SAJC 2023 JC1 H2 Price Mechanism and its Applications Part 1 Lecture Notes Uploaded Version

Price Mechanism and its Applications Part 1: Demand, Supply and Price Determination 1 0 INTRODUCTION 4 1 PRICE MECHANISM AND ITS FUNCTION 1.1 Allocation of Scarce Resources in the Free Market 4 2 THEORY OF DEMAND 2.1 Definition of Demand 6 2.2 Demand Curve 6 2.3 Law of Demand 8 2.4 Individual vs. Market Demand 8 2.5 Price and Non-price Determinants of Demand 9 3 THEORY OF SUPPLY 3.1 Definition of Supply 19 3.2 Law of Supply 19 3.3 Supply Curve 19 3.4 Individual vs. Market Supply 21 3.5 Price and Non-price Determinants of Supply 22 4 PRICE DETERMINATION 4.1 The Interaction of Demand and Supply 29 4.2 Market Equilibrium 29 4.3 Demand and Supply Analysis 31 4.4 Effects of Changes in Both Demand and Supply 33 4.5 Effects of Changes in Demand for and Supply of Labour 37 5 CONSUMER AND PRODUCER SURPLUS 5.1 Consumer Surplus 5.2 Producer Surplus 40 42 6 GOVERNMENT INTERVENTION IN THE FREE MARKET 6.1 Price Control: Maximum Price (Price Ceiling) 44 6.2 Price Control: Minimum Price (Price Floor) 46 6.3 Indirect Taxes 47 PRICE MECHANISM AND ITS APPLICATIONS PART 1: DEMAND, SUPPLY AND PRICE DETERMINATION The theme on Price Mechanism and its Applications provides an introduction on how markets deal with the Central Problem of Economics, and how decisions are made by self- interested consumers and producers in markets. You will learn how market forces of demand and supply interact to bring about market equilibrium, allocating resources via the price mechanism to maximise social welfare. You will also be able to apply this knowledge to analyse market outcomes in different situations. ST ANDREW’S JUNIOR COLLEGE JC1 H2 ECONOMICS 2023

Price Mechanism and its Applications Part 1: Demand, Supply and Price Determination 2 6.4 Subsidies 49 6.5 Quantity Control: Quotas 51 Reading List and References 1. Colander, David. C (2006) “Supply and Demand” in Economics. 6th Edition, New York: McGraw Hill p 102-108 2. Colander, David. C (2006) “Using Supply and Demand” in Economics. 6th Edition, New York: McGraw Hill p 114-128 3. Sloman, John "Supply and Demand" in Economics. 6th Edition, UK: Prentice Hall 4. Colander, David. C (2006) “Using Supply and Demand” in Economics. 6th Edition, New York: McGraw Hill p 114-128 5. Economic Review, Volume 27 No. 1 September 2009 p.15-17 6. Mankiw, N. Gregory, Quah, Euston and Wilson, Peter (2008) “In the News” in Principles of Economics. An Asian Edition, Cengage Learning Asia Pte Ltd p 79 Learning Objectives By the end of this series of lectures and tutorials, you should be able to: ▪ Define demand and state the law of demand. ▪ Explain why the demand curve is downward sloping. ▪ Explain the relationship between individual demand and market demand. ▪ Explain the price and non-price determinants of demand. ▪ Distinguish the effects of a change in price and non-price factors of demand. ▪ Define consumer surplus. ▪ Illustrate and explain changes in consumer surplus diagrammatically. ▪ Define supply and state the law of supply. ▪ Explain why the supply curve is upward sloping. ▪ Explain the relationship between individual supply and market supply. ▪ State and explain the price and non-price determinants of supply. ▪ Distinguish the effects of a change in price and non-price factors of supply. ▪ Define producer surplus. ▪ Illustrate and explain changes in producer surplus diagrammatically. ▪ Define market equilibrium. ▪ Explain how market equilibrium is determined via the price mechanism diagrammatically. ▪ Explain how equilibrium price and quantity adjusts with changes in demand and/or supply. ▪ Explain the rationale for (i) price ceilings, (ii) price floors, (iii) indirect taxes, (iv) subsidies, and (v) quotas, and explain how they affect the market equilibrium. Concepts and Tools of Analysis ▪ Price mechanism ▪ Ceteris paribus

Price Mechanism and its Applications Part 1: Demand, Supply and Price Determination 3 ▪ Demand and its determinants ▪ Change in demand vs. change in quantity demanded ▪ Supply and its determinants ▪ Change in supply vs. change in quantity supplied ▪ Market equilibrium – equilibrium price and quantity ▪ Market disequilibrium – shortage and surplus ▪ Consumer expenditure and producer revenue ▪ Consumer and producer surplus ▪ Taxes and subsidies ▪ Price controls – maximum and minimum prices ▪ Quantity controls – quotas

Price Mechanism and its Applications Part 1: Demand, Supply and Price Determination 4 INTRODUCTION In the previous chapter, we were introduced to the Central Economic Problem and why economic agents need to make choices and incur opportunity costs. We also learnt how economic agents make decisions using the decision-making framework. In this chapter, we will examine in greater detail how markets deal with the Central Economic Problem and how decisions are made by economic agents in markets. 1. PRICE MECHANISM AND ITS FUNCTION In any economic system, scarce resources have to be allocated among competing uses. In the free economy, the price mechanism allocates scarce resources through signaling, incentive and rationing functions. • Signaling function . Changes in the forces of demand and supply determine the changes in the prices of an economy’s goods and services. Changes in prices provide information to producers and consumers about changes in market conditions. For example, if prices are rising due to higher demand, this is a signal to producers to expand production. • Incentive function: Changes in prices provide incentives for producers to reallocate their scare resources. Fo r example, rising prices act as an incentive for producers to allocate more resources to earn more profits. • Rationing function: Changes in prices enable scarce resources to be rationed to the parties who are most willing to pay. For example, when there is a shortage, those with greater willingness and ability to pay will bid up the price of the good, thus enabling the goods to be rationed to these buyers. Before looking at how the price mechanism works in the free market, we need to understand the factors that affect the forces of both demand and supply. Then we will be able to recognise how prices of goods and services are determined and explain how price s change through demand and supply analysis.

Price Mechanism and its Applications Part 1: Demand, Supply and Price Determination 5 Introduction to Demand and Supply How does Economics help us to understand the world around us? Read the short extract below: Have you wondered how prices of food are determined? What led to the increase in food prices observed? How may a government intervene to prevent the prices from rising further? To answer these questions, we need to understan d the interplay of demand and supply in the market. The price mechanism explains how the price and quantity of a good or service are being determined or influenced in the market. Every market has two sides – a demand (buying) side from the consumers and a supply (selling) side from the producers. Buyers and sellers in a market are led by an invisible hand (as characterised by Adam Smith) to determine the equilibrium pri ce and quantity in the market. The invisible hand is a metaphor used to describe the self -regulating behaviour of the marketplace (through the inte raction of the forces of demand and supply) to reach market equilibrium automatically. As illustrated in Figure 1 below, the equilibrium price (Pe) and equilibrium quantity (Qe) of a good are determined by the intersection of both the demand (D) and supply (S) curves. Changes in demand for and/or supply of a good will cause the demand and/or supply curves to shift. This will lead to a change in the market equilibrium price and quant