price can therefore be referred to as the market clearing price.  At any other price where quantity demanded and quantity supplied are not the same, the market is said to be in disequilibrium. There will be shortages or surpluses of the good in the market. Point to ponder: What assumptions have to be made for equilibrium to exist? Point to ponder: Which markets are you most familiar with? @dream

Year 5 H1 Economics 2018 Microeconomics Lecture Notes Price Mechanism and its applications Raffles Institution 25 Economics Department Lecture Exercise 1 i. Complete the rightmost column in the Table 1 by indicating whether there is a shortage or surplus. ii. Identify the equilibrium price and quantity. iii. What do you notice about the relationship between price and