Chapter 2 Economic: Market analysis

Chapter 2 Economic: Market analysis

Market concept

A market is a place where buyers and sellers can meet to facilitate the exchange or transaction of goods and services. Markets can be physical like a retail outlet, or virtual like an e-retailer

Price theory

Price theory is the study of prices in the market.

 Price is the sum or amount of money or its equivalent for which anything is bought, sold, or offered for sale at a given time.

OR.

Price is the amount of money which must be given up in order to obtain a commodity in a given, market at a given time                                                                                                                . .        ,

 Types of Markets

  1. Competitive (Perfect) market. This is a market where buyers and sellers have no ability to influence the price in the    Prices are determined by the market forces of demand and supply.

Characteristics/Features of competitive market

  • Large numbers of buyers and sellers in the market.
  • Identical/homogenous products sold by all firms,
  • the freedom of entry into and exit out of the industry or perfect resource mobility
  • Perfect knowledge of prices and technology.
  • No price control.
  • Perfect mobility of factors of production, the factors of production are completely mobile leading to factor-price equalization throughout the market.
  • Cheap and Efficient Transport and Communication
  • the consumer has plenty of choice when buying goods or services
  1. Imperfect market. This is a market where the buyers or sellers have ability to influence the price set in the market by either controlling supply or
  2. Goods market: This is a market where goods are
  3. Commodity market: This is a market where goods and services are
  4. Factor market. This is a market where factors of production are For  example land, labour, capital, entrepreneurship

Note. Factor price is the monetary reward to factors of production for their contribution in the production process. For example wages, interest, profit and rent.

  1. The spot market is where financial instruments, such as commodities, currencies, and securities, are traded for immediate delivery
  2. Future (Forward) market. This is a market where commodities are traded for future

Methods of Price determination   in the Market

  • Haggling (Bargaining). This is where the buyer negotiates with the seller for the suitable price of the During bargaining, the seller keeps on reducing the price and the buyer keeps on increasing until the agreed price is reached.
  • Auctioning (Bidding). An auction is a sale in which buyers compete for an asset by placing bids. The highest bidder takes the commodity.   This is method is common in fundraising especially in churches and other functions.
  • Fixing by treaties (Agreements). This is where buyers and sellers come to an agreement to fix the price of the commodity.  The price remains fixed for a given time but the agreement can be renewed and prices can be changed.
  • Government determination (legislation). This is where the government fixes the price of the commodity.  The government can either fix the maximum or minimum price.
  • Price leadership. This is where a large and low cost firm in the industry fixes the price of a commodity which has to be followed by other small firms.  This firm normally has a large share of the market.
  • Price fixing   by cartels.    A cartel is an organization of firms producing and selling similar products.  These firms come together and fix one price at which they have to sell the commodity to the consumers for example OPEC.
  • Interaction of the forces of demand and supply.  This is where the price in the market is determined by the forces of demand and supply at a point where quantity demanded equals to quantity supplied.
  • Resale price maintenance. This is where the producer (manufacturer) fixes the price of a commodity at which the seller (retailers) has to sell to the final consumers. The price is usually written the commodity container. For example Newspapers, soft drinks. etc.

Advantages (merits) of resale price maintenance

  • It is time saving since it does not involve  bargaining
  • It reduces unnecessary competition among sellers.
  • It helps to control consumer exploitation in form of increasing prices by sellers/retailers.
  • It helps to maintain price stability.
  • It helps to reduce on the duplication of the products by other producers.

The theory   of demand

 Demand.  This refers to the a consumer’s desire to purchase goods or services and willingness to pay for them at a particular prices

Quantity demanded.   This is the volume   of goods and services   that consumers   are willing   and able  to buy at a given price in a given time.

Determinants of quantity demanded

  1. The price of the commodity .The higher the price, the lower the quantity demanded and the lower the price, the higher the quantity demanded of the commodity.
  2. The nature of tastes and preferences. Favorable  tastes  and preferences  by  the consumer increase  the  quantity  demanded  of  the  commodity  but unfavorable  tastes  and  preferences decrease the quantity demanded.
  3. The price of related commodities. An increase in the price of the substitute increases the demand for the commodity in question but a reduction in the price of the substitute reduces the demand for the commodity  in
  4. Price of complements. An increase   in the  price  of  the complement leads to a fall in the demand of the commodity in question and a fall in the price of the complement leads to an increase in demand for the commodity in question.
  5. Government policy. An increase in taxes on the commodity by the government  leads to a decline  in  quantity  demanded  of  the  commodity  but subsidization  to   consumers  by  the government encourages  the consumption of the commodity and therefore quantity  demanded Increases.
  6. Population size and structure. A population comprised of a big percentage of middle and high income earners increases the quantity demanded of the commodity   but a population with a big percentage of low income earners leads to a fall in quantity demanded of the commodity.
  7. The nature of income distribution. Even distribution of income among the consumers increases the quantity demanded of the commodity but uneven distribution of income reduces the demand for the commodity.
  8. The level of the consumers’ income.  This depends on the nature of the commodity, that is, normal good, a necessity or an inferior good.
  • For a normal good, an increase in the consumers’ income increases the quantity demanded of a commodity and the decrease in the consumers’ income leads to decrease in the quantity demanded.
  • For the necessity, an increase or decrease in the consumers’ income does not affect quantity demanded of the commodity.
  • For the inferior good, an  increase in consumers’  income leads to the  decrease in quantity  demanded and  a decrease  in consumers’  income  increases  the quantity    The  three  situations  are illustrated using the angle curve

  1. Future price speculation. An expected future increase in the price of a commodity increases its current demand  but an expected future reduction in the price  reduces the quantity  demand for the commodity with the hope of consuming more  in future at a lower price.
  2. Seasonal factors. In certain seasons of the year, the demand for some commodities increases or decreases e.g. in  the  rainy  season,  there   is high demand  for rain  coats  and  their  demand decreases in the dry season.
  3. Religion and culture   The  demand  for pork  is low  in places  where  there  are many  Moslems   as compared  to places  where  there are many  Christians   especially
  4. Sex of the consumer. Some commodities   are demanded  by a particular   sex e.g. the demand  for shirts  is likely  to be high  in places  where  there  are many  males  as compared   to females.    Also, the demand for sweets is likely to be high  in a girls’  school  as compared  to a boys’
  5. Marital status. For example, the demand for wedding  rings  is high  in a society  where  there  are many  married  couples  as compared  to that dominated   by singles.
  6. Level of education. For example,   the demand   for scholastic   materials   is high in places where there are many people going to school as compared   to places where there   are few students.

Demand curve

The demand curve is a graphical representation of the relationship between the price of a good or service and the quantity demanded for a given period of time.

The graph shows that increase in price leads to reduction in quantity demanded and vice versa

Reasons why demand curve slopes down from left to right

  1. The law of diminishing marginal utility. As a person consumes more units of a commodity, the extra satisfaction derived from extra units of the same commodity diminishes. Therefore a consumer will only be willing to purchase more of the units at a lower price explaining a downward sloping curve.
  2. Substitution effect. As price of a commodity falls consumer purchase more units of the commodity and less of its substitutes. However, as its price rises, consumers purchase less of it and buy more of its substitutes. Thus at higher prices, less of a commodity is purchased and more is purchased at lower prices.
  3. Real income effect. As price of a commodity falls, the real income of the consumer increase and therefore he is able to buy more of a commodity at a lower price. But as the price rises, the real income of the consumer falls and is only able to buy less.
  4. Presence of low income earner. Ordinary people or low income earners buy more of a commodity when the price falls because that is when they can afford to purchase it. Increase in price of a commodity lowers demand. The rich do not affect the demand curve as they are well capable of buying more commodities even at high prices
  5. Commodities with different uses. As prices of these commodities increase consumer reduce the quantity demanded by only purchasing what is essential e.g. lighting n case of high price for electricity. However when prices reduce consumer demand for more to use for luxurious purpose.
  6. New buyers. Due to the fall in the price of a commodity new buyers get attracted towards it and buy it. Thus, this increases the demand for the commodity.
  7. Tendency To Satisfy Unsatisfied Wants. There is always a human tendency to satisfy unsatisfied wants. Each and every person has some unsatisfied wants. When the prices of goods, such as apples, falls, the consumer will buy more of that commodity as he wants to satisfy his unsatisfied wants. As a consequence of this habit of humans, the demand curve slopes downward to the right.

Change in demand

This refers to increase or decrease in amount of the commodity bought due to changes in other factors affecting demand keeping price of the commodity constant. It involves a shift in demand curve either to the left or to the right

A shift in the demand   curve to the right (from D0D0 to D2D2) is called an increase in demand.  It refers  to the outward  shift  in the demand  curve  caused  by the  favorable  factors  which  affect  demand at constant  price  of the commodity.   Such factors include;

  1. Increase in the price of the substitute
  2. A fall in the price of the complement
  3. A favorable change in the tastes and preferences   of the consumer
  4. Expected increase in the future price of the commodity
  5. An increase in the size of the population
  6. Favorable season of the commodity
  7. Favorable government   policy like subsidization   of consumers
  8. Increased even distribution   of income
  9. Increase in the disposable   income of the consumer
  10. Increase in advertisement of the commodity
  11. Increase in the amount of credit facilities offered by the government to consumers.

A shift in the demand curve to the left (from D0D0 to D1D1)   is called a decrease in demand.  It refers to an  inward  shift  in  the  demand   curve  caused  by  the  unfavorable    factors  which  affect  demand   at constant  price  of the commodity.   Such factors include;

  1. Decrease in the consumer’s   disposable   income
  2. Decrease in the price of the close substitute.
  3. An increase in the price of the complement.
  4. Unfavorable   change in tastes and preferences   of the consumer
  5. Expected fall in the future price of the commodity
  6. A decrease in the size of the population.
  7. Unfavorable   season of the commodity
  8. Unfavorable   government   policy like increased   taxation of consumers.
  9. Increase in income inequalities.
  10. Reduction in the advertisement of the commodity
  11. Withdrawal of credit facilities offered by the government   to consumers

Types of demand

  1. Competitive demand. This is the demand for commodities which   serve   the same   purpose. (Demand for substitutes).   For example the demand for tea and coffee, brands of detergents, etc.
  2. Complimentary (Joint) demand. This is the demand for commodities    which are used together. (Demand for complements).     An increase in the demand for one commodity   leads to an increase in demand   for another   commodity.   For example   demand   for car and petrol,   camera   and films, guns and bullets, etc.
  3. Composite demand. This refers to the demand  for the commodity    which   is used   for several (various) purposes e.g. the demand for water, electricity.                                              “,  .
  4. Independent (unrelated) demand. This  refers   to  the  demand   for  commodities    which   are  not related  such  that  the  demand  for one  commodity   does  not  directly  affect  the demand   of another commodity.   For example demand for a car and a pen, clothes and sugar.
  5. Derived demand. It refers to the demand for a commodity  not for its own .sake, but for  its  own purposes  (uses).  For example the demand for factors of production.

