NJC SH1 H1 H2 Econs Chap 2A

CHAPTER 2A Markets: Price Mechanism and its Applications (Demand and Supply) OVERVIEW OF CHAPTER ........................................................................................................................................ 1 1. INTRODUCTION ..................................................................................................................................................... 2 1.1 THE PRICE MECHANISM AND ITS ESSENTIAL ROLE OF RATIONING ............................................ 2 1.1.1 THE PRICE MECHANISM AND HOW IT ANSWERS THE THREE ECONOMIC QUESTIONS 2 1.2 KEY FEATURES OF THE FREE MARKET ECONOMY ........................................................................... 5 1.2.1 THE PRICE MECHANISM ...................................................................................................................... 6 2. THEORY OF DEMAND .......................................................................................................................................... 7 2.1 LAW OF DIMINISHING MARGINAL UTILITY ......................................................................................... 9 2.2 INDIVIDUAL DEMAND VERSUS MARKET DEMAND ........................................................................ 11 2.3 THE LAW OF DEMAND .............................................................................................................................. 12 2.4 CHANGE IN QUANTITY DEMANDED VERSUS CHANGE IN DEMAND .......................................... 12 2.5 NON-PRICE DETERMINANTS OF DEMAND ......................................................................................... 13 2.6 DERIVED DEMAND ..................................................................................................................................... 19 3. THEORY OF SUPPLY .......................................................................................................................................... 20 3.1 THE LAW OF INCREASING OPPORTUNITY COST ………………………………………………………….. 22 3.2 INDIVIDUAL FIRM SUPPLY VERSUS MARKET SUPPLY .................................................................. 23 3.3 THE LAW OF SUPPLY ................................................................................................................................. 24 3.4 CHANGE IN QUANTITY SUPPLIED VERSUS CHANGE IN SUPPLY ................................................. 24 3.5 NON-PRICE DETERMINANTS OF SUPPLY ........................................................................................... 25 4. MARKET EQUILIBRIUM ................................................................................................................................... 30 4.1 THE PRICE MECHANISM REVISITED .................................................................................................... 31 4.2 THE CONCEPT OF CONSUMER SURPLUS (FOR H2 ONLY) ............................................................. 36 4.3 THE CONCEPT OF PRODUCER SURPLUS (FOR H2 ONLY).............................................................. 38 5. DECISION-MAKING EXAMPLE……………………………………….……………………………………………………..41

2025 SH1H1/ H2 Economics Chapter 2A National Junior College H1 / H2 Economics – 8843 / 9570 1 OVERVIEW OF CHAPTER In his book The Wealth of Nations (1776), Adam Smith argued that economic agents in pursuit of their own self-interest invariably allocate resources in society’s best interest. Smith argued that although the free market economy appears chaotic and unrestrained, it is actually guided to produce the right amount and variety of goods by a so -called “invisible hand”. If a product shortage occurs, for instance, its price rises, thereby creating incentives for its production, and eventually resolving the resulting shortage. The market forces described here, working through the price mechanism, are the essence of Adam Smith’s “invisible hand”. KEY DECISIONS RELATED TO THIS CHAPTER ✴ Consumers decide what goods and services to consume to meet their wants given their limited purchasing power. ✴ Producers decide what goods and services to produce, how much to produce and how to produce, given their limited resources. KEY ECONOMIC AGENTS ✴ Consumers ✴ Producers

2025 SH1H1/ H2 Economics Chapter 2A National Junior College H1 / H2 Economics – 8843 / 9570 2 1. INTRODUCTION 1.1 THE PRICE MECHANISM AND ITS ESSENTIAL ROLE OF RATIONING In Chapter 1, you have learnt that all societies face the problem of scarcity; where unlimited human wants exceed limited resources. As a result, there has to be some method to ration the available resources, goods and services. The price mechanism, which you will learn in this chapter, performs this rationing function. Other examples include rationing by coupons, lotteries, and queues (first-come-first-served basis). Governments may arrange for rationing, too. There is no one best method of rationing. However, economists say that rationing via the price mechanism leads to the most efficient use of available resources. 1.1.1 THE PRICE MECHANISM AND HOW IT ANSWERS THE THREE ECONOMIC QUESTIONS The price mechanism describes the means by which various decisions are made by consumers and firms interacting to determine the allocation of scarce resources between competing uses. Prices are signals to reflect what is relatively scarce and what is relatively abundant. This signaling aspect of the price mechanism provides information to buyers and sellers about what should be bought and what should be produced. Learning Objectives Describe the features of a free market economy Explain the role of price mechanism in resource allocation in a market-based economy

2025 SH1H1/ H2 Economics Chapter 2A National Junior College H1 / H2 Economics – 8843 / 9570 3 a. What and how much to produce? In a free market system, the interaction of demand and supply for each good determines what and how much to produce. Consumers indicate their preferences by the price they are willing to pay for various goods and services. The prices then act as a signal to producers indicating what goods are demanded by consumers (also known as Consumer Sovereignty). Producers respond to the price signals by increasing or reducing the production of the respective goods and services. For instance, a rise in demand for a particular good is signaled by a rise in price, ceteris paribus. The higher price of this good relative to its cost of production is signaling that consumers are willing to see resources diverted from other uses. The rise in price acts as an incentive for production (i.e. quantity supplied) to rise, as firms’ profits will increase by selling more of the good at the higher price. Firms divert resources from goods with lower prices relative to costs (and hence lower profits) to those goods that are more profitable. In this way, resources are allocated to goods which are demanded by consumers (consumer sovereignty), thus addressing the question “what to produce”. At the same time, more resources are diverted from goods with lower demand to goods with higher demand, thus determining “how much to produce”. b. How to produce? In a free market system, competition forces firms to use the least cost combination of inputs to produce a given level of output. This is because the least cost combination helps firms to earn higher profits (recall the objective of firms in Chapter 1). Any firm that does not employ the least costly production technique will find that other firms can undercut its price, causing it to lose its customers and this inefficient firm will eventually be forced out of business. The price mechanism helps producers i n determining the method of production based on the prices of inputs. If the price of labour (wages) r