TOPIC TWO

ELEMENTARY PRICE THEORY

The price theory is concerned with the determination of price of any commodity. It is
determined by the interaction between the demand and supply of a given commodity. We
shall thus consider demand and supply concept under the price theory.

CONCEPT OF MARKET
 Market can be defined as a collection of buyers and sellers who interact, resulting in
the possibility for exchange.
 It is a group of firms and individuals in touch with each other in order to buy and sell
some goods and services.
 It is also an arena in which buyers and sellers of goods and services come into contact
with each other to transact business.

CONCEPT OF DEMAND
Demand is defined as, the amount of a commodity people are willing and able to buy at
all possible prices and in a given time.
There is a difference between demand and wants, in that demand are human desires that
are fully backed by the ability to pay. On the other hand, wants are human needs that are
not backed by ability to pay.

FACTORS THAT INFLUENCE QUANTITY DEMANDED

 Price of the commodity itself
 Price of other commodities which are related to the good in question (be they substitute
or complementary) (Py)
 Consumer income (y)
 Consumer taste and preference for the good (T)
 Advertisement
 Consumer expectation about future prices (E)
 Size of population and its composition (N)
 Credit availability (C )
 Other factors (Z)

Using a functional notation we come up with the following demand function

Dx  f  p x , p y , y, T , A, E, N , C, Z ..........................................1

This simply states that the individual demand for good X is a function of all the factors
listed in the brackets.

i) The price of the commodity itself

In order to analyze the effects of price on quantity demanded of the commodity, we
hold all other factors fixed. the relationship between price and demand can be
explained by the help of the law of demand. According to Alfred Marshall this law
is defined as, “other things being equal, with a fall in price, the demand for the
commodity is extended (increases), and with a rise in the price, the demand is
contracted (decreased)”
This law can be explained with the help of a demand schedule and diagram.
Demand Schedule: is a tabular representation of the quantity demand of a good at
given price level and at a given point in time.
Demand diagrams on the other hand is a graphical representation of the content
of the demand schedule.

Demand schedule

Price in Kshs Quantity demanded

25 1
20 2
15 3
10 5
5 7

2
 From this demand schedule, a demand curve can be plotted as shown below.

Price
(Kshs)
25
*
20
* Demand curve
15
*
10
*
5
*
012 34 5 67Quantity
Demande
d

In the above diagram it is seen that the demand curve slopes downwards from left
to right showing that at higher prices less is demanded and at low prices more is
demanded. We can thus say that for normal demand curve, less is demanded at
higher prices and more is demanded at low prices.

REASONS FOR THE DOWNWARD SLOPING DEMAND CURVE.

i) Lowering prices brings in new buyers who were not able to buy at the previous
price.
ii) Reduction of price may coax out some extra purchases by each of the initial
consumers of the goods, while a rise in price may lead to less purchases. Naturally,
consumers will try to substitute the commodity with another cheaper one.
Note also that a fall in price implies a rise in real income, hence the ability to
purchase more of the same good.
iii) Whenever a commodity becomes expensive its consumption normally will be left
for only very important uses. For instance a consumer may opt to use electricity

3
 lighting only, and not for cooking if its prices sky rocket. The vice versa is also
true.

EXCEPTION TO THE LAW OF DEMAND

There exists cause where demand may slope upwards instead of downwards from left to
right.
(i) In the case of Giffen goods:- Giffen goods (named after the economist Sir Robert
Giffen) are very inferior goods for which demand increase as price rises and
decrease as price falls. This applies to poor communities.. e.g. In Asia people’s
stable food is rice. If price of rice was to fall, consumers may reduce their demand
for rice or consume the same amount of rice and use their extra money saved as a
result of fall in price to purchase some more nutritional food. If price increase of
rice, then they would only consume the rice.

Q
0
p

(ii) Veblen good (goods of ostentation)

Goods associated with the rich, luxury goods such as jewellery, luxurious vehicles etc.
the value of such goods (quality) is measured by how much expensive it is. For such
goods, the higher the price, the higher will be the demand.

Q
0
p

(iii) Fear of future rise in price

fear of future rise in price makes consumers buy more quantities of different goods
even at higher prices than before because they know that if they dent buy more now,
they will have to pay much higher prices in future.

4
The existence of such goods and factors explain why under exceptional case the demand
curve may be positively sloped as below.