 

Aggregate demand

Aggregate demand refers to the total demand of finished goods and service produced in an economy by both households and firms

Aggregate demand curve

A demand curve is the locus of points showing total demand of finished goods and service produced in an economy by both households and firms in a period of time. It draws on assumption that the higher the price, the lower the quantity demanded other factors remaining constant.

Aggregate demand curve is the horizontal summation of all individual household demand curves.

Note that different reasons account for down slopping of a demand curve (one product) and aggregate demand curves (many products)

Reasons cause the aggregate demand curve to be downward sloping.

  • The first is the wealth effect. The aggregate demand curve is drawn under the assumption that the government holds the supply of money One can think of the supply of money as representing the economy’s wealth at any moment in time. As the price level rises, the wealth of the economy, as measured by the supply of money, declines in value because the purchasing power of money falls. As buyers become poorer, they reduce their purchases of all goods and services. On the other hand, as the price level falls, the purchasing power of money rises. Buyers become wealthier and are able to purchase more goods and services than before. The wealth effect, therefore, provides one reason for the inverse relationship between the price level and real GDP that is reflected in the downward‐sloping demand curve.
  • A second reason is the interest rate effect. As the price level rises, households and firms require more money to handle their transactions. However, the supply of money is fixed. The increased demand for a fixed supply of money causes the price of money, the interest rate, to rise. As the interest rate rises, spending that is sensitive to rate of interest will decline. Hence, the interest rate effect provides another reason for the inverse relationship between the price level and the demand for real GDP.
  • The third and final reason is the net exports effect. As the domestic price level rises, foreign‐made goods become relatively cheaper so that the demand for imports However, the rise in the domestic price level also means that domestic‐made goods are relatively more expensive to foreign buyers so that the demand for exports When exports decrease and imports increase, net exports(exports ‐ imports) decrease. Because net exports are a component of real GDP, the demand for real GDP declines as net exports decline.

The factors which affect the level of aggregate demand

  • The general price levels in the country: when the general price level s of goods and services are high, aggregate demand lowers and when the general price level is low aggregate demand increases.
  • The general level of incomes: when the incomes of households and firms in a country are high, the demand for goods and services are high and vice versa.
  • The amount of money supply in an economy: the high supply of money in the country increases the purchasing power of the households and firm raising the aggregate demand.
  • The level of aggregate money demand in a country. High level of aggregate money demand reduces the purchasing power of consumers reducing aggregate demand and the vice versa.
  • The supply of consumer goods and service. A limited supply of good and services force prices to increase and reduces the aggregate demand and vice versa.
  • The distribution mechanism of good and services: When the distribution of goods and services is poor, the level of aggregate demand will be low and vice versa.
  • The size of the population: high population increase purchasing power and aggregate demand and vice versa.
  • The tastes and preferences. If the tastes and preferences are positive for particular goods and service, the purchasing power increases leading to increase in aggregate demand.
  • The political climate in the country. A stable conducive political climate increase the purchasing power leading to increase in aggregate demand
  • Economic climate. Stable economic climate such as stable prices increase purchasing power and therefore increase aggregate demand.
  • Levels of development of the commercial sector. A well-developed commercial sector implies high levels of income leads to an increase in aggregate demand.
  • Government polity on taxation and subsidization. When the tax rates in the country are high, this reduces the income of consumers leading to low purchasing power thus reducing aggregate demand.
  • The expectation of inflation/speculation:– If the consumer expects high inflation in the future then the demand rises in the present such that the aggregate demand curve shifts rightward.
  • Level of Advertising. The higher the level of advertising the higher the aggregate demand

Abnormal (Regressive/exceptional) demand curves

These are demand curves which violate(disobey)the law of demand which state that “the higher the price, the lower the quantity demanded and the lower the price, the higher the quantity demanded keeping other factors constant”. The demand curves normally slope from left to right.

 Causes of the Abnormal demand curve

  1. Demand for goods (Articles) of ostentation. This refers to the demand for expensive luxurious commodities   .For example very expensive     In this case, a further price increase leads to an increase in the demand of the commodity.     This  is because  consumers   want  to be unique   and they  tend  to  show  their  economic    status   by  demanding   for  very   expensive    items   so  as  to impress  the public.

.

AB is the abnormal   part   of the demand   curve. Further   increase   in the price   from   0P0 to 0P2 leads to an increase   in quantity   demanded    from 0Q0 to 0Q2.

  1. Giffen good paradox. Giffen  goods   are  inferior   goods  which  take  a  large  percentage    of  the consumer’s   income  such that as their  prices  increase,  their  quantity  demanded   also  increase  andas their prices  fall, quantity  demand  also decreases  g. staple  food stuffs.


.

ABC   is the   demand    curve.      CB is   the abnormal   part.   An increase    in  the   price form  0P1  to  0P2 leads   to  an  increase   in quantity  demanded   from  OQ1 to 0O2.

  1. Future price expectation.  When  the  consumers   expect  a future  price  increase,   they  buy  more units  of the  commodity   in the  current  period   even  if the prices   are  slowly     On the other  hand,  when  they  expect  a future  price  fall,  they buy  less units  of the  commodity   even  if the prices  are falling  slowly  hence  violating   the law of demand.
  2. Ignorance effect of the consumers. Some  consumers  may buy more  units  of the commodity   at high  prices   due  to  their  ignorance   about  the  existing  market       This is normally   due to persuasive advertisement   sellers hence violating the law of demand.
  3. Depression effect.  A depression   is an economic   situation where all economic   activities   are at low levels g. low prices, low incomes,   low investment   levels etc.   In such  situations   when  the price  of  the  commodity   reduces,  quantity   demanded   remains  low  due  to  the  low  purchasing power  of consumers  as a result  of low incomes.  This violates the law of demand.
  4. Addiction (Habit) to the consumption of the commodity. This violates   the  law  of  demand   in such  a way  that increasing   the price  of the commodity   may  not  reduce  the quantity   demanded of that commodity  to a consumer  who  is addicted  to consuming  that commodity, e.g. smokers
  5. High degree of necessity of the commodity. When   the commodity    is of high   degree   of necessity,   its demand remains   constant   even if its price increases   or reduces,   for example   the demand for salt.
  6. Judging quality by price. Some consumers   tend to judge   quality by price.  Hence  they  tend  to buy  more  of  a commodity   whose   price is   high,  thinking   that  it is  of  high, quality.     This is common in developing countries.
  7. Special seasons (occasions). For example, during Christmas   seasons,   wedding   occasions   In such  seasons,  the demand  for certain  commodities   increases   with  an increase  in their  prices due to high  need for them.  For example the demand for fruits increases during Idd season.

 

The supply theory

Supply is the total amount of a given product or service a supplier offers to consumers in a given period and at a given price level.

Supply Schedule refers to the numerical   representation    showing   the quantity supplied   of the commodity    at various   prices   in a given   time.   OR. It is the table   showing   quantities    of the commodity   supplied in. the market at various prices in a given time.

Hypothetical    example to illustrate   the supply schedule

Price 500 1000 1500 2000 2500
Quantity 20 25 30 35 40
  • From the supply schedule above, as the price  increases,  quantity  supplied  also
  • From the supply schedule we derive the supply curve by plotting price against quantity supplied.

Supply Curve.

This refers to the graphical representation   of quantity supplied of a commodity   at various   prices   in a given time.   OR.   It is a locus of points   showing   quantity   supplied   of a commodity   at various prices  in a given  time.

From the graph, the supply curve is positively   slopping that is, it slopes upwards from left to right.

The law of supply

The law of supply states that “the higher the price, the higher the quantity of commodity supplied and the lower the price the    lower the quantity supplied keeping other factors constant”.

 

Factors affecting quantity supplied of the commodity

  1. The price of the commodity.  The  higher   the  price,  the  higher   the  quantity   supplied   and  the lower  the price  of the commodity   the lower  the quantity  supplied.
  2. The number  of producers   of the commodity.     The  higher  the number  of producers   of  the same commodity   the greater  the quantity  supplied,  and  the smaller  the number  of suppliers,   the lower the quantity  supplied:
  3. Level of costs of production.  A reduction  in the factor  prices  reduces  the cost  of production   and this  leads   to  an   increase  in supply   but  an  increase   in  the  costs   of  production    discourages producers  and  this leads to a fall in the quantity  supplied.
  4. Degree of availability of factor   inputs.  An increase  in the supply  of factor  inputs  in form  of raw materials   increases   quantity   supplied  of the  commodity   but  a reduction   in the  supply  of  factor inputs  reduces  the quantity  supplied  of the product.
  5. Degree of freedom    of entry of firms   in production.    Free entry of firms increases   the supply of the commodity   while restricted entry of firms reduces the supply of goods.
  6. Level of technology    used in production.       Use  of  better   and  improved   technology    increases quantity   supplied   but  in case  the  technology   used  is  inefficient,   the  quantity   supplied   reduces e.g. a tractor  versus  a hand hoe.
  7. Nature of the working   conditions.    Favorable    working   conditions   in form of higher   wages, transport   and food allowances   etc.  motivate   workers   to  work  hard  and  this  increases   quantity supplied   of  the  product.   But unfavorable    working   conditions   encourage   workers   to become inefficient and therefore quantity supplied of the product decreases.
  8. The length of the gestation   period.     This is the time taken for a commodity    to be ready   on market.    The   longer   gestation   period,   the lower   the   quantity   supplied   and   the   shorter    the gestation period, the higher the quantity supplied.
  9. Goal of the firm.   A firm  that aims  at profit  maximization    may  put  less quantity   on market   and charge  a high  price   hence  reducing   the  quantity   supplied   of  the  commodity   but  for  the  firm aiming  at sales maximization,   quantity  supplied  of the product  increases.
  10. Government    policy,    increasing    taxes   by   the   government     on   the   producers    of   a certain commodity   increases   the cost of production   and this reduces quantity   supplied   of the product. But  subsidization    of producers   by  the  government   in  form  of  reduced   prices   for  factor   inputs increases  the quantity  supplied  of the commodity.
  11. The   nature    of   the   Climate.    Favorable    climate    increases    the   supply   of   the   commodity especially    for   the   agricultural    products    but   unfavorable     climate    reduces    the   supply    of agricultural   commodities.
  12. Degree of political stability of the country.   A politically   stable country encourages   investments and production    of goods   and services   hence   increasing    the supply   of commodities.     But   a politically   unstable   country discourages   the production   of goods and services hence a fall in the supply of commodities.
  13. The size of the market,   the bigger the market    size, the higher the supply of the commodity   and the smaller the market size, the lower the supply of the commodity.
  14. Future price   expectations.    An  expected   future  increase   in  the price  of  the  commodity    by  the producers   reduces  the  current  supply  of the commodity.   This is because they expect to sell at a higher price and earn more profits in future.  But an expected future fall in the price increases   the current supply of the commodity.   This is because the producers   want to avoid making losses by selling at lower prices in future

 

Change in quantity supplied

This  refers  to the increase  or decrease  in the quantity   supplied  of a commodity   due  to change  in its price  keeping  other  factors  constant.  It involves the movement   along the supply curve.

