FOUNDATION IN BUSINESS

ECONOMICS
THE PRICE SYSTEM

In a free market, the price in the market is determined by the demand (DD) and supply (SS). And
price determines the quantity demanded (QD) and quantity supplied (QS). This is applicable in
markets for goods and services, such as fruits, labour, tuition, foreign currencies etc.

Demand Quantity Demanded

Price
Supply Quantity Supplied

Price functions as a signal (invisible hand) to the producers on what to be produced. This means
that it answer the economic question. When the consumers demand more, the increase in the
demand causes the price to increase. Producers respond by re-allocating the resources to the
production with the higher demand. For example, when the production of Wira continues to enjoy
a good demand, EON uses more of its resources in this department, instead of in the department
to produce Tiara.

Price also rations the goods in the market. Demand and supply changes. When excess demand
happens, this means that there are more demanded than what is supplied. The inequilibrium
causes the price to increase, which means that only those who are able to pay would be able to
have this item. It helps to reduce the quantity demanded, as well as the shortage.

Demand

Demand refers to the willingness and ability of the consumer to buy an item. It refers to effective
demand. A demand schedule shows the quantity demanded by a consumer at each price level,
in a given time period.

P ($) QD
A 10 5 Price
B 8 6 B
C 6 7
8
D 4 8
4 D
DD

6 8 Quantity
As observed, the relationship between the price and the quantity demanded is inverse. The law
1
of demand says that as price decreases, quantity demanded increases, ceteris paribus and
vice versa.
QDx = f (PX, Y, PZ, Ad, Pop etc)
This means that an individuals desire to buy is not influenced by the price of the item itself only,
but by other factors as well.

1
Ceteris paribus refers to all factors remain unchanged.

1
 A Change in Quantity Demanded - Causes movement along the same
- Caused by the change in the price of the demand curve only.
item itself.
- B to D : Extension. Caused by the
Price decrease in the price.
- D to B : Contraction. Caused by
B the increase in the price.

D
DD

Quantity

A Change in Demand - Causes the entire demand curve to

- Caused by the change in the factors
other than the price of the item.
Price
shift.
- D1 to D2: An increase in demand.
The demand curve shifts rightward.
- D2 to D1: A decrease in demand.
The demand curve shifts leftward.

D2
D1

Quantity

Factors that cause the demand curve to shift rightward:

- An increase in income (Y), or real income. This applies only if the product is not an
inferior product.
2
- An increase in the price of the substitute (PZ).
- A decrease in the price of the complementary3.
- An increase in the advertising frequency (Ad).
- An increase in population (Pop).

2
Substitute goods are goods that replace one another for the same usage.
3
Complementary goods are goods that must be used together.

2
Supply

Supply refers to the willingness and ability of the seller to sell an item. It refers to effective
supply. A supply schedule shows the quantity supplied by a seller at each price level, in a given
time period.
Price
P ($) QS SS
A 10 5 16 D
B 12 10
C 14 15
D 16 20 B
12

10 20 Quantity

As observed, the relationship between the price and the quantity supplied is direct. The law of
supply says that as price increases, quantity supplied increases, ceteris paribus and vice
versa.

QSx = f (PX, Cost, PZ, Tech, Policies etc)

This means that a sellers desire to sell is not influenced by the price of the item itself only, but by
other factors as well.

A Change in Quantity Supplied A Change in Supply

- Caused by the change in the price of - Caused by the change in the factors
the item itself. other than the price of the item.

Price Price
S1
S S2

Quantity Quantity

- Causes movement along the same
supply curve only.
- B to D : Extension. Caused by the
increase in the price.
- D to B : Contraction. Caused by
the decrease in the price.
- Causes the entire supply curve to
shift.
- S1 to S2: An increase in supply.
The supply curve shifts rightward.
- S2 to S1: A decrease in supply. The
supply curve shifts leftward.

3
Factors that cause the supply curve to shift rightward:

- A decrease in the price of inputs.

- An improvement in the technology level.
4
- An increase in the price of the joint good (PZ).
- A decrease in the price of the rival goods5.
- An increase in government subsidy.
- A decrease in indirect tax.

Market Demand and Supply

A market demand is the horizontal summation of individuals quantities demanded at each price
level, in a given time period. If we assume that at the price of RM10, consumer A wants 5 units
and consumer B wants 3 units, then, in this market of only 2 consumers, the markets quantity
demanded is 8 units. When the price drops to RM8, consumer A increases his quantity
demanded to 8 units, while consumer B wants 5 units. So, the market quantity demanded now
has increased to 13 units.

The same applies to the market supply. A market supply refers to the horizontal summation of
sellers quantities supplied at each price level, in a given time period.

Market Equilibrium

In a free market, the price is determined by the interaction between demand and supply of the
good. A market equilibrium exists when there is no tendency for the price to change. The price
has no tendency to change when the quantity supplied (QS) equals quantity demanded (QD). The
equilibrium point (e) is where the demand curve intersects the supply curve.

Price
Supply

Pe e

Demand

Qe Quantity
+ Equilibrium
Market
From the e point, the equilibrium price (0Pe) is determined. The equilibrium quantity is 0Qe. In
this condition, the QD = QS.

However, if the quantity demanded is not the same as the quantity supplied, then, the market is
not in equilibrium. The price will change, causing quantities demanded and supplied to change,
until equilibrium is attained.

4
Joint goods are goods that produced together simultaneously.
5
Rival goods are goods that compete for the same inputs in the same firm.

4
Price
When the price is 0P1, quantity
demanded is P1a, while the quantity
Supply supplied is P1b. At a higher price, the
P1 a b sellers are willing to sell more, while
consumers are not keen to buy much.
This price does not hold, as the market
e cannot continue to sustain the excess
supply (ab).

The price has the tendency to fall. As

Demand price falls, quantity supplied falls, while
quantity demanded increases. Excess
supply shrinks, until e is reached, as
Quantity the equilibrium price is obtained.
Excess Supply

Price
When the price is 0P2, quantity
demanded is P2g, while the quantity
Supply supplied is P2f. At a lower price, the
consumers are willing to buy more,
while sellers are not keen to sell much.
This price does not hold, as the market
e cannot continue to sustain the excess
demand (fg).
f g
P2 The price has the tendency to
Demand increase. As price increases, quantity
supplied rises, while quantity
demanded decreases. Excess
Quantity demand shrinks, until e is reached, as
Excess Demand the equilibrium price is obtained.

5
Changes in Demand And Supply

As demand or supply changes, a new equilibrium point is created, where there would be new
equilibrium price and quantity. Any factors, other than the change in the price of the item itself,
shift the demand, or supply, curve, which adjusts the market.

Price Price

S1
S S2

P2
e2 P1
P1
e1 P2

D2 D
D1

Q1 Q2 Quantity Q1 Q2 Quantity

An Increase In Demand An Increase In Supply

This results in a higher This results in a lower

equilibrium price and quantity. equilibrium price and higher
equilibrium quantity.