MM/EBM 2143 – Managerial Economics

02
Price Theory and its application

Ms. Sanduni Dilanka

 Exercise 01:

E.g. Suppose that there are three consumers, X, Y and Z in a market

each with demand function for eggs,

QdX = 80 – 3p, QdY = 200 – 5P and QdZ = 120 – 2P respectively.

a) Derive the market demand function for eggs.

b) Plot the three individual demand curves and the market demand
curve on the same set of axes.
c) If market price of an egg is Rs. 15.00, calculate the market demand
for eggs.
2
 Exercise 02:

The market supply of T-shirt is QsT = -40 + 20PT . As a result of an

improvement in the technology, suppose that producers supply function
becomes QsT = -10 + 20PT .
a) Derive the producers initial supply schedule
b) Derive the producers new supply schedule.
c) On one set of axes draw this producer’s supply curves before and after
the improvement in technology.
d) How many T-shirt does this producer supply at the price of Rs 100
before and after the improvement in technology?
e) What would happen if the price of T-shirt increases from Rs 100 to
200?

3
 Exercise 03:

Eg: There are 100 identical individuals in the market for rice, each with a
demand function given by Qdr = 70 – 2Pr and 100 identical producers of rice,
each with a function given by Qsr = -90 + 6Pr .

a) Find the market demand function and the market supply function for rice.
b) Find the market demand schedule and market supply schedule of rice.
c) Find the equilibrium price and quantity.
d) d) Plot on one set of axes, the market demand curve and the market supply
curve of rice and show the equilibrium point.

e) e) Take the market demand and supply functions of rice and obtain the
equilibrium price and quantity mathematically.
4
 What is Market…?

• Originally the word market designated a physical place where commodities

were bought and sold.

• We can divide markets into two types as follows based on the type of
commodity sold.
1. Goods Markets (Commodity markets)
2. Factor Markets

6/8/2019 5
Contd…

• Goods Markets
• Goods markets are those where goods and services are bought and sold
• The sellers in such markets are usually the firms; the buyers may be households, other firms
or the central authorities

• Factor Markets
• Factor Markets are those where factor services are bought and sold
• The sellers in such markets are the owners of factors of production (usually households) ;
the buyers are usually firms and the central authorities
6/8/2019 6
 Definition of Demand
1. Demand

Demand reflects the quantity that consumers are both willing

and able to buy at each alternative price.

Demand is a relationship indicating the quantity of a well-

defined commodity that consumers are both willing and able
to buy at each possible price during a given period of time,
when other factors determining demand, are held constant.
Effective Demand = Want + Purchasing Power
6/8/2019 7
 Demand Function

The above list of determinants can be summarized in functional

notation as;
Qdx = f (Px , Py , Y, S …..)

Where,
Qdx = Quantity demanded by households
Px = Price of the product
Py = Price of other products
Y = Consumer’s income
S = A host of sociological factors such as
number of children and place of residence 6/8/2019 8
Contd…
• We will not be able to understand the separate influences of each
of the above variables if we ask what happens, when everything
changes at once.

• To avoid this difficulty, we consider the influence of the

variables one at a time. (study the effect of changes in one
influence on quantity demanded assuming that all other
influences remain unchanged)

• The assumption that all other influences remain unchanged is

called ceteris paribus by economists.

Qdx = f (Px ) cet.par. (The price and quantity relationship when 6/8/2019 9

other factors are held constant)

 Demand and Price

• How will the quantity of a product demanded vary as its own

price varies?
“A basic economic hypothesis is that the lower the price of a
product, larger the quantity that will be demanded, other things
being equal”.
A higher / lower in price often cause a lower / higher in quantity
demanded for two reasons.
I. When the price of one good goes up and price of the other
goods does not change, this good become relatively more
costly.
6/8/2019 10
 Contd…

• Consumers are then inclined to substitute other goods for the

higher-priced goods. This is called the “Substitution Effect” of a
price change.

