# Chapter 4: Price Determination

The price of an item in a market-based economy is determined by the forces of demand and supply. It is the equilibrium point where supply intersects with supply. Therefore, price determination in economics is based on the intersection of demand and supply curves.

The Concept of Equilibrium in Economics

Equilibrium in economics refers to a situation in which the forces that determine the behavior of variables are in balance and therefore exert no pressure on these variables to change. In equilibrium the actions of all economic agents are mutually consistent. Market equilibrium occurs when the quantity of a commodity demanded in the market per unit equals the quantity of the commodity supplied to the market over the same period of time. Geometrically, equilibrium occurs at the intersection point of the commodity’s market demand and market supply curve. The price and quantity at the equilibrium are known as the equilibrium price and equilibrium quantity respectively. The price PE is also referred to as market clearing point. At this equilibrium point the amount that producers are willing and able to supply in the market is just equal to the amount that consumers are willing and able to demand. Both consumers and producers are satisfied and there is no pressure on prices to change and thus the market for goods is said to be at equilibrium.

This is illustrated in Figure 2.13 Equilibrium point Figure 2.13

Equilibrium can be defined as a state of rest or balance in which no economic forces are being generated to change the situation. Economic forces lead to excess demand and supply and are illustrated in Figure 2.14. At P1, the quantity demanded by consumers is Q1 units but producers are willing to supply at that price a quantity of Q2 units. Therefore, there is an excess supply equal to (Q2 –Q1). Excess supply refers to a situation where quantity demanded is less than quantity supplied at prevailing market price. Producers may therefore react to the excess supply by lowering prices of their products so as to sell the unsold stocks. Excess supply is referred to as a buyer’s market since suppliers may be obliged to lower their prices in order to dispose of excess output; a situation which is favorable to buyers. Excess supply represents an economic force that exerts downward pressure on prices. At P2 the quantity demanded is Q2 but producers are willing to supply Q1 units of goods. Therefore, there will be excess demand equal to (Q2-Q1). This situation of excess demand is referred to as sellers’ market because competition among buyers will force up the price due to the existing shortage. Excess demand is a situation where quantity demanded is greater than quantity supplied at prevailing market prices.

In this case, the price of goods will rise because of competition among buyers. Excess demand represents an economic force on prices which exerts upward pressure. Prices P1 and P2 are disequilibrium prices and market is said to be at disequilibrium.

The following economic function has been derived by the finance manager of Kenya Breweries ltd.

In studying equilibrium, our objective is to determine the market price and quantity and try to identify the forces that influence such a price and quantity.

• Equilibrium can be defined as a state of rest. It is a situation whereby quantity demanded is equal to quantity supplied.
• In this case, we say that the market is clearing and there are no economic forces generated to change this point hence it is stable.
• We determine this graphically by the interpretation point of the demand and supply curves as below.

In the above diagram it can be seen that the forces of demand and supply determine the price in the market, i.e. a price at which both consumers and sellers are happy and where quantity supplied equals quantity demanded. That price is known as the equilibrium price.

In the diagram, should the price be above the equilibrium price, forces of demand and supply will work together and lower the price towards the equilibrium price until the equilibrium price is reached. For example at consumers will only be willing to buy from the market while sellers will by willing to supply. In this case an excess supply which equals to Q2-Q1 will be created. Because of this excess supply, sellers will have to reduce the price in an attempt to encourage consumers to buy more. Prices will be reduced until a point is reached where quantity demanded equals quantity supplied.

Should the price be below the equilibrium price (e.g. at P2) again the forces of demand and supply will work together to ensure equilibrium is restored. At this price suppliers are not willing to supply because they consider the price to be very low. On the other hand, consumers will be willing to buy since very many of them can afford to pay. In this case, an excess demand (shortage) equal to Q4-Q3 will be created. Because of shortages, consumers will compete among themselves for the little that is available and because of this competition, prices will be pushed upwards until equilibrium is eventually is reached.

Mathematical Derivation of Equilibrium

You are given the following functions:

Q1 = 1526 + 240p

Q2 = 3550 – 266p

Which of the two functions is a demand function and which one of them is a supply function? Determine the equilibrium price and quantity.

Solution:

The demand function is 3550 – 266p because it has a negative slope, while the supply function is Q1 = 1526 + 240p because it has a positive slope.

Equilibrium point is where demand is equal to supply, which is given as:

Q1 = Q2

1526 + 240p = 3550 – 266p

When you collect the like terms, you rearrange the equation as follows:

240p + 266p = 3550 – 1526

506p = 2024

P = 4

The equilibrium price is 4. To get the equilibrium quantity, you can use either the demand function or supply function and substitute P with 4 as follows:

Q = 3550 – 266(4)

Q = 3550 – 1064

Q = 2486

Thus,

PE = 4

QE = 2486

Types of Equilibrium

There are three types of equilibrium: stable equilibrium, unstable equilibrium, and neutral equilibrium

Stable Equilibrium

If there is a force that disrupts the market equilibrium, then there would be adjustments that bring back to the initial equilibrium. Stable equilibrium occurs when the forces of demand and supply are in balance, making the price and quantities of the product to be at equilibrium.