  • The movement downwards    the   supply curve is called a contraction (decrease in quantity supplied). It   is   brought about       by    the    fall    in    price     of    a commodity         keeping       other      factors constant.
  • An upward movement along the supply curve is called   an expansion   (increase in quantity supplied).     It   is   brought about by increase  in the price of the commodity keeping other      factors constant

 

Change in supply

Change in supply refers to an increase or decrease in supply due to changes in other factors affecting supply of the commodity   at a constant price.  OR. It refers to a shift in the supply curve brought   about  by the changes  in other  factors  affecting  supply  at constant  price  of a commodity.

  • A shift in the supply curve  from  S0  to S1 is  called  a  decrease  in supply,    It refers  to  the  shift  in the  supply   curve to  the  left  caused   by  the  unfavorable factors     which  affect     supply     at    a constant
  • A shift in the supply curve  from  S0  to S2 is  called  a  increase  in supply,    It refers  to  the  shift  in the  supply   curve to  the  left  caused   by  the  favorable factors     which  affect     supply     at    a constant

 

 Types of Supply

  1. Competitive supply.  This  is  where   the  supply   of  one  commodity    leads   to  a  reduction    in  the supply  of another  commodity.   For example increasing the supply of beef at the expense of milk.
  2. Complementary (Joint) supply. This refers to the situation where the commodities    are supplied together.  That is, the supply of one commodity   automatically   leads to the  supply  of another   e.g. beef and hides,  mutton  and wool.

Regressive (Abnormal/Exceptional) supply curve

A regressive supply curve  is one which  violates  (disobeys)   the  law  of supply  which  states  that  “the higher  the  price,  the  higher   the  quantity   supplied   and  the  lower  the  price,   the  lower  the  quantity supplied  keeping  other  factors  constant”.   It does not slope upwards from left to right.

Examples of regressive supply curves

  • Fixed supply curve of land in short run

From the graph above, an increase in price from OP1 to OP2 does not lead to an increase in the quantity of land supplied; that is; despite the increase in price, the quantity supplied remains constant at OQ0

  • Supply curve for labour

From the graph, ABC is the backward bending labour supply curve,   When  the wage increases  from OP1  to OP2 labour supply increases from OQ1 to 0Q2, After point B,  the wage increase  from  OP2  to OP3   leads  to  a  reduction  labour  supply from OQ2 to OQ3

This regressive labour supply curve is due to the following factors;

  • Presence of target workers. These  are  workers  who  work  only  to  fulfill  their  targets  or objectives after which they abandon work or decide to work for fewer hours.  This violates the law of supply.
  • High preference for leisure. As workers earn more wages, they prefer leisure to work and therefore they end up working for fewer hours.
  • Decline in the real wage of workers due to high levels of inflation .This forces workers to work for fewer hours.
  • Use of progressive taxation by the government. That is where the tax rate increases as the income of the tax payer       These discourage hard work for high wage earners and are forced to work for fewer hours so as to earn a lower wage and pay fewer taxes.

 

  • Speculative supply. When prices are expected to increase in future, sellers or producers put less on market even if prices are slightly increasing. This is because they are expecting to get a lot of profits in future at very high prices.                                                     ‘
  • Supply of perishable goods. For perishables, more is supplied (put on the market) immediately after harvest. Therefore even if prices are low or decreasing, more is supplied hence violating the law of supply.
  • Existence of Catastrophic periods. In such periods, supply may not increase even if prices are increasing due to scarcity of commodities.

Market equilibrium

In a competitive market,   the market   is in equilibrium   when   quantity   demanded    equals   quantity supplied.  This is graphically illustrated as shown below

  • At high  price  OP2  supply  exceeds   demand   and  therefore   a surplus   of  Q0Q2  is      When supply  is in excess,  the  producers   decrease  the price  in order  to sell  the  surplus  (excess)   and in the process  equilibrium   is restored  in the market  at point E.
  • At lower  price  OP1, quantity   demanded   exceeds  quantity   supplied   therefore   a shortage   Q1Q0  is created   which   forces  the  producer   (seller)   to  increase   the  price  until  the  equilibrium    point   is attained  at point E.

Note

  • Market price refers to the prevailing (ruling) price in the market   at a given time.   Market price  is  any  price  determined   by  the  buyers  and  sellers  in  the  market   irrespective    of  whether quantity  demanded  is equal  to quantity  supplied  at a given.
  • Equilibrium price refers to the market   price   where   quantity   demanded    is equal   to quantity supplied.
  • Normal (natural) price refers to the long run equilibrium price established   in the market after a long period of price fluctuations.
  • Reserve price refers to the minimum price set by the seller below which he is not willing to sell his commodity.
  • Reserve wage refers to the minimum wage set by a worker below he is not willing to work/offer services.

Factors affecting/Determinants   of Reserve price

  1. Degree of durability of the commodity. The higher  the  degree  of durability   of  the  commodity, the higher  the reserve  price  and the more perishable   the commodity   is the lower  the reserve  price.
  2. Cost of production. The higher the costs of production,   the higher the reserve price and the lower the cost of production, the reserve price.
  3. Degree of liquidity preference. Liquidity   preference   refers   to  the  extent  to  which   individuals prefer  to hold  their  wealth  in cash  or near  cash  form  instead  of investing   it in alternative   assets. The higher  the level  of liquidity  preference,   the lower  the reserve  price  and  the lower  the level of liquidity  preference,   the higher  the reserve  price.
  4. Future price expectations. When the seller expects the price to increase in future, he fixes a high reserve price but when the seller expects the price to fall in future, he fixes a lower reserve price.
  5. Degree of necessity of the commodity. The higher the degree of necessity, the lower the reserve price and the lower the degree of necessity, the higher the reserve price.
  6. Quality of the commodity. The higher the quality of the commodity, the higher the reserve price and the lower the quality of the commodity, the lower the reserve price.
  7. Level of storage expenses. The higher the storage expenses, the lower reserve price and the lower the storage expenses, the higher the reserve price.

Importance (uses) of prices in the economy

  • Price acts as a signal for shortages and surpluses which help firms to determines what to produce and how to produce it
  • Determines the value of goods and services.
  • High prices act as incentives to increased supply of goods and services and economic growth
  • Guides producers on what techniques to use i.e. technology to use
  • Helps consumer in making consumption plan
  • Determines peoples income distribution, the price mechanism is a system of real flows from producers to consumers and from consumers to producers
  • Ensures efficient utilization of resources; the factors of production (land, labour, capital) will be used for their most valuable purposes.
  • High prices is an incentive for improvement on quality of the product
  • Prices help to redistribute resources from goods with little demand to goods and services which people value more.
  • Income distribution in the economy is determined by price mechanism. High incomes or revenues go to those expensive goods.
  • Distribution of goods and services; the price mechanism determines the products are for. Goods and services are normally produced for those to can pay high prices
  • Where to produce commodities from is determined by price mechanism. Production units tend to be located in places where there is demand for the products
  • Price mechanisms determines when to produce; goods are produced when their demand is higher to ensure profit maximization
  • . They help in the automatic adjustment of demand and supply for example when prices increase, quantity demanded reduces and supply increases.

 

The theory of elasticity

Elasticity  is  the  measure  of  degree  of  responsiveness  of  dependent  variable  due  to  changes (variations) in the independent variable(s).

In the theory of demand and supply, quantity supplied and quantity demanded are said to be dependent variables while their determinants like price of the commodity are said to be independent variables.

There are two broad categories of elasticity. These include: .

1) Elasticity of demand

2) Elasticity of supply

 

Elasticity of demand

This is the measure of degree of responsiveness of quantity demanded due to changes in the factors which influence quantity demanded.

Types of Elasticity   of demand

(a)   Price elasticity of demand

(b) Point elasticity of demand

(c)   Arc elasticity of demand

(d)  Cross elasticity of demand

(e)   Income elasticity of demand

Price elasticity of demand

This is the measure of the degree of responsiveness of quantity demanded due to changes in the price of the commodity.

The negative is multiplied in the formula because of the negative relationship between quantity demanded and the price of the commodity.

 Examples 1

A change in price form 10/= to 15/= lead to a reduction in quantity from 24 to 20. Calculate price elasticity of demand

Example 2

A 20% change in price of a commodity led to a fall in quantity demanded of the commodity from 40 to 20 units. Calculate price elasticity of demand.

Interpreting price elasticity of demand

(a) Perfectly inelastic demand (EP= 0). This is when price elasticity of demand equals to zero. Here the quantity demanded does not respond to changes in price at all.

 

From the graph a change in price from OP1 to OP2   to OP2   leaves   quantity demanded unchanged   at 0Q0.

(b) Inelastic demand (0 < Ep<1)

In   this    case,    the   price    elasticity     of demand is greater than zero but less than one.   A big proportionate    change in price leads to a smaller percentage change in quantity demanded.

(c) Unitary elasticity of demand

In this case, the price elasticity   of demand equals   to one.    The percentage    change   in quantity demanded   equals to the percentage change    in price.      It is   illustrated    by   a rectangular   hyperbola.

 (c) Elasticity of demand (1 < Ep < ꝏ)

In   this   case,    the   price    elasticity     of demand is greater than one but less than infinity or is between   one and infinity.  A big percentage    change    in quantity demanded   is due to a small percentage change in price

 (e) Perfectly elastic demand (Ep = ꝏ)

Point elasticity of demand

This measures the elasticity of demand at a particular point on the demand curve. It is given by the formula

 Arc elasticity of demand

This is a measure   of elasticity of demand between two points on the demand curve. It is given by the formula

Given two points A and B along the same demand curve

Example 3

Given the graph below

 Calculate

This is the measure of the degree of responsiveness of quantity demanded of commodity (Y) due to the changes in the price of a related commodity (X). It is given by the ration of the percentage change in the quantity demanded of commodity (Y) to the percentage change in price of related commodity (X).