II. When the price of a particular good goes up, your real
income, number of units you can buy, declines, if other things
are being constant. Therefore you typically reduce the
quantity demanded. That is called “Income Effect” of the
price change.
6/8/2019 11
The Individual’s Demand for a commodity

• The relationship between the quantity of a commodity, that a

consumer wish to purchase per period of time, and the price of
that commodity, when other things held constant.

1. The Demand Schedule

• One way of showing the relationship between quantity

demanded and price.
• It is a numerical tabulation showing the quantity that is
demanded at selected prices.

6/8/2019 12
Demand Schedule for Beans

Price per Kg Quantity

(Rs) demanded per
month (Kg)
18 30
19 28
20 25
21 23
22 20
23 18 6/8/2019 13
Contd…

2. Demand Curve
A graphical presentation of the relationship between the product price
and the quantity demanded.

Price

10

5
Quantity
0 100 400 demanded 6/8/2019 14
 The Market Demand for a commodity

• The market demand for a commodity gives the alternative

amounts of the commodity demanded per time period, at various
alternative prices, by all the individuals in the market.
• The market demand for a given commodity is the horizontal
summation of the demand of the individual consumers in the
market.
Eg: If there are 1000 identical individuals in a market, each with
the demand for commodity X given by Qd = 38 – P; ceteris
paribus, calculate the market demand function.

6/8/2019 15
Contd…

Qd = 38 – P
Qd = 1000(38 – P)
Qd = 38000 – 1000P

E.g. Suppose that there are two people, A and B in a market each with
demand function for tea, QdxA = 38 – Px and QdxB = 78 – 2Px
respectively. Calculate the market demand function for tea.

Qdx = QdxA + QdxB

Qdx = (38 – Px) + (78 – 2Px)
Qdx = 116 – 3Px 6/8/2019 16
 Market Demand Schedule

E.g. Suppose that there are two identical individuals (as A and B) in a
market each with demand for commodity X.
Price Quantity demanded Market
by consumers Demand
A B
18 20 22 42
19 19 21 40
20 18 20 38
21 17 19 36 6/8/2019 17

22 16 18 34
 Market Demand Curve

The derivation of market demand curve by summing individual demand

curves is a theoretical operation. In practice, usually market demand
curve is derived by observing total quantities directly.
P
P
A B
20
20

18
6/8/2019 18

0 18 20 Qd 0 38 42 Qd
 Definition of Supply

• Supply is defined as the quantity of a good that producers are

willing and able to supply at a specified price and a specified
time.

• Supply must be distinguished from the total stock of a

commodity in existence.

• Supply is only the part of the stock which comes to the market in
response to the prevailing price.

6/8/2019 19
 Supply Function

The above list of determinants can be summarized in functional

notation as;

Qsx = f (Px , Py , T …..)

Where,
Qsx = Quantity of Supply
Px = Price of the product
Py = Prices of factors of production
T = Technology 6/8/2019 20
 The Supply Schedule

• Supply can be expressed in a tabular form called as a supply

schedule. This is the relationship between quantity supplied and
the price.

Price per liter Quantity

(Rs) supplied per
month (Liter)
18 13
19 15
20 17 6/8/2019 21

21 19
 Supply Curve

• A graphical presentation of the relationship between the product

price and the quantity supplied.

6/8/2019 22
 The Market Supply
• The market supply is the sum of amount supplied at each price
levels by the entire individual suppliers.

Price Quantity supplied by Market

producers supply
A B
18 13 11 24
19 15 13 28
20 17 15 32
21 19 17 36 6/8/2019 23

22 21 19 40
 Market Supply Curve

The individual supply curves have been added together to obtain the
market supply curve.
SB SA
S = SA + SB
20
19

0 13 15 17 0 28 32 6/8/2019 24
 Market Equilibrium

• Market equilibrium is a situation where buyers and sellers

agree to an exchange of a given quantity of a good at a
given price.
• Any other situation is considered as one of disequilibrium.
• The simple rule is that when the quantity demanded exceeds
the quantity supplied, market price would rise; and when the
quantity supply exceeds the quantity demanded, price would
fall.
• There will be one price at which the quantity demanded and
quantity supplied is perfectly equal. This unique price is called
the equilibrium price. 6/8/2019 25
 The equilibrium condition can be found by three methods
1. Using a Table – Equilibrium price and Quantity

Price (Rs) Quantity Quantity

demanded supplied
(units) (units)
18 42 24
19 40 28
20 38 32
21 35 35
22 34 40 6/8/2019 26

23 32 44
2. Using a Graph.

