# Theory of Price Determination

CHAPTER 5 THEORY OF PRICE DETERMINATION

Now that we have seen how consumers and producers behave, we can turn to the determination of price in a market, aka the price mechanism (aka price theory. As of now, there are no government involvement in our free market, and the essence is of the simultaneous interaction of demand (SS) and supply (SS) forces that determine the equilibrium price (and equilibrium quantity) of the goods and services.

5.1 Market Equilibrium

The price mechanism is the essence of the free market system. The interaction of the demand and supply forces determines the prices of the goods in the market, and the market is said to arrive at an equilibrium position.

Equilibrium Price and Quantity
The term equilibrium means a state of balance or rest. When we see buyers (consumers on demand curve) and sellers (producers on supply curve) interact in the market, we obtain the equilibrium price and quantity. The quantity demanded and quantity supplied will be equal at one and only one market price. This is the equilibrium price.

If the equilibrium price is not reached, market forces would come into play until quantity demanded equals quantity supplied to push the price back into equilibrium. Market equilibrium occurs at a price at which the quantity demanded by consumers is equal to the quantity supplied by producers. At \$0.75, the market “clears”. This is shown at point C in Figure 1.

At prices above the equilibrium price, the quantity supplied > the quantity demanded; at these prices there is a surplus, and there is a downward pressure on the price. At prices below \$0.75, quantity demanded > quantity supplied; the resulting shortage puts upward pressure on the price.

In summary, there are tendencies for prices to rise when a shortage occurs and for prices to fall when a surplus occurs. This is known as the price mechanism (market mechanism) or the invisible hand
which explains that the market behaves as if some unseen force was examining each individual’s supply or demand and then selecting a price that assured equilibrium.

5.2  Changes in Conditions of DD

Consider a non-price factor of demand at work, say incomes rise. The demand will rise, shifting the demand curve from DD to DD1. At the original price of \$0.75, quantity demanded exceeds quantity supplied, i.e. a shortage occurs. The invisible hand will act, pushing the price up, so as to clear the market.

As the price rises, quantity supplied increases along supply curve SS (from point A), and quantity demanded falls along the demand curve DD1 (from point B). When the new equilibrium price of \$1.00 per quart is reached, the quantity demanded will once again equal the quantity supplied. Both the final price and quantity are higher following the increase in demand.

In contrast, a decrease in demand will shift the demand curve to the left, resulting in a lower equilibrium price and quantity.

## 4.3 Changes in Conditions of SS

Any non-price factor that raises the supply, will lead to the supply curve shifting to the right. The surplus that occurs at the original price will eventually lead to market to clear at a lower price, with a higher equilibrium quantity.

In contrast, a decrease in supply will shift the supply curve leftward, resulting in a lower equilibrium quantity but higher equilibrium price. (Do sketch diagram to verify.)

## 5.4 Simultaneous Changes in DD and SS

If both the demand and supply curves shift at the same time, then either final price or quantity is indeterminate.
1. An Increase in Demand and Supply If the demand and supply curves both shift rightward, the equilibrium quantity increase. However, the new equilibrium price is indeterminate. Although E1 is to the right of E, it could be above or below E, depending on the relative shifts of the demand and supply curves.

Consider the effects on price and quantity for the following:
2. A Decrease in Demand and Supply
(Output falls but price is indeterminate.)

3. An Increase in Demand and a Decrease in Supply
(Price rises but quantity is indeterminate.)

4. A Decrease in Demand and An Increase in Supply
(Price falls but quantity is indeterminate.)

(You will need to sketch out the impacts)

In general, when the demand and supply curves shift in the same direction, equilibrium quantity also shifts in the direction. The effect on price depends on which curve shifts more. If the curves shift in opposite direction, price will move in the same direction as demand. The effect on quantity depends on which curve shifts more.

In the next chapter, we look at the way producers behave.

## 5.5 Sample Short Answer Questions

1. Explain how a recession and lower fuel costs affects the price of air tickets.
2. Explain why the price of smartphones have been increasing, despite that the phones parts have been shifted to lower-cost producing countries.
3. Discuss whether the implementation of health campaigns and lower prices of packaging materials impact the revenue earned producers of potato chips.
(More sample essay questions for Market Mechanism here.)

The above questions require your knowledge of the content of both supply and demand theory, as well strong exam techniques to answer them to get a “Level 3 response”, otherwise known as higher order thinking skills (HOT). More of these HOT skills in our Econs tuition lessons.

## 5.6 Sample Outline Essay Answer

“Airbus failed to deliver its super jumbo jets (A380) on time. This, coupled with more than two billion passenger trips made last year as compared to 1.88 billion trips made in 2004, could lead to an increase in air fares, say analysts. It is all a question of demand and supply.”
Source: The Straits Times, 15 Oct 2006
(Update; Production has been stopped for Airbus, 2019)

(a) Explain the demand and supply factors which could “lead to an increase in air fares”. 
(b) Assuming that the increase in air fares had come about from a specific fuel tax imposed on the airline industry, discuss the impact this would have on airline firms revenue. 

Part (a)

Demand factors:
o increase in incomes
o rise in taste and preferences for holidays o increase in prices of train/ship travel
o decrease in prices of holiday packages/hotel rooms, etc

(Any 2 DD factors, as long as both are applied to the context.)

Supply factors:
o fall in number of planes supplied by Airbus (must be included)
o increase in the price of fuel or an increase in any of the input prices
o expectations of a particular flight route being unprofitable in the future o decrease in number of airline firms (e.g. bankruptcy)
o contracts with plane suppliers terminating, etc

(Any 2 SS factors, as long as both are applied to the context.)

Level 3: (7-10m): Explain factors and illustrate with contextual examples. e.g. † income → †DD ↑P as people demand more holidays (normal good)
Level 2: (5-6m): Explain at least two DD and two SS factors e.g. income → †DD
Level 1: (1-4m): Mere listing of SS and DD factors without explanations

Part (b)
Explain that a specific fuel tax increases unit / marginal production cost and would result in an increase in prices as the firms in the industry attempt to pass on some of the cost to consumers. Price increases and quantity demanded decreases ceteris paribus.

Explain parallel SS shift left by the amount of the tax.

Standard PED analysis
o Elastic DD (TR decreases) and inelastic DD (TR increases),
o Draw 2 diagrams (diagrams must have both SS/DD curves)
(Note: extended analysis may involve the price elasticity of demand aka PED, as you will learn shortly in the next few chapters.)

Evaluation
Derived demand: Air travel a necessity for businessmen (more inelastic DD), a luxury for holiday-makers (more elastic DD) o Depending on which market segment dominates, TR may increase (former) or decrease (latter)

SR: TR may be unchanged as tickets are booked in advance and not many close substitutes for long distance travel especially, Airlines absorb the tax; profits affected; LR: TR may decrease as people look for travel alternatives o Airlines transfer some tax burden to consumers; SS decreases; P increases

. LR: DD may be quite elastic as there may be available substitutes (e.g. teleconferencing for business meetings), especially if one airline pulls out of a particular route and other airlines take over

L3 Analyse the effects of varying PED on TR
L2 Explain and illustrate how the fuel tax affects P & Q
L1 Recognising that a fuel tax causes P to increase OR causes SS curve to shift left

Up to 5m for EV: Assess the possible elasticities, substantiated with theory and applied in context of the different consumer market segments

Prior Chapter: Theory of Supply | Next Chapter: Price Elasticity of DD & SS