Interpretation of cross elasticity of demand

  • If XED > 0 (positive): it implies that the commodities are substitute. An increase in the price of one of the commodity leads to an increase in to an increase in the quantity demanded of the other commodity. For example blue band and butter.
  • If XED < 0 (negative): it means that the commodities are compliments. Increase in the price of one commodity leads to a decrease in the quantity demanded of the other commodity. For example a car and petrol.
  • If XED = 0: it implies that the commodities are nonrelated. A change in price of one commodity has no effect on the quantity demanded of the other commodity.

 Example 4

An increase in the quantity demanded of commodity X from 50 units to 80 units was due to the fall in price of commodity Y from 100/= to 150/=.

(i) Calculate the cross elasticity of demand of commodity X and Y.

(ii) State the nature of commodities X and Y

The two commodities are complements

(iii) Suggest two examples of X and Y

Camera and film; car and petrol, shoes and shoe polish

Example 5

A 30% increase in the quantity of commodity P is due to an increase in price of commodity Q from 200/= to 250/=

(i) Calculate the cross elasticity of demand of commodities P and Q

(ii) State the nature of commodities P and Q

The two commodities P and Q are substitute

(iii) Give two examples of commodities P and Q

Kakira Sugar and Kinyara sugar,  Samona baby jelly and Sleeping baby jelly, Omo and Nomi, Colgate tooth paste and Closeup tooth paste.

 Income elasticity of demand

Income elasticity of demand is the degree of responsiveness of demand of a commodity due to a change in Consumer’s income.

It is obtained as a ratio of the percentage change in the quantity demanded of a commodity to the percentage change in the customer’s income

Interpretation of Income elasticity of demand

  • If YED > 0 (positive): the commodity is a normal good. The demand for normal good increase as the consumer’s income increase.
  • If YED < 0 (negative): the commodity is an inferior good. The demand for an inferior good reduces as the consumer’s income increases.
  • If YED = 0: the commodity is a pure necessity. The increase in consumer’s income has no effect on the quantity demanded for a pure necessity such as salt.

 Example 6

An increase in the consumer’s income from 1000/= to 1800/= led to an increase in the quantity demanded of commodity X from 20 to 30.

(i) Calculate the income elasticity of demand for commodity X.

(ii) What is the nature of commodity X

Commodity X is normal good

Example 7

A 10% decrease in consumers income led to an increase in quantity demanded of commodity P from 25 to 32.

(i) Calculate the income elasticity of demand of commodity P

(ii) State the nature of commodity P

P is an inferior good

Example 8

Income Quantity demanded of commodity P
250 50
600 25

(i) Calculate the income elasticity of demand of commodity P

(ii) What is the nature of commodity P

P is an inferior good

 Determinants of price elasticity of demand

  1. Level of consumers’ income. The higher the  level  of consumers’   income,  the  lower  the elasticity of  demand   (inelastic)   and  the  lower  the  level  of  income,   the  higher   the  elasticity   of  demand (elastic).
  2. Degree of necessity of the commodity. The higher the degree of necessity  of the commodity   likes salt,  the lower  the  elasticity  of demand   (inelastic)   while  the lower  the degree  of necessity   of the commodity   the higher  the elasticity  of demand  (elastic).
  3. Degree of availability of substitutes. The demand for a commodity   with many substitutes   tends to be elastic while the demand for a commodity   with few or no substitutes   tends  to be inelastic.
  4. The cost of the commodity. The demand for the commodity   that takes a small proportion   of the consumers’        income tends to be inelastic.  For example elasticity   of demand   for a match box.  On the other hand, the demand for a commodity   that takes a large proportion   of consumers’    income tends to be elastic.
  5. Habit (addiction) in the consumption of the commodity. The demand   for the commodity    for which the consumer   is addicted to tends to be inelastic for example a consumer   who is addicted to the consumption   of cigarettes.  On the other hand, the demand for the commodity   for which the consumer is not addicted to tends to be elastic
  6. Number of uses of the commodity. The demand for the commodity  that has many uses “tends to be elastic.  For example, if the unit price of electricity   increases, consumers   use less of it for only vital purposes for lighting:   On the other hand, the demand for the commodity   that has few uses tends to be inelastic.
  7. Degree of durability of the commodity. The demand   for a durable   commodity    tends   to be inelastic.   This  is  because   even  if the price   of  such  a commodity   falls,  the  consumer   may  not demand  more  of that commodity   because  he already  has  that commodity.    On the other hand, the demand for a perishable   commodity tends to be elastic.
  8. Level of advertisement for the commodity.   The   demand   for a commodity     that   is highly advertised   tends to be inelastic but the demand   for the commodity   that is not highly   advertised tends to be elastic.
  9. Future price expectations. The demand for the commodity  whose price is expected to decrease in future makes  its current  demand  to be elastic  but the demand  for the commodity   whose  price  is expected  to increase  in future makes  its current  demand  to be inelastic.
  10. The demand for a commodity whose use can be postponed. The demand  for the commodity whose use can be postponed   to a future date tends to be elastic but the demand for the commodity whose use cannot be postponed   tends to be inelastic.
  11. Time period. In the short run, the demand   for  the  commodity    may   be  elastic   because   the consumers   are not  yet used  to the new  product   on  the market  while  in the  long  run  the  demand for such a commodity may be inelastic  after  the consumers   getting  used  to the product.
  12. Level of consumers’ ignorance. Consumers may buy commodities at a high price when they do not know where such commodities   or their substitutes   are sold. Consumers   may  also  mistake  the increase  in the price  to be a result  of increase   in the  quality  of products   which  may  not  be the case.  Consumers’   ignorance therefore leads to low elasticity of demand of commodities.
  13. Degree of convenience in obtaining the commodity. The higher the level of convenience,  the lower the elasticity of demand and the lower the level of convenience,   the higher the elasticity   of demand.

Practical application of price elasticity of demand to consumer

  • It helps in determining incidence of tax. For goods whose demand is elastic, the burden is borne by the producer and for those whose demand is inelastic; the burden is borne by the consumer.
  • It is used to determine the expenditure of the consumers. Consumers spend more on commodities whose demand is inelastic such as soap and spend lend less on commodities whose demand is elastic
  • Protection and subsidization. The government has a duty to protect its citizens from over exploitation by giving subsidies to essential commodities such as drugs and maintenance of roads.

Practical application of price elasticity of demand to Producers

  • It helps a producer in determining prices for his commodities. If a commodity has elastic demand, the producer will reduce the price and charge high price for a commodity that has inelastic demand
  • It helps the producer in determining wages of his workers. Workers whose demand is inelastic are paid more than those whose demand is elastic
  • It helps monopolists in price discrimination. A monopolist will charge high price for same for commodity where prices are inelastic and less price are elastic price.
  • It helps a producer to determine advertisement costs. If a commodity has inelastic demand, the producer tends to spend less on advertisement and spends more on advertisement of commodities that have elastic demand because of stiff competition.
  • In the Determination of Output Level: For making production profitable, it is essential that the quantity of goods and services should be produced corresponding to the demand for that product. Since the changes in demand is due to the change in price, the knowledge of elasticity of demand is necessary for determining the output level
  • In Demand Forecasting: The elasticity of demand is the basis of demand forecasting. The knowledge of income elasticity is essential for demand forecasting of producible goods in future. Long- term production planning and management depend more on the income elasticity because management can know the effect of changing income levels on the demand for his product.
  • Making decisions on what to produce. A businessman chooses the optimum product- mix on the basis of price elasticity of demand for various products. The products having more elastic demand are preferred by the businessmen. The sale of such products can be increased with a little reduction in their prices.
  • Shifting of tax burden:e. if the demand is inelastic the larger part of the indirect tax can be shifted upon buyers by increasing price. On the other hand if the demand is elastic the burden of tax will be more on the producer
  • Wage discrimination; worker who have elastic demand such as causal workers are paid less than workers with inelastic demand such as doctors.

 Practical application of price elasticity of demand to government

  • Helps government to regulate prices. I.e. In order to protect the interest of consumers’ government fixes the maximum price of the commodity with inelastic demands and those for export.
  • Can be used by government to determine taxes on commodities.  Government can impose higher taxes on goods with inelastic demand whereas low rates of taxes imposed on commodities with elastic demand
  • It helps government in currency devaluation. The government can devalue it currency if her imports and exports have elastic demand and supply such that as the prices of imports increase, quantity of imports reduce and as prices of exports reduce the volume of export increase.
  • The concept of elasticity of demand enables the Government to decide as to which industry should be declared as public utility and consequently owned and controlled by the state. The products like electricity, gas, water, transportation, etc. have inelastic demand to avoid high prices to the nationals.
  • Protection and subsidization. It helps the government in giving subsidies to producers. The producers whose products have elastic demand seek more protection and assistance from the government because they are unable to face strong competition whereas produce whose products have inelastic demand will get fewer subsidies from government.
  • Wage policy. This helps the government when establishing wages of its workers. Workers with inelastic demand such as Doctors are paid more than those that have elastic demand are paid less e.g. office messengers, cleaners, drivers
  • Gain in international Trade: The ‘terms of trade’ can be determined by measuring elasticity of demand in two countries for each other’s goods. In international trade, a country earns more profits by importing the commodities, which have high elastic demand and exporting the ones, which have relatively less elasticity.
  • It applicable under the tariff policy. A tariff is a tax imposed on exports and imports of the country. Tariffs are imposed on imports with the aim of discouraging their importation and local consumption. Such a policy is only successful when the price elasticity of demand for imports is elastic.
  • This measurement can be useful in predicting consumer behavior as well as forecasting major events, such as an economic recession or recovery.
  • To address Paradox of poverty amidst plenty. Government can stabilize the prices of agricultural goods by following a policy of price support program in the event of increased production.
  • To regulate consumption of harmful goods by high taxation.
  • To reduce inflation. Government can levy taxes on products with inelastic demand to withdraw money from circulation

Elasticity of supply

Elasticity of supply refers to the degree of responsiveness of quantity supplied due to changes in the factors which influence supply

Price elasticity of supply is the measure of the degree of the responsiveness in quantity supplied due to changes in the price of commodity supplied

Example 8

An increase in the price of sugar from 100/= to 120/= per kilogram lead to an increase in the quantity supplied of sugar from 30kg to 40kg. Calculate the price elasticity of supply.

Solution

Example 9

An increase in the price of commodity by 40% causes an increase in quantity supplied of sugar from 200kg to 250kg. Calculate price elasticity of supply.

Solution

Interpretation of price elasticity of supply

(a)Perfectly inelastic supply (Es= 0).

In this case, quantity supplied does not respond to changes in price. For example the supply of agricultural products in short runs.

(b) Inelastic supply (EP= 0 < Es < 1).

