DDSS Summary Notes 2023

Price Mechanism & Applications – Summary Important: This set of summary notes does NOT replace the importance of the main set of notes in providing a clear understanding of the topic that is required in the A Levels. Check list – Key requirements. Part (1) Explain how the price mechanism allocates resources in a free market Identify the determinants of demand and supply, and explain how they influence demand and supply Explain and analyse how prices are determined by free market forces of demand and supply. Ability to explain simultaneous shifts of both demand and supply. Part (2) Define the concepts of price elasticity of demand/supply (PED/PES), cross elasticity of demand (CED) and income elasticity of demand (YED). Explain the determinants of PED, PES, CED and YED. Analyse the extent of changes in price and quantity in response to shifts in demand or supply, using PES or PED respectively. Analyse the change in revenue in response to changes in price using PED. Analyse the direction and extent of shift in demand in response to changes in price of related goods or income, using CED or YED respectively. Explain the relevance of PED, CED and YED to a firm’s decision-making. Define the types of government intervention such as taxes (direct vs indirect), subsidies (direct vs indirect), price controls and quantity controls. Distinguish between price floor/ceiling, explain the resultant surplus/shortage, and analyse the size of the surplus/shortage using PED and PES. Explain the mechanism of the different government interventions in the market, and the effects on price, quantity, welfare and government revenue/expenditure. Explain the determinants of labour demand and labour supply, and how they interact to determine wage and employment. Key information Part (1) • The price mechanism is the invisible hand that allocates resources, based on the self - interest of consumers and producers, to result in the right mix of goods and services for society. • Market Adjustment Process / Price Adjustment Mechanism: (fall in price when dd falls) – At the initial price, there is a surplus in the market since quantity supplied exceeds the quantity demanded resulting in a downward pressure on the price. To sell their surplus, producers will begin to lower prices. As pri ce falls, consumers are willing and able to buy more causing quantity demanded to increase. As price falls, producers will also be less incentivised to produce due to a fall in profitability, causing quantity supplied to decrease. • The Law of Demand states that the quantity demanded of a good/service is inversely related to its price, ceteris paribus. This can be explained by the Law of Diminishing Marginal Utility which states that beyond a certain point of consumption, each extra unit consumed gives less additional utility than previous units. In maximising utility with a given budget, the rational consumer will increase the quantity demanded as price decreases, and vice versa.

• The demand curve is downward sloping due also to the substitution and income effect. • Factors affecting the demand curve (shift): o Taste and Preferences o Seasonal changes / climate o Expectation of future prices o Income o Prices of related goods  Substitutes  Complements o Derived demand o Govt policy  Direct subsidy / Tax  Interest rates  Exchange rates • Law of Supply - The quantity supplied is directly related to the price of a product. The higher the price of a good, the greater the quantity supplied and vice versa, ceteris paribus. • Factors affecting the supply curve (shift): o Cost of Production / Prices of Factors of Production o Innovation / State of Technology o Natural factors o Number of firms o Government Policies  Indirect Taxes / Subsidies o Prices of related goods  Joint supply  Competitive supply o Expectation of future prices • Economic Welfare o Consumers’ Surplus - is the difference between the maximum amount that consumers are willing and able to pay for a given quantity of a good and what they actually pay. o Producers’ Surplus - is the difference between the amount received by producers for selling their good and the minimum prices that they are willing and able to accept for supplying additional units of the good. • 3 main functions of prices - the price mechanism seeks to address the resource allocation questions of what and how much to produce, how to produce and for whom to produce. o Signaling Function - prices communicate information to decision-makers. 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 re- allocate to different industries due to this signalling function. o Incentives Function - motivates a consumer or producer to change his behaviour. Higher market prices of a good motivate existing producers to increase output due to the possibility of more revenue and higher profits (assuming firms maximise profits) while a fall in price of a good provides an incentive to consumers to increase their quantity of the good demanded as they seek to maximise their utility. o Rationing Function - Prices will ration the good/resource to consumers/producers who are willing and able to pay for it. Whenever there is a shortage, the market price will

increase and the effect is to discour age consumption and conserve resources. Consumers or producers who are not willing and/or unable to pay for the good/resource will be rationed out of the market. • The price mechanism achieves allocative efficiency by clearing shortages or surpluses in markets through signalling. • The price mechanism allows for productive efficiency to be achieved in competitive markets as the adjustment of factor prices in the factor markets act as a signal and incentive for producers to adjust their production methods. Part (2) • Price Elasticity of Demand (PED is a measure of the degree of responsiveness of the quantity demanded of a good to a change in its price, ceteris paribus. o PED: The sign of PED is normally negative because of the inverse relationship between price and quantity demanded. o Size ranges between 0 to infinity and indicates the sensitivity of consumers to price changes. • Determinants of PED o Substitutes – Number and Closeness of substitutes o Habitual Consumption o Income – Proportion of Income spent on the good o Time period • Application of PED - The concept of PED is most relevant when there are price changes, typically resulting from changes in supply in a perfectly competitive market. When supply changes, the extent to which price and quantity demanded changes depends on PED. o Use of PED to explain changes in total revenue/total expenditure. o Use of PED to make a few beneficial decisions – Pricing decisions. Non-pricing decisions to make it less price elastic in demand. • Price elasticity of supply (PES) is a measure of the degree of responsiveness of the quantity supplied of a good to a change in its price, ceteris paribus. o PES: The sign of PES is normally positive because of the direct relationship between price and quantity supplied. o Size ranges between 0 to infinity and indicates the sensitivity of producers to price changes. The larger the magnitude of the coefficient the greater the sensitivity of producers to price changes. • Determinants of PES o Level of Stock/inventory o Availability of Spare Capacity o Mobility of Factors of Production o Time horizon o Length of production period • Application of PES - The concept of PES is most relevant when there are price changes resulting from changes in demand in a perfectly competitive market. When demand changes, the extent to which price and quantity supplied changes depends on PES.

o PES is not relevant to explain chang