Describe the price theory (demand, supply, market equilibrium and elasticity)

2.1 Concept of Demand

Demand is the willingness and ability of a consumer to purchase a certain quantity of a good or service at a prevailing market price in a given period. It is not simply a desire or want—it requires both the wish to buy and the purchasing power to do so.

Quantity demanded is the specific amount of a good that consumers are willing and able to buy at a given price during a specific period.

2.2 Law of Demand

The law of demand states that, ceteris paribus (all other factors remaining constant), when the price of a good rises, its quantity demanded falls, and when price falls, quantity demanded rises. There is an inverse relationship between price and quantity demanded.

2.3 Demand Schedule and Demand Curve

A demand schedule is a table showing quantities demanded at different prices. Table 1 shows an individual demand schedule for boxes of pens.

A demand curve is a graphical representation of the demand schedule, with price on the vertical axis (y-axis) and quantity on the horizontal axis (x-axis). The curve slopes downward from left to right, reflecting the inverse relationship.

2.4 Why Does the Demand Curve Slope Downward?

• Substitution effect: When a good's price falls, consumers substitute it for more expensive alternatives.
• Income effect: A lower price increases consumers' purchasing power, allowing them to buy more.

2.5 Change in Quantity Demanded vs. Change in Demand

• Change in quantity demanded is movement along the same demand curve caused by a change in the good's own price.
• Change in demand is a shift of the entire demand curve (right for increase, left for decrease) caused by factors other than price.

2.6 Determinants of Demand

• Consumer income: For normal goods, higher income increases demand; for inferior goods, higher income decreases demand.
• Price of related goods: Substitutes (e.g., Pepsi and Coca Cola) have a positive relationship; complements (e.g., tea and sugar) have a negative relationship.
• Tastes and preferences: Favorable changes increase demand; unfavorable changes decrease it.
• Consumer expectations: Expecting higher future prices increases current demand.
• Number of buyers: More buyers increase market demand.

2.7 Exceptions to the Law of Demand

• Giffen goods: Inferior goods where demand increases as price rises (negative income effect dominates substitution effect).
• Veblen goods: Luxury goods that become more desirable as prices rise (snob value).
• Necessities: Goods like medicine whose demand does not change with price.
• Expectations of future price changes: If prices are expected to rise further, current demand may increase despite higher prices.

3.1 Concept of Supply

Supply is the willingness and ability of sellers to produce and offer for sale different quantities of a good at various prices in a given period.

Quantity supplied is the specific amount sellers are willing to sell at a given price.

3.2 Law of Supply

The law of supply states that, ceteris paribus, when the price of a good rises, quantity supplied rises, and when price falls, quantity supplied falls. There is a direct (positive) relationship between price and quantity supplied.

3.3 Supply Schedule and Supply Curve

A supply schedule table shows quantities supplied at different prices. A supply curve slopes upward from left to right.

3.4 Change in Quantity Supplied vs. Change in Supply

• Change in quantity supplied is movement along the supply curve due to price change.
• Change in supply is a shift of the supply curve due to factors other than price.

3.5 Determinants of Supply

• Prices of factors of production: Higher input costs reduce supply.
• Technology: Better technology increases supply.
• Expectations of future prices: Expecting higher future prices reduces current supply.
• Price of related goods: An increase in beef price may increase leather supply (joint supply).
• Number of sellers: More sellers increase market supply.

4.1 Concept of Equilibrium

Market equilibrium occurs where the demand and supply curves intersect. At this point:

$Q_d = Q_s$

The equilibrium price is the price at which quantity demanded equals quantity supplied. The equilibrium quantity is the amount bought and sold at that price.

4.2 Determining Equilibrium

Example 4.1: Given the demand function $Q_d = 20 - 0.5P$ and supply function $Q_s = -10 + 1.5P$, find equilibrium price and quantity.