In this case, a big proportionate change in price leads to a small proportionate change in quantity supplied

(c) Unitary supply (Es = 1)

In this case, a percentage change in price leads to an equal percentage change in quantity supplied

(d) Elastic supply

In this case, a small percentage change in price leads to a big percentage change in the quantity supplied.

(e) Perfectly elastic supply

In this case, at constant price, quantity supplied increases. This situation is not applicable in the real world.

Determinants   of Price Elasticity of supply

  1. Cost of production. The  higher   the  cost  of  production,   the  more   inelastic   the  supply   of  the commodity   and the lower  the cost of production;   the higher  the elasticity   of supply.
  2. Gestation period (Length of the production process).  The longer the gestation period, the lower the elasticity  of supply  and the shorter  the gestation  period,  the higher  the elasticity  of supply.
  1. Level of technology. The higher   the level   of technology    e.g.,  use   of  modem    techniques    of production    the  higher  the  elasticity   of  supply  while  the  lower  the  level   of  technology   (use  of inelastic production   techniques)   the lower  the elasticity  of supply
  2. Degree of availability of factor inputs. The supply of the commodity   whose   factor inputs are readily   available   tends to be elastic but the supply of the commodity    whose   inputs   are scarce tends to be inelastic.
  3. Degree of entity of firms  in the production process.    Free entry   of firms   in the production process   increases   the  number  of producers   of  the  product  hence  elastic   supply  while  restricted entry of firms  in the production  process  leads to inelastic  supply  e.g., the case  of a monopolist.
  1. Degree of factor mobility. Factor mobility refers to the ease with which a factor of production  be changed    from   one   occupation/geographical       location    to   another.    Highly    mobile    factors    of production   make the supply of the commodity   elastic while immobile   factors of production   make supply inelastic.
  2. Government policy   of taxation.  High taxes imposed by the government    on producers   increase the cost   of production    hence   inelastic   supply.     However   subsidization     of producers    by the government   reduces the cost of production   hence elastic supply.
  3. Price expectation. An expected   future price fall by the producer   relative   to the current   prices makes the current supply of the commodity   elastic.   But the expected   future  price  increase  by the producer  relative  to the current  prices  makes  the current  supply  inelastic.
  4. The nature of the product (commodity).  Durable   commodities    have   elastic   supply.     This is because   they  can  be  stored  for  a  long  time  and  any  increase   in price   is  accompanied    by  an increase  in price.   On the other  hand,  perishable   commodities   have  inelastic   supply  because   they cannot  be stored  for a long time such that if there  is an increase  in price  nothing  can be supplied.
  1. Objectives of the firm. A firm whose objective  is to maximize   sales is associated   with elastic supply of the commodity   while a firm whose objective   is to maximize   profits,   the  supply  of the commodity   tends  to be inelastic.
  2. Time. This can be short run or long run. In the long run supply becomes   elastic since producers have  enough   time  to vary  (change)   the  factors  of production   so as to  increase   output  but  in the short  run,  supply  is inelastic  because   it is difficult   to change  the  fixed  factors   of production   in order  to increase  supply.

Price discrimination

Price discrimination is the process (practice) of selling the same commodity to different consumers at different prices by the same seller in a given period of time, for reasons not associated with costs. For example prices of entertainment tickets at different costs for public and students or children and adults.

Conditions necessary for price is discrimination succeed

  • The commodity should not have close substitute.
  • Businesses must prevent resale. Prevention of re-sale could be enforced in many different ways. For example students can only receive student discounts with a legitimate student ID, children can easily be identified from adults.
  • The market in question must be geographically distant /spatially separated in case of seats for football or entertainment such that it is easy for monopolist to charge different prices in the different market places or transfer of goods from one market to another is difficult
  • There should be different elasticity of demand in the different markets.
  • Ignorance among customers about other markets
  • The seller or producer must be a monopolist or the market must be imperfect.
  • Personal services that can be resold or transferred e.g. medical Doctor, teacher, entertainment etc.
  • Product differentiation; artificial differences made on similar products by a way of branding, trademarks.
  • Low transport costs also lead to monopoly power in that goods can be transferred from one market to another without affecting their prices.
  • No government interference

Engel curves

Engel curve describes how household expenditure on a particular good or service varies with household income

Angel curve for normal good

Quantity demanded for the commodity increases as household income increase

Angel curve for inferior good

Quantity demanded for the commodity decreases as household income increase

Angel curve for necessity

Quantity demanded for the commodity remains unchanged as household income change

Revision questions

Section A questions

1 (a) Distinguish   between competitive   demand and joint demand

(b) Give two examples of competitive demand

2 (a) Distinguish   between market price and equilibrium   price

(b) Outline any two methods of price determination in an economy

3 (a) Distinguish   between normal price and Reserve price

(b) State any two determinants of Reserve price

4 (a) what is meant by the angel curve

(b) Graphically illustrate the angel curves for normal, necessity and inferior goods.

5 (a) Explain the concept of regressive demand curve.

(b) Outline any three examples of regressive   demand curves.

6 Give four circumstances   under which the demand for a commodity may not fall despite a rise in its price.

7 With illustrations, explain the effects of a change in supply on the equilibrium price and quantity at constant demand of the commodity.

8  Give any four circumstances under which a consumer may buy more of a commodity when its price  increases.

9  (a) What is meant by resale price maintenance

(b) Give any three advantages of resale price maintenance

10 (a) What is meant by a regressive supply curve

(b)  Give any three reasons why the labour supply curve may be regressive

11 An increase in income of the consumer from 10,000/= to 30,000/=  led to a decrease in quantity demanded of commodity x from 50kgs to 20kgs.

(a) Calculate the income elasticity of demand for commodity X

(b) What type of commodity is X

12 (a) Distinguish between income elasticity of demand and price elasticity of demand

(b) An increase in the consumer’s income from 50,000/= to 60,000/= led to an increase in quantity demanded of commodity X by 10%. Calculate the income elasticity of demand for commodity X

13 Given that the price of commodity Y decreased from 15,000/= to 10,000/= and the quantity demanded of a related commodity Z increased from 200,000kgs to 600,000kgs, calculate the cross elasticity of demand for commodity Z. State the consumption relationship between the two commodities

14 (a) Distinguish between price elasticity of demand and cross elasticity of demand

(b) Quantity demanded of commodity X increased by 50% due to a fall in commodity price by 25%.   Determine the value and nature of price elasticity of demand for commodity X

15 Calculate the cross elasticity of demand, if the price of the commodity A declined by 20% and quantity demanded of commodity B increased from 20 to 30units. How are commodities A and B related?

16 Explain in details the following concepts;

(a)  Price elastic demand

(b)  Price inelastic demand

(c)  Price elasticity of supply

  1. Use the table below to answer the questions that follow
Year Income Commodity X Commodity Y Commodity Z
2020 40000 100 60 200
2023 80000 100 30 2500

(a)  Calculate the income elasticity of demand of each commodity from 2000 to 200 1.

(b) What type of goods are X, Y and Z.

18  Study the table below and answer the questions that follow;

Position Price Quantity demanded
Original position A 40 400
New position B 80 150

(a)    What is the movement from A to B called?

(b)  Determine the value of price elasticity of demand for commodity

19   Use graphs to illustrate;

(a)  an increase in supply at constant demand.

(b) an increase in demand at constant demand.

20 with the help of the graph distinguish   between   “Extension in demand”    and”   Contraction    in demand”

21  Given  that  quantity   demanded   is Qd =36- 4P    and  quantity   supplied  is  Q. =-12+12P   find  the equilibrium   price  and quantity.

Section B questions

1 (a) How are prices determined   in your country

(b) Examine the factors that influence quantity of a commodity   demanded in an economy.

2 (a) Distinguish   between a contraction   in demand and an extension in demand

(b) Explain the factors that may lead to a decline in demand for a commodity.

3 (a) Distinguish   between change in supply and change in quantity supplied (Use graphs to illustrate)

(b) Explain the factors which influence the supply of commodities   in your country.

4 (a) Explain why demand curve slopes downwards   from left to right

(b) Explain the circumstances   under which the law of demand may be violated.

5 (a) Explain the causes of high price elasticity of demand for commodities in an economy

(b) What are the practical applications   of the concept of price elasticity of demand?

6  (a) Distinguish   between  a change  in supply  and change  in quantity  supplied

(b) Explain that factors that influence the elasticity of supply for the commodity   in an economy

7  (a) Under  what  circumstances   may the law of supply  be violated

(b) Under what circumstances   may the elasticity of demand for a commodity   be price inelastic?

8  (a) Distinguish   between  Arc elasticity  of demand  and point  elasticity  of demand  …

(b) Explain the determinants   of elasticity of demand for the commodity   in an economy.

9  (a) Explain   why people  tend to buy more  of a commodity   when  its price  falls.

(b) What are the exceptions to tins phenomenon?

 

Consumers’ surplus   and producer’s surplus

Consumers’   Surplus

This  refers  to the  difference   between   what  the  consumer   is willing and able   to pay  for  the  commodity   and what  he  actually  pays,  whereby  what  he  actually  pays  is less  than  what  the  consumer   is willing  to pay.

From the graph, consumer surplus is the shaded area below the demand curve and above the equilibrium price

Consumer surplus = total utility – actual expenditure

Example 10

Given the demand schedule

Price 1000 750 500 400 300 250
Quantity demanded 1 2 3 4 5 6

Calculate the consumer surplus if equilibrium price is 400/=

Solution

Total utility = (1000 x 1) + (750 x(2- 1)) + (500 x (3-2)) + (400 x (4-3))

= (1000 x 1) + (750 x 1) + (500 x 1) + (400 x 1)

= 1000 + 750+ 500 +400 = 2650/=

Actual expenditure = 400 x 4 = 1600/=

Consumer surplus = 2650 – 1600 = 1050/=

 

Example 11

Price 1000 750 500 400 300 250
Quantity demanded 4 6 9 13 14 18

Calculate the consumer surplus if equilibrium price is 500

Total utility = 1000 x 4 + 750 x (6 – 4) + 500 x (9 – 6)

= 1000 x 4 + 750 x 2 + 500 x 3

= 4000 + 1500 + 1500 = 7000/=

Actual expenditure = 500 x 9 = 4500/=

Consumer surplus = 7000 – 4500= 2500/=

 

Producer surplus

Producer surplus is the difference between what the producer is willing to charge and what he actually charges for the commodity when what he actually charges is higher than what he is willing to charge.

Graphically Producer surplus is represented by the shaded area above the supply curve but below the equilibrium price.