21

0 35 6/8/2019 27
Basic Concepts in Equilibrium

P
S
Excess
Supply
Excess Excess
demand supply
P1
price price
Excess
Demand
D
6/8/2019 28
0 Q1 Qd / Qs
Contd…

• Excess supply is when quantity supplied is more than quantity

demanded.

• Excess demand is when quantity supplied is less than quantity

demanded. That is called “Economic Shortage”.

6/8/2019 29
 Changes in Equilibrium
The equilibrium price will persist until there is a change in the
conditions of either demand or supply.
Eg: Suppose that the demand for Chinese rolls of university
students is given by Qdc = 700 – 50Pc and the supply function
Qsc = -300 + 50Pc .
a) Calculate the equilibrium price and quantity of the Chinese rolls.
b) Suppose that there is an increase in students bursary, so that a
new market demand curve is given by Qdc = 800 – 50Pc .
State the new equilibrium price and quantity.
 Elasticity

• Elasticity is the measurement of responsiveness.

• It is used to measure the degree of consumers responsiveness
(sensitivity) to price changes, income changes and changes in the
price of related products.
o The Price Elasticity of Demand
o Income Elasticity of Demand
o Cross Elasticity of Demand
• The elasticity concept has practical applications in several areas of
economics such as a firm’s pricing and production decisions and
6/8/2019
government’s taxation policy.
31
Contd…

• For example, a change in price is expected to lead to a change in

the quantity demanded of a good. Here, price is the independent
variable and quantity demanded is the dependent variable.

• It is also used to measure the responsiveness of supply to a

change in a determinant of supply.

6/8/2019 32
 Ranges of Elasticity
• Perfectly inelastic – Price change does not lead to any change in
quantity demanded.
• Inelastic – Change in price leads to a less than proportionate
decrease in demand.
• Unit Elasticity – Changes in price results in an exactly
proportionate change in quantity.
• Elastic – Change in price leads to a more than proportionate
change in demand.
• Perfectly elastic – Buyers buy all they can at the given price, but
nothing at a higher price.

6/8/2019 33
 Perfectly Inelastic

P
D
ED = 0

0 6/8/2019
Qd 34
 Unitary Elastic

ED = 1

D
0 6/8/2019
Qd 35
 Perfectly Elastic

ED = ∞

0 6/8/2019
Qd 36
 Elastic

P
ED > 1

0 6/8/2019
Qd 37
 Inelastic

ED < 1

0 6/8/2019
Qd 38
 Elasticity along a Linear Demand Curve
P
ep = ∞
10 Elastic
D
ep = 2.33
7
ep = 1 Inelastic
5
ep = 0.25
2
ep = 0
0 6 10 16 20 Qd 6/8/2019 39
The range of values of the elasticity is;

0 ≤ ED ≤ ∞

If ED = 0, the demand is perfectly inelastic or zero price elasticity

If ED = 1, the demand has unitary elasticity
If ED = ∞, the demand is perfectly elastic
If 0 < ED < 1, we say the demand is inelastic
If 1 < ED < ∞, we say the demand is elastic 6/8/2019 40
 Different types of Elasticity

Elasticity

Demand Supply

Price Cross Income Price

6/8/2019 41
 Point Elasticity of Demand

• Point elasticity of demand measures the elasticity at any given point

on the demand curve.
• It can be defined as the proportionate change in the quantity
demanded resulting from a very small proportionate change in the
price.

ed = ∆Q * P
∆P Q

Eg: Considering demand function Qd = 100 – 20P calculate the

6/8/2019 42
price elasticity at Rs. 2/=
 Arc Elasticity of Demand

• When the price change of a commodity is significant, point

elasticity gives us two coefficients when the price is increased and
when the price is decreased.