Solution: At equilibrium: $Q_d = Q_s$

$20 - 0.5P = -10 + 1.5P$ $20 + 10 = 1.5P + 0.5P$ $30 = 2P$ $P = 15$

Substitute $P = 15$ into demand function: $Q_d = 20 - 0.5(15) = 20 - 7.5 = 12.5$

Equilibrium price = TShs 15, Equilibrium quantity = 12.5 units

4.3 Market Adjustments

• Increase in demand: Demand curve shifts right → equilibrium price and quantity rise.
• Decrease in demand: Demand curve shifts left → equilibrium price and quantity fall.
• Increase in supply: Supply curve shifts right → equilibrium price falls, quantity rises.
• Decrease in supply: Supply curve shifts left → equilibrium price rises, quantity falls.

4.4 Price Controls

• Price floor (minimum price): Set above equilibrium to protect producers. Results in surplus (excess supply).
• Price ceiling (maximum price): Set below equilibrium to protect consumers. Results in shortage (excess demand).

Elasticity measures how much quantity demanded or supplied responds to changes in price, income, or other factors.

5.1 Price Elasticity of Demand

Price elasticity of demand measures the responsiveness of quantity demanded to a change in the good's own price.

$e_p^d = -\frac{\Delta Q^d}{\Delta P} \times \frac{P_0}{Q_0}$

The value is always positive (using absolute value) and falls between 0 and ∞.

Worked Example 4.2: When price of beef was TShs 6,000 per kg, quantity demanded was 100,000 kg per day. Price rose to TShs 8,000 and quantity demanded fell to 80,000 kg. Calculate point price elasticity of demand.

Solution: $\Delta Q^d = 80,000 - 100,000 = -20,000$ $\Delta P = 8,000 - 6,000 = 2,000$ $e_p^d = -\left(\frac{-20,000}{2,000}\right) \times \frac{6,000}{100,000}$ $e_p^d = 10 \times 0.06 = 0.6$

Interpretation: A 1% increase in price leads to 0.6% decrease in quantity demanded. Demand is inelastic (less than 1).

5.2 Determinants of Price Elasticity of Demand

• Nature of commodity: Necessities have inelastic demand; luxuries have elastic demand.
• Availability of substitutes: More substitutes → more elastic demand.
• Proportion of income spent: Larger proportion → more elastic.
• Time period: Longer time → more elastic (consumers find substitutes).

5.3 Income Elasticity of Demand

$e_y^d = \frac{\Delta Q^d}{\Delta Y} \times \frac{Y_0}{Q_0}$

• Normal goods: $e_y^d > 0$ (demand increases with income)
  • Necessities: $0 < e_y^d < 1$
  • Luxury goods: $e_y^d > 1$
• Inferior goods: $e_y^d < 0$ (demand decreases as income increases)

5.4 Cross-Price Elasticity of Demand

$e_c^d = \frac{\Delta Q_X}{\Delta P_Y} \times \frac{P_{Y0}}{Q_{X0}}$

• Substitutes: $e_c^d > 0$ (e.g., Pepsi and Coca Cola)
• Complements: $e_c^d < 0$ (e.g., car and petrol)
• Unrelated goods: $e_c^d = 0$

5.5 Price Elasticity of Supply

$e_p^s = \frac{\Delta Q^s}{\Delta P} \times \frac{P_0}{Q_0}$

The same categories apply: perfectly elastic (∞), perfectly inelastic (0), unitary elastic (1), elastic (> 1), and inelastic (< 1).

Determinants of supply elasticity:

• Cost of production: Rising unit costs → inelastic supply
• Technology: Simple techniques → elastic supply
• Availability of inputs: Readily available inputs → elastic supply
• Time period: Longer periods → more elastic supply
• Excess capacity: More capacity → more elastic supply

A Tanzanian small-scale maize farmer in Dodoma can use price theory to decide when to sell their harvest. If maize prices are low at harvest time (high supply), they might store grain and sell later when prices rise—as the law of supply predicts, higher prices incentivize more supply. Similarly, understanding elasticity helps a shop owner in Kariakoo decide whether to raise prices: if the demand for essential goods like cooking oil is inelastic ( consumers will buy similar amounts even at higher prices), raising prices increases revenue. Conversely, for non-essential items with elastic demand, lowering prices attracts more buyers and may increase total sales.