Producer surplus = actual revenue – willingness to accept

Example 12

Given the supply schedule below

Price 50 60 80 100 140 200
Quantity demanded 1 2 3 4 5 6

Taking 100/= to be the equilibrium price, calculate the producer surplus

Solution

Actual revenue = equilibrium price x equilibrium quantity

= 100 x 4 = 400/=

Willingness to accept = (50x 1) + (60 x 1) + (80 x 1) + 100 x 1 = 290/=

Producer surplus = 400 – 290 = 110/=

 

Transfer earning (supply price) and economic rent

Transfer earning (supply price) is the minimum reward (payment) given to a factor of production in order to maintain its current employment (occupation)

Or

Supply price is the opportunity cost of keeping a factor of production in its current occupation

Economic rent is the payment to a factor of production over and above its supply price

Actual earnings = Transfer earning + economic rent

Example 13

Given that the transfer earnings for a factor of production is 3 times the economic rent and economic rent is 100/=.calculate the actual earnings for the factor of production.

Transfer earnings = 3 x 100 = 300/=

Actual earning = 300 + 100 = 400/=

Example 14

Given that the supply price of a worker is 5000/= and the actual payment is 7500/=. Calculate the level of economic rent.

Economic rent = actual payment – supply price

= 7500 – 5000 = 2500/=

 

Types of economic rent

  • Quasi rent. This refers to the payment to a factor of production over  and above its transfer earnings whose supply is inelastic in the short run but elastic in the long run. For example the supply of engineers and doctors. The supply of doctors is inelastic in the short run but elastic in the long run.
  • Commercial rent. This refers to the hire price for a durable asset, for example rent paid for hiring a building.

Determinants of Economic rent

  1. Degree of specificity of the factor of production. The higher the degree of specificity of a factor of production, the lower the economic rent and the lower the degree of specificity of a factor of production, the higher the economic rent.
  2. Level of demand for a factor of production. The higher the demand for a factor of production, the higher the economic rent and the lower the demand for a factor of production the lower the economic rent.
  3. Degree of substitutability of a factor of production. The higher the degree of substitutability of a factor of production, the lower the economic rent and the lower the degree of substitutability of a factor of production, the higher the economic rent.
  4. Elasticity of demand for a factor of production. The higher the elasticity of demand, the higher the economic rent and the lower the elasticity of demand, the lower the economic rent
  5. Elasticity of supply of a factor of production. The higher the elasticity of supply, the lower the economic rent and the lower the elasticity of supply, the higher the economic rent.

Price mechanism (invisible hand)

Price mechanism is a system under the free enterprise economy where resource allocation and prices are determined by the market forces of demand and supply.

Assumptions of Price mechanism

  1. Consumers aim at utility maximization.
  2. There is no government interference (intervention) in resource allocation.
  3. Producers aim at profit maximization.
  4. There are many buyers and sellers of the same commodity
  5. It assumes that  incomes  are  equally  distributed  and  therefore  individuals  have  the  same purchasing power.

Advantages (Merits) of Price mechanism 

  • Increases variety of goods and service
  • Encourages hard work
  • It increases efficiency in resource allocation. Under price mechanism, the major aim of producers is profit maximization. This minimizes resource wastage.
  • Price mechanism encourages competition in production. This leads to the production of better quality goods and services hence improved standards of living for consumers.
  • The system facilitates the exploitation and utilization   of resources in the economy. This increases the production of goods and services hence economic growth and development.
  • It leads to the creation of more employment opportunities. The  high  profits  made  by producers are used  to expand  business  activities  hence  creating  more  employment
  • It promotes consumer sovereignty. Consumer   sovereignty   refers to the situation under the free enterprise   economy where the consumer has the freedom to determine   what to be produced   in the economy   by  buying  more  of  a particular   commodity   (casting a vote). Producers   allocate   more resources   in the production   of a commodity   which is highly bought in the market.
  • It promotes research, inventions and innovations due to the high profits got by producers. This leads to improvement   in the techniques of production.
  • Price mechanism encourages speculation.   Speculation   refers  to  the  buying  of  commodities    in periods  when  they are in plenty  and “cheap and selling them in periods when  they  are  scarce  and at high prices.   This leads to price stability.
  • It facilitates arbitrage. Arbitrage   refers to me geographical transportation of commodities from areas   where   they are at low prices   to areas where   they   are   at high prices.   This helps   in redistribution   of resources.
  • Price mechanism does not require much administrative     machinery since it is automatic.   This lowers the cost of administration   of the economy by the government.
  • It encourages flexibility in production as producers can easily adjust the production activities due to changes in price.
  • It facilitates income distribution. This is because incomes go to those people who own resources and are able to buy goods and services.
  • It encourages the development of entrepreneurial skills in the economy. This is because   it promotes individual initiatives and creativity in the economy.

Disadvantages (Demerits) of Price mechanism

  1. It promotes income inequalities.  This is because   the more   resources   you have, the more the income.  Therefore   people who do not have resources   remain poor thereby   widening   the income gap.
  2. It leads to monopoly tendencies in the economy. This   is because   the large   efficient   firms (producers)   may force the inefficient firms out of the production   process through competition   and as a result,   they   end   up restricting    output   and   charging    high   prices   hence   exploiting    the consumers.
  3. This system   does not cater for public goods which   are collectively    consumed   and that are expensive   to produce.  For example security, roads etc. This is because such public goods are not profit making.
  4. It leads to unemployment. Producers aim at maximizing profits   and minimizing   costs and in the process,   they end up using capital intensive production   techniques   which leads to technological unemployment.       In addition,   unemployment    can also be due   to inefficient    firms   being   out competed   from the production   process and workers from such firms remain unemployed.
  5. It leads to fluctuation in incomes of sellers. Individuals   selling umbrellas   and rain coats, their incomes   are high  during  the rainy  season  and Iow  during  the  dry  season  which  makes  planning difficult.
  6. It promotes the production   of socially harmful products.   For example   cocaine,   marijuana, alcohol,   cigarette   if not restricted.     This is because   such commodities’   may be fetching   high profits to the producers.
  7. The system undermines the provision of basic and cheap essential goods and services which are non-profit making.  This is because   the private individuals   aim at venturing   in activities   in which they maximize   profits.
  8. It leads to over exploitation of natural resources. Due to competition in production   and lack of government   control, the producers   may want to produce   more output  hence  over  exploiting   the resources.
  9.  There is consumer’s ignorance due to market imperfections
  10. High competition is always wasteful as it leads to duplication of activities and excessive advertisement
  11. It leads to exploitation of the population
  12. It encourages speculation and gambling
  13. It makes government planning difficult
  14. Price mechanism fail to project future needs
  15. Excessive price fluctuations
  16. Failure to respond promptly to immergences such as war and catastrophes.
  17. does not cater for the unprivileged and vulnerable members of the society like the poor and disabled

Ways of reducing the defects of price mechanism

  1. Forming consumers’ association to educate and sensitize the consumers about the quality of commodities brought in the market. This helps to reduce on consumers’ ignorance.
  2. Taxing the rich and subsidizing the poor. This helps to reduce income inequalities through progressive taxation where the rich are taxed more than the poor. The standards of living of the poor can be improved.
  3. Using price controls by the government. Government can fix either the minimum or maximum price for the commodity as a way of regulating price fluctuations in the economy.
  4. Using anti-monopoly      This   is   where   the government demonopolises   private monopolies by setting anti-monopoly laws which help to reduce consumer exploitation by private monopolists.
  5. Reducing on social cost. This is done by over taxing and issuing costly licenses in order to discourage producers from over exploiting natural resources.
  6. Subsidizing weak and small producers by the government.   This enables such producers to remain in the production process and compete favorably with the big firms. This helps to reduce on unemployment caused by firms being out competed from the production process.
  7. There is need for proper planning to reflect structural changes, detect future needs of society and direct economic growth through government intervention.

Price controls (price administration)

This is the act of the government intervention in price mechanism by regulating the prices of goods services.    In  this  case,  the  forces  of  demand  and  supply  no  longer  determine  the  prices  of commodities.

Types of price control

(a) Maximum price legislation (price ceiling)

(b) Minimum price legislation (price floor)

Maximum Price legislation (Price ceiling)

This is where the government fixes the price below the equilibrium price above which it is illegal to exchange a given commodity. It is fixed to favor the consumers especially in periods of scarcity.

Advantages   (merits) of maximum Price legislation   (price ceiling)

  1. It protects consumers from being exploited   by monopolists   who aim at maximizing   profits   by restricting   output and charging high prices.
  2. It enables the   low income earners to acquire necessities (essential)   commodities    especially during period of scarcity .This helps to improve on the standard of living of low income earners.
  3. It helps to ensure equal distribution of income. This is because   it helps to reduce the profits   of producers   and expenditure by consumers.
  4. It helps to maintain price stability. This is because   fixing the price below the equilibrium   price helps to control inflation in the economy.
  5. Maximum   price helps to discourage the production of harmful products.  Examples of harmful products are alcohol, cigarette, pornographic materials   etc.  This is because   when the government    fixes a maximum price for such commodities   it becomes uneconomical   for producers   to continue their production.
  6. 6. The government sets a maximum price to discourage the importation of expensive commodities and to encourage exports.  This helps to increase on the foreign exchange earnings of the country.
  7. It helps to reduce the cost of labour in case a maximum wage is fixed for the employees.    This helps to reduce the cost of production   hence increase in the production   of commodities.

Disadvantages (Demerits) of price ceiling

  1. It promotes excess capacity in production.   Excess capacity refers to a state of underutilization of resources.    This  is because  the  maximum   price  set does  not  encourage   producers   to  increase production   so as to exploit  more  resources.
  2. It promotes black marketing and hoarding of commodities. In this case, producers   are forced to sell a commodity   at a price which violates the maximum   price.

(a)  Black market.  This  is a market  which  involves   the illegal  exchange   of commodities    at  a price which                 violates  the one set by the government.

(b) Hoarding.   This   refers   to the   situation    where   producers    create    artificial    shortage    of   the                             commodity   in the market so as to sell at a higher price.

  1. It encourages corruption and bribery in the process of exchange. This  makes  the  low  income earners  to go without  the commodity   hence  poor  standard  of living.
  2. It encourages exploitation of workers by employers. This is because   the maximum   wage fixed may be too low as compared to the work done by the employees.
  3. It reduces labour efficiency in case workers are given a very low maximum wage.
  4. It encourages smuggling of goods to neighboring countries where the prices   are   high   as compared   to the low domestic prices.   This creates a shortage in the local markets.
  5. It is expensive to implement and supervise by the government in terms of administration costs to enforce price controls.
  6. It encourages strikes by workers in case the maximum wage fixed is very low.
  7. Leads to time wastage due to long queues to obtain the scarce commodity.

Minimum price legislation   (Price Floor)

Minimum price legislation is where the government sets the price above the equilibrium price below which it is illegal   to exchange   a given   commodity.   It is fixed to protect   producers    from   being exploited especially in periods of excess supply.