• We can measure the price elasticity between two points on the

demand curve. This measurement is called as Arc (price) elasticity
of demand.

• Here we use average two prices and average two quantities in the
calculation. 6/8/2019 43
 (P2 + P1)
∆Q 2
ed = *
∆P (Q2 + Q1)
2

ed = (Q2 – Q1) * (P2 + P1)

(P2 – P1) (Q2 + Q1)

• Where the 1 and 2 refer to the initial and to the new values,
respectively.
• The price elasticity of demand in general differs at every point
along the demand curve. Arc elasticity is therefore, only an
6/8/2019 44
estimate.
Exercise
Eg: Given the market demand schedule in the following table, find
the price elasticity of demand for a movement from point A to point
B.

Point Px Qdx
A 4 160
B 8 80

6/8/2019 45
 Exercise 03:

Eg: Suppose that the market demand for Vegetable is Qd = 50 – 5p.

a) Find the arc price elasticity for a movement from Rs 5 to Rs 10.

b) Calculate the price elasticity at Rs 2 and Rs 3.
c) Show that the price elasticity of demand is unity at the middle point of the
demand curve.

6/8/2019 46
 The Price Elasticity of Demand (PED)

Eg: Suppose that the demand schedule for eggs is as follows;

Price Quantity Demanded

4.00 50000
4.50 45000
5.00 40000
5.50 35000
Calculate the price elasticity of demand at price Rs. 4.00,
6/8/2019 47
Rs. 4.50, and Rs. 5.00
Determinants of Price Elasticity of Demand

• Availability of substitute goods

• Degree of Necessity
• Force of Habit
• Definition of a product
• Product durability
• Insignificant spending on a good
• Time factor 6/8/2019 48
 Practical Importance of PED

• Ifthe product has elastic demand, the seller can earn more
revenue by reducing the price of that product.
• If the product has inelastic demand, the seller can earn more
revenue by increasing the price.
• A supermarket dealer gains by reducing price. He relies on a
high volume of sales, keeping a small margin on each
transaction.
• A monopolist is a sole supplier of a product to the market and
there will be no competitors and no substitutes. The demand for
his product will be inelastic and he can increase his revenue by
increasing the price. 6/8/2019 49
Contd…
• In a perfectively competitive market, where all sellers are selling
a identical product, the demand curve faced by a single seller is
perfectly elastic. If one seller raises the price of his product,
buyers will turn to the readily available perfect substitute
provided by his rivals and the sales of the former would drop to
zero.
• For government too, the concept of PED is important.
• It can earn more revenue by imposing taxes on goods that
have inelastic demand (e.g. cigarettes and liquor)
• Government can control inflation by imposing taxes on goods
which have elastic demand
6/8/2019 50
Income Elasticity of Demand
The following equation expresses the market demand for shoes in Colombo as
a function of the price of shoes and per capita disposable income;

Qd = 15000 – 25p + 2.5y

Where,
Qd = Number of shoes sold
p = Price of shoes
y = Per capita disposable personal income

Suppose one is interested in determining the income elasticity when the Price =
Rs 800 and per capita personal income = Rs 6000.
6/8/2019 51
Calculate the income elasticity
 Identifying Type of Good through YED
Coefficient
• The YED coefficient can either be positive or negative
depending on the nature of the good and the relationship
between the change in income and the resulting change in
quantity demanded.

• The particular good may be a luxury, a normal good or an

inferior good.

• For luxuries, YED will be >1; for necessaries, YED will be a

positive value between 0 and 1; for inferior goods, YED will have
a negative value. 6/8/2019 52
 Practical Importance of YED

• YED is important for a firm’s product decision.

• If peoples’ incomes are rising, then a producer should shift

resources from producing basic necessities to luxury items, and
electrical and electronic goods. Consumer demand is likely to
rise for personal computers, i-pads, i-pods, musical equipment,
kitchen appliances, entertainment etc. but not so much for
basic necessities.

6/8/2019 53
Practical implication of Cross Elasticity of Demand?????
Thank you…!!!

55