Unstable equilibrium

Unstable equilibrium occurs when the deviation from the equilibrium position tend to push the market further away from the equilibrium. Conditions of unstable equilibrium occurs when the demand curve is positively sloped as in the case of a giffen good or when the supply curve is negatively sloped as in the case of labor supply.

Neutral equilibrium

This type of equilibrium occurs when the initial equilibrium is disturbed and the forces of disturbances lead to a new equilibrium point. It may occur due to shift of either demand of supply curve, and through effects of taxes etc.

The Effects of Shifts in Demand and Supply on Market Equilibrium

Shift in Demand: Increase in Demand

Figure 2.16: Increase in Demand

Consider Figure 2.16 which illustrates the effect of an increase on demand on market equilibrium. An increase in demand is represented by a shift of the demand curve from D1D1 to D2D2. The immediate effect will be shortage and this will force prices to rise leading to increase in quantity supplied until equilibrium is re-established at PE.

Shift in Demand: Decreasing Demand

Fall in demand Consider Figure 2.17 which illustrates the effect of a fall in demand on the market equilibrium. A fall in demand is represented by a shift of demand curve to the left from D1D1 to D2D2. The immediate effect will be a surplus and this will force the producers to lower the price in an attempt to get rid of excess stock. This fall in price will led to decline in quantity supplied until a new equilibrium is established at Pe1; Qe1.

Shift in supply

Increase in supply Consider Figure 2.18 which illustrates the effect of an increase of supply on the market equilibrium. An increase in supply is represented by a shift of supply curve to the right from S1S1 to S2S2. The immediate effect will be surplus and this will force the producer to lower their prices in order to get rid of excess stock. This fall will lead to an increase in quantity demanded from QE to Q1 where a new equilibrium is established at PE1.

A fall in supply Consider the Figure 2.19 which illustrates the effect of a fall in supply on the market equilibrium. A fall in supply is represented by a shift of supply curve to the left from S1S1 to S2S2. The immediate effect will be shortage and thus will force the prices to go up leading to a fall in quantity demanded until a new equilibrium is established at Pe1, Qe2.

Price Control

This refers to a deliberate action by the government to artificially impose through legislation the prices of certain goods and services. Such imposed prices are referred to as flat prices. These flat prices may be a maximum or a minimum price. A maximum price refers to that price above which a good or a service cannot be sold. A minimum price refers to that price below which a good/service cannot be sold. The government may find it necessary to control the prices of certain good/service because:

• Cheapness It may be objective of the government to keep price of certain goods and services at a level at which they can be afforded by most people hence protecting the consumer being exploited by producers
• Maintenance of income. The government may want to keep the income of certain producers at a higher level than that which would be supplied by market forces demand and supply. Thus the government is able to maintain the low income producers in the market.
• Price stability if there is a wide variation in the price of product year to year the government may wish to iron out these variations for the interests of both producers and consumers. This price control will act as one of the methods to curb inflation.

Maximum price control/price ceiling

Consider Figure 2.23, if the government imposes a price ceiling, given by P1 there will an excess demand or shortage equivalent to Q2- Q1. Under normal circumstances this economic force of excess demand will exert an upward pressure on prices. However, in this case the price cannot go above P1, since P1 is the maximum price. This price is unable to fulfill the rationing function leading to a demand for a centrally administered system of rationing of the good in question.

Other effects of Price controls

• Rise of black market where goods are sold above legal price even above the equilibrium price.
• Shortages are likely to become chronic as producers move away from production of price controlled goods.
• Research and development will be encouraged as the producers move from the price controlled industry
• There will be increased costs efficiency in production by firms as profits can only be increased by reducing costs.

Minimum price/price floor

This refers to the action taken by the government to set a price below which a good/service cannot be sold. They are normally imposed above the equilibrium price since the government feels that the price determined by forces of demand and supply is too low as illustrated in Figure 2.24 If the government imposes a minimum price by P1, the immediate effect will be surplus given by Q1 Q2. Under normal circumstances excess supply exerts a down ward pressure on prices, but in this case prices cannot go below P1 for it is a minimum price. The government then has to intervene by buying excess stock or limiting it to prevent prices from going down.

Other effects of price floors

• In the case of a minimum produce price floor, (low income producers) will have a stabilizing effect on their income.
• In the case of minimum wages employed workers will be guaranteed an income compatible with the cost of living.
• Some producers may be willing to dispose off their product below the minimum legal prices especially in the case of labor.
• In the case of minimum wage rate, it will lead to reduction in employment.