Advantages of minimum price legislation   (Price Floor)

  1. It helps to protect the producers from being exploited by middlemen and consumers. This is in form of low prices given to producers especially for agricultural   products.
  2. It encourages the production of goods and services in the economy. The producers earn high profits as they charge a high minimum price.   This leads to economic   growth and development.
  3. It helps to create more employment opportunities. This is as a result of increased production of commodities   and trade in the economy.
  4. The minimum wage  fixed   helps   to  improve  on  the  efficiency   of  labour  which   leads   to production  of high  quantity  and quality  products.
  5. The minimum wage fixed protects the workers (employees) from being   exploited   by their employers.  This is because it is fixed above the equilibrium   wage.
  6. It promotes research. This is due to the high profits received  by the producer  which  leads  to the production  of better  quality  products  hence  better  standards   of living.
  7. It helps to minimize strikes by workers and this creates a better working relationship between the employer and the employees.                                                                                                          .
  8. It helps to increase government revenue. This is because the government is in position   to charge a tax on profits received by producers
  9. It helps to maintain price stability especially for the agricultural products.
  10. It helps to control rural-urban migration in case it is fixed for farmers in rural areas.

 Disadvantages (Demerits) of Minimum Price legislation (Price Floor)

  1.  It leads to a fall in the purchasing power of low income earners.  This is because   it is fixed above equilibrium   price.   This leads to the decline in the standards   of living.
  2. It leads to inflation in case the minimum wage fixed   is very high.  This is because   a high minimum   wage        increases   aggregate   demand   which leads to an increase   in the general prices of commodity.
  3. It leads to excessive supply of goods and services. This results into storage problems especially in the agricultural    sector.
  4. It increases government expenditure inform of price controls.  This is because   the government pays for the man power which is involved in the supervision   and administration   of price controls.
  5. It encourages dumping of commodities to other countries   by the local producers.     Dumping refers   to .the  selling   of  the  commodity   in  the  external   market   at  a  lower  price   than  that  one charged  in the local  market.    This leads to shortage of goods in the local market as they are sold to outside markets.
  6. It creates unemployment in the labour market.  This is because in case the minimum   wage fixed is high, employers may not be able to employ a large number of workers.
  7. It leads to rural-urban migration in case attractive minimum wages are fixed in urban areas.
  8. Farmers are discouraged in the long run in case the government fails to buy tile surplus output at the minimum price fixed.
  9. It increases the costs of production in form of high minimum wage   fixed.  This discourages production   in the long run.
  10. It leads to market imperfections  (distortions)    in  form  of  black  marketing   where   producers violate   the  minimum   price  fixed  by  the  government   and  decide   to  sell  at  a lower  price  to the consumers.

Price fluctuations (oscillations) of agricultural   products

Price fluctuation refers to the variations in the prices of products in the economy over time.

Causes of Price Fluctuations   of Agricultural   products

  1. Inelastic supply of agricultural products in the short run. Agricultural  products   have   a long gestation period and therefore fanners   cannot increase on their supply in the short run.  The prices of agricultural   products are high in the short run and low in the long run.
  2. High degree of perishability. Agricultural    products   are highly   perishable    and therefore, they cannot be stored for long time, for example tomatoes.    In periods  of harvest,  there  is excess  supply and therefore,  their prices  fall and in periods  of scarcity  their prices  increase.
  3. Bulkiness of agricultural products. Agricultural  products   are bulky and this makes it difficult to transport them from production   areas to market areas.   This leads to a fall in prices in production areas and an increase in prices in market areas.
  4. Divergence between actual and planned output. Agricultural  products   are greatly   affected   by natural factors like bad weather, pests and diseases.    In case the actual output exceeds the planned output due to favorable   natural factors, there is excessive   supply which leads to a fall in prices. But  in  case  when  the  actual  output   is  less  than  the  planned   output   due  to unfavorable    natural factors,  there  is a shortage  hence  an increase  in prices.
  5. Competition from synthetic (artificial) fibers. Synthetic fibers are cheap and are of high quality. Such fibers like nylon, silk etc. have led to low demand for agricultural   products   like cotton, sisal hence a decline in their prices in the world market.
  6. Lack of diversification by farmers. Many farmers end up over producing a particular   commodity which leads to a fall in prices as a result of excess supply in the market.
  7. Price inelastic demand for agricultural products. Agricultural  products   are used as inputs in the production   of industrial products and they form a small proportion   of the total cost of the product. For example in the manufacture   of cars, agricultural   products are only used in the making of tyres which   makes   their demand   inelastic.   Even if their prices   fall, their quantity   demanded    cannot increase by a big proportion.
  8. 8. Income inelastic demand for agricultural products.   Even   if the   income   of the   consumer increases, quantity demanded   of the agricultural   product   does not increase.  This leads to a fall in their prices.
  9. Cobweb theory. This theory explains price fluctuations of agricultural   products.    The high prices in the current period force the farmers to produce more of the commodity   in the next season.  This leads to excess supply hence a fall in prices.    In the  current  periods   of low  prices,   farmers   are discouraged  from  producing  more of a commodity   in the next  season  hence  an increase  in prices,   “

Measures (ways) of reducing Price Fluctuations   of agricultural   products

  1. Fixing prices of agricultural products by the government. The  government   can  fix  either  the minimum   or maximum   price  at which  the  agricultural   products   have  to  be  sold.  This helps   to stabilize their prices.
  2. Encouraging diversification by farmers. Producing    a variety   of agricultural   products   helps   to reduce on the over production   of a particular   commodity   by farmers hence stabilizing   prices   in the economy.
  3. Using buffer stock policy by the government. Buffer   stock   is where   the marketing    boards (government)   buy the surplus output from farmers,   store it and sell it during periods   of scarcity. This helps to stabilize prices and supply of agricultural   products.
  4. Improving the quality of storage facilities. For example   using refrigerators    to ensure   proper storage of the highly   perishable   products   like milk,   fish, tomatoes   etc.  helps to  reduce   excess supply in the market  hence  stability  in prices.
  5. 5. Forming international commodity agreements.  These   help   to fix prices   and quotas   for the buyers and sellers of commodities   to avoid fluctuations   of prices in the  world  market   resulting from excess supply.
  6. Industrialization (processing) of agricultural products.      Agro-based    industries    should    be emphasized   so as to add value on the agricultural   products.    This helps to improve on the quality and prices of agricultural   products.
  7. Use of stabilization fund. This is where   marketing    boards   (government)    fix prices   given   to farmers.    When  there  is a fall in supply,  marketing   boards  sell  the commodity   at a high  price  on the world  market  than  that paid  to the  farmers.    During  periods   of plenty,  the high  profits   made by marketing   boards  .are used  to compensate   fanners   for  the  low  prices  as a way  of  stabilizing prices  of agriculture  products.
  8. Improvement in technology and research. This not only improves on the quality of agricultural products but also leads to a reduction in their gestation   period.   For example   introducing    hybrid seeds and use of cross breeding can help to increase   supply of agricultural products   in a shorter period hence stabilizing   prices.
  9. Formation of farmers’ cooperatives and associations. Co-operatives   help to educate the farmers about the use of better   fanning   methods.   In  addition,   they  help  to look  for  the  market   for  the farmers’  output  which  helps  to stabilize  the prices  of agricultural   products.
  10. Improvement in the transport network. Construction of social and economic   infrastructure    like feeder roads linking   production   areas to market   centers.   Such  roads  help  the  farmers   to  easily transport  their produce   from rural areas  to market  areas  through  arbitrage  hence  stabilizing   prices of agricultural  products.

 Effects of price fluctuations   of agricultural   products

  1. Fluctuations in the incomes of the farmers. Incomes of the farmers are high when the prices are high and low when the prices fall.  This leads to low standards   of living of the farmers especially when their incomes are low.
  2. Difficulty in planning by the government. With  price  fluctuations,   it becomes   very  difficult   for the  government   to plan  as  the  expected  revenue,  is highly  uncertain.    The fluctuations    in prices lead to fluctuations in   incomes of farmers and hence fluctuations    in the tax revenue for government.
  3. Price fluctuations discourage production on a large scale by farmers.  This leads to subsistence production   hence a decline in economic growth and development.
  4. Fluctuation in the levels of employment especially in the agricultural sector. This is because the low  prices-discourage     producers   and  this  leads  to  a reduction   in output  and  in. the  process workers  remain  under  or unemployed.                                                                            .
  5. Unstable foreign exchange   earnings by the country.   The   fluctuations    in   the   exports    of agricultural   products   and their prices lead to fluctuations   in the foreign   exchange   earnings.   This results  into balance  of payment  problems  as the prices  for agricultural   products  (exports)   tend  to be very low on the world  market  as compared  to the prices  for Imports.
  6. Unfavorable terms of trade. Terms of  trade refers  to  the  ratio  of  the price  index  of  exports   to price  index  of imports.    When the prices for imports exceed the price for exports, the country is said to experience unfavorable   terms of trade.
  7. They encourage rural-urban migration.  Price   fluctuations    lead   to  rural-urban    migration    as farmers  abandon  agriculture   and move  to towns  in search  for white  collars  jobs  which  are highly paying.     In addition   other farmers   move   to towns   to carryout   business   where   the prices   are relatively stable and the profits relatively high.
  8. Increase in income inequalities between individuals engaged in agriculture   and those employed in other   sectors   like industries.      This  is   because  -farmers   earn   low  profits   and   incomes    as compared   to their  counter  parts  in other  sectors  which  widens  the  income  gap  between   farmers and other  individuals  employed   in other  sectors.
  9. Price fluctuations discourage farmers/rom    borrowing. This  is because   farmers  are  not  sure  of the  returns   from  the  output  due  to price  fluctuations.    This hinders   agricultural   investment    and commercialization
  10. Price fluctuations increase on the dependence of a country on other countries in form of foreign assistance. This  is because   a country  gets  less  tax  revenue  which  cannot  be used  to finance   all government   activities.  This forces the government   to borrow other countries.

Consumer   behavior

A consumer is an individual who uses final goods and services to satisfy his/ her needs.  A consumer is assumed   to be rational   meaning   that he/she   aims   at utility   maximization    given   the available income and commodity prices.

Theories of Consumer Behavior

(a) The cardinal utility theory

(b) The ordinal utility theory (Indifference   curve Approach)

The cardinal utility theory

Definitions of concepts

Utility refers to the satisfaction   derived from consuming   a given commodity.   The expected utility from the commodity   forms the basis for consumer   demand.  Hence consumers   demand   a commodity   because they expect to derive utility from it.

Total Utility refers to the total satisfaction   derived from consuming   a given commodity. It is measured   utils using an instrument called utilometer.

 Marginal utility refers to the additional   satisfaction   derived from consuming   an extra unit of a commodity.

Disutility   (negative utility) is   the dis-satisfaction resulting from   consuming a commodity in excess.

Assumptions of the cardinal utility theory

  1. A consumer is rational that is, he/she aims at utility maximization.
  2. A consumer has a fixed level of income.
  3. The commodity prices are (given) fixed.
  4. The consumer has perfect   knowledge    about the prevailing   market   prices   and quality   of the product.
  5. The consumer’s tastes and preferences   are constant.
  6. It assumes consumption of only one commodity whose units are homogenous.
  7. There is perfect divisibility of the commodities consumed   into smaller units
  8. The theory assumes   diminishing   marginal utility.  That   is, “As more   and more   units   of a commodity      are successively   consumed,    the additional   unit consumed   provides    less and   less satisfaction   to the consumer.”

A hypothetical example to illustrate total utility and marginal utility of the commodity

Units of the commodity T.U M.U
1

2

3

4

5

6

6

9

11

12

12

10

3

2

1

0

-2

 

From the schedule above, the relationship between total utility, marginal utility and demand curve can be illustrated graphically as follows

From the graph,

  • As total utility is increasing, marginal utility is falling but still positive.
  • When total utility is at its maximum, marginal utility is zero. This  is the point  of satiety
  • When total utility is decreasing, marginal utility is negative and this shows disutility.
  • When marginal   utility  is decreasing,   a consumer   can  only  be  induced   to buy  an extra  unit  of  a commodity   only when  its  price       Therefore,   as marginal   utility   decreases,   prices   also decrease   as more and more units of the commodity   are consumed.     This explains   the negative slope of the demand  curve.

Note.  The demand curve is the positive part of the marginal utility curve.

 

The law of diminishing marginal utility

The law of diminishing  marginal  utility states  that  “As  more  and  more  units  of  a commodity   are successively   consumed,   marginal  utility  diminishes   (reduces/decreases).

Applications (Importance) of the law of diminishing marginal utility

  1. It helps to explain the law of demand that is the higher the marginal  utility,  the higher  the price, the  lower  the  quantity  demanded   and  the  lower  the marginal   utility,   the  lower  the  price  and  the higher  the quantity  demanded.
  2. It is applied under the principle of progressive taxation. As the tax payers’ income increases, the tax rate also increases.  This is because marginal utility of money for the tax payer reduces as his income increases.
  3. The law is used to explain water-diamond paradox. Because   of  scarcity   of  diamond,   it has  a high  marginal   utility  and  therefore  commands   a high  price  and  on the  other  hand  water  exists  in abundance   and therefore  it has low marginal  utility  and low price  as compared   to diamond.

Limitations (criticisms) of the law of diminishing marginal utility

  1. It is not applicable in situations where the commodity prices keep on changing due to inflation.
  2. It assumes homogenous units of the commodity consumed   which is not always the case.  Units of the same commodity   may be different e.g. when consuming   a sugar cane.
  3. It  is  not  applicable to commodities  like money  where  marginal   utility   increases   as  more  and more money  is consumed  .
  4. It is not applicable under habitual   consumption   where   marginal    utility   increases    as   the consumer consumes more of the commodity.
  5. It assumes constant tastes and preferences yet for the same individual,   tastes and preferences keep on changing from time to time.
  6. Utility cannot be measured as the law assumes that is, there is no instrument which can be used to measure utility.
  7. The law cannot be applied in situations of joint consumption (demand) where two commodities are consumed    at the same   time.     This   is because   it assumes   the   consumption    of only one commodity   at a time.
  8. In most cases the consumers are ignorant about the market prices of commodities. This violates the assumption   of perfect knowledge   of the consumer   about the market price.

The ordinal utility theory (Indifference   curve approach)

This approach   assumes   consumption   of two commodities;    say X and Y, whose prices   are fixed or constant.   It is explained   by the concept of the indifference   curve.

Indifference   curve is a locus of points   showing   alternative combinations    of two   commodities    that   give   rise   to equal   levels   of satisfaction/utility to the consumer when consumed.   Therefore   combinations   along the indifferent curve represent   equal levels of satisfaction   to the consumer.

The slope of a normal indifference curve

It is called the marginal rate of substitution (MRS)   of the two commodities.

The marginal   rate of substitution   of two commodities   X for Y (MRSx, y) refers to a number of units of commodity Y that   must  be  given  up  in  order  to  gain  an  extra  unit  of  commodity   X  and  maintain   the  same  level   of satisfaction.

MRSx,y   is the slope  or gradient  of the indifference   curve.  It is given by

Properties of the indifference   curves

  1. Different combinations   of commodities    that   lie   on   the   same   indifference    curve,   give   the consumer the same level of satisfaction.
  2. An indifference   curve which lies above and to the right of another represents a higher level of satisfaction than the one below it. Therefore   a rational   consumer   will always prefer bundles   of commodities   on a higher Indifference   curve in that they give higher satisfaction   than bundles   on a lower indifference    curve.  This property   is derived   from the assumption   of non-satiation     or greed.
  3. In between any two indifference curves, there can be many other indifference   curves.
  4. An indifference   curve is down ward sloping, implying that it has a negative slope. That  is if a consumer  wants  to increase  on quantity  consumed   of one  commodity,   X, she must  reduce  on the quantity  consumed   of commodity  Y if she is to remain  with  the same level  of satisfaction.
  5. A normal indifference   curve is always convex   to the origin which   reflects    the   law   of diminishing   marginal   rate of substitution.   As units of commodity   X are substituted   for units of commodity   Y, commodity   Y becomes   scarce and commodity   X becomes more abundant.   Hence the consumer   is willing to give up less of the scarce commodity   Y, in exchange   for a unit of an abundant commodity X.
  6. An indifference curve does not touch either of the axes. If it happens  it would  mean  a particular level of satisfaction   can be obtained  by consuming   only  one  commodity   and nothing  of the other which  is unrealistic.
  7. Indifference   curves do not intersect.   This   is based   on the   assumption    of consistence     and transitivity.   If they  intersect,   then  the  point  of  intersection would  imply  two  different   levels  of satisfaction   which  leads to inconsistence   in consumer’s   choice.

Illustration

From   the  above   diagram   the  combination    B and C  give  the  same   level   of  satisfaction    to  the consumer,   they  both  lie  on the  same  indifference   curve,   lC1  Combinations    C and A  also  give  the same   level   of   satisfaction,    since   they   both   lie   on   indifference    curve,    IC2.       This   implies    that combinations   A and B   give the consumer   the same level of satisfaction.   However,   combination    A gives a higher level of satisfaction   than B since it is on a higher indifference   curve IC2 and it should be preferred to B. Therefore the point of intersection   implies inconsistency.

The indifference   map

This is a set/combination    of several   indifference    curves.   The higher   the’ indifference    curve,   the greater the level of satisfaction

Illustration

Combinations   on   a higher   indifference    curve   give   higher    satisfaction    and   are   preferred    than combinations    on a lower indifference curve.  Therefore,   the movement    from a lower   indifference curve to a higher indifference   curve represents an improvement   in the consumers’   welfare.

Budget line (Consumption   possibility   curve)

The budget  line  refers   to  the  locus  of  points   showing   a  combination    of  two  commodities    that  a consumer   can  buy   using   a  given   level   of  income   at  given   prices.

OR

It is a line joining    the combination   of two commodities   that can exhaust consumer’s    income at given commodity   prices.

 Consumers’ Equilibrium   under the Indifference Curve Approach

A consumer is said to be in equilibrium   when she chooses the most satisfying   combination   given her income   and commodity   prices.   Under   this approach,   the consumer   will choose   that combination which lies on the highest affordable   indifference   curve.  Graphically   it is represented   by the point of tangency of the highest possible indifference   curve and budget line (Point E).

Section A questions

1    Mention four assumptions   on which price mechanism   is based

2· (a) Distinguish between price legislation   and price leadership

(b) State any two objectives of price legislation   in an economy

3  (a) Define  the term price?

(b) Outline any three uses of price.

4 (a) what is a black market?

(b) Give two reasons why a black market may occur.

5 (a) What is meant by consumer’s   surplus

(b) Give the demand schedule

Price 500 450 400 350 300 250
Quantity 1 3 5 7 9 11

If the equilibrium price is 350/= calculate the consumer’s   surplus

6 (a)     Distinguish   between Transfer earnings and economic rent

(b)    State any two factors which influence the level of economic rent.

7 (a) Distinguish   between Quasi Rent and commercial   rent

(b) Given that the Transfer earnings for the factor of production   is 200,000 and the economic rent is two thirds of the Transfer earnings.  Calculate the actual earnings for the factor of production

8  Explain  the meaning  of the following  terms;

(a)  Marginal   Utility of income.

(b) Marginal   rate of substitution.

9 (a) A given factor of production   earns 500,000/= as its transfer earnings.   If it’s  actual  earnings  are thrice  it’s  transfer  earnings,  calculate  it’s  economic  rent

(b) How is elasticity of supply related to a factor’s   economic rent?

10 (a) State the law of diminishing marginal utility.

(b)  Mention any three limitations   of the law of diminishing   marginal utility.

(c)  How is diminishing marginal utility related to demand curve and price?

11 Mention   four short comings of price fluctuations   of primary products in an economy.

12 State the properties of a normal indifference   curve.                    .

Section B questions

1 (a) What is meant by price mechanism.

(b)  Examine the advantages and disadvantages   of price mechanism

2 (a) Explain the role of the price mechanism   in allocating resources in the   economy

(b)    Explain   the circumstances    under   which   price   mechanism    may   fail to  allocate   resources efficiently.

3 (a) Distinguish   between maximum price legislation   and minimum price legislation

(b) Examine the merits and demerits of fixing a maximum price.

  1. (a) Distinguish between price  control  and price  support.

(b)  Assess the consequences   of price legislation   in an economy

5 (a) Account for price fluctuations of agricultural   products in your country

(b) What are the effects of such price fluctuations   in your country?

(c) How may government stabilize prices of agricultural   products in your country?

  1. (a) Explain the reasons for setting  maximum   price  in an economy

(b) What are the negative effects of fixing a minimum price in an economy?

7 (a)  Why  are  prices  of manufactured    goods  more  stable  than  prices  of  primary   products   in your country?

(b)  Account   for the need to stabilize prices of agricultural   products in your country.

8  (a)  Discuss   the  assumptions   and  limitations    of  using  the  cardinal   utility   theory   in  explaining consumer  behaviour

(b) With  the use  of a clear  diagram,   explain  how  the demand  curve  for  a normal  good  is derived under  the cardinal  utility  approach

Thank you Dr. Bbosa Science

+256 778 633 682

 

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