Price of
commodity

D Demand Curve for

Exceptional case

0 Quantity
demanded

CONCEPT OF MOVEMENT ALONG DEMAND CURVE AND SHIFT OF

DEMAND CURVE.
A movement along a given demand curve is coursed by change in the price of the
commodity. An upwards movement is caused by an increase in prices while a downwards
movement is caused by a fall in prices. This can be shown as below.

5
Price of
Commodity
D

p2 a

p1 b
D

0 Q1 Q2 Quantity
Demanded

A movement from b to a is caused by a (rise) change in price prom p1 to p 2 and a

movement form a to b is caused by a fall in prices from p 2 to p1 .

Note: as price falls from p 2 to p1 , quantity demanded rises from Q1 to Q2 .

A shift of the demand curve is caused by change in other factors influencing demand
other than price of the commodity. The impact of these other factors shall be observed
later.
A shift of the demand curve can either be to the right or left depending on the direction on
which a change has taken place. A shift to the right shows an increase in demand while a
shift to the left shows a decline in demand.

6
Price of
commodity
D

Increase
Decrease
D1
D
D2

0 Quantity
demanded

In the diagram above D1 D1 represents an increase in demand while D2 D2 represents a

decline in demand.

OTHER FACTORS THAT INFLUENCE DEMAND

2) price of other commodities which are related to the good in question:
There are three possible relations between the demand of one commodity and the price
of other commodity.
A fall in price of one commodity may lower the quantity demanded of good x, the two
commodities x and y, are said to be substitutes.
When prices of one commodity fall, the household buys more of it and less of
commodities that are substitutes for it.
Example:
a. Butter and Margarine
b. Sukuma wiki and Cabbage
c. Beef and Fish

7
If a fall in price of one commodity raises the quantity demanded of another commodity the
two are said to be complements.

When the price of one commodity falls, more of it is consumed and more of those
commodities that are complementary to it are consumed also. Example, motor cars and
petrol, butter and bread etc.

Price of Price of
Good Y Good Z

p0 p0

p1 p1

Q1 Q0 Quantity Q0 Q1 Quantity
of X of X
i  ii 

Graph 1: curve sloped upwards indicating that as price of a substitute falls, the quantity
demanded of good x falls. So good y, and x, are substitutes.
Graph 2: curve slopes downwards, indicating that when the price of a complement falls
there is a rise in the quantity of good x demanded.

3) Consumer income
We would expect a rise in income to be associated with a rise in the quantity of a good
demanded. Goods obeying this rule are called normal goods. In some cases a change
in income might leave the quantity demanded completely unaffected. This will be the
case with goods for which desire is completely satisfied after a level of income is
obtained.

8
Example: if one used to eat salt, the consumption of it will not change even though his
income rises, unless his income is very low.
Incase of other commodities, rise of income beyond a certain level may lead to a fall in
the quantity that the household demand. If the demand for a commodity falls as income
rises, the good is called inferior good.
The relation between income and quantity demanded can be shown by the use of
Engels curve

Income Y

0 Quantity
demanded

The curve shows the relationship between income and demand, holding other factors
constant. Engel curve for normal good slopes upwards, implying that as income rises,
quantity demanded will also increase. Incase of inferior good, if Y increases Q
decreases. In this case the Engels curve will slope downwards from left to right.

DISTINCTION BETWEEN GIFFEN GOOD AND INFERIOR GOOD

Giffen good; relates to behavior of quantity demanded in relation to price.
Inferior good: relates to behavior of quantity demanded in relation to income.

9
4) Consumers tastes and preferences
When the tastes for a commodity are favorable, consumers will prefer more of that
commodity to other commodities thereby increasing the demand for the commodity.
For example, in the beauty, would the taste of women have moved towards colored hair
products such as pony tail or dyeing of hair. So the demand of such products would
hike.

5) Advertisement:
As a producer advertises his product, he creates awareness that his products exist, and
he tries to show the superiority of his product over others in the market. If we hold
other factors constant, we expect that an increase in advertisement expenditure will
lead to an increase in demand.
Advertising is
 Informative
 Persuasive on price, availability, performance.

6) Consumers expectations about future prices:

If consumers expect the price of a commodity to rise in future, they will buy more of
the commodity now and store it. In this case quantity demanded increases. However,
should they expect a fall in price in future they will buy less on the commodity now
hoping to buy more in future after the price has fallen. In this case quantity demanded
becomes less.

7) The size of population and its composition.

The greater the size of population to satisfy, the greater the quantity consumers will be
willing to demand. The fewer the consumer in the market, the less the quantity
demanded will be.
When we talk of composition of population we are talking of the sex proportion and
age group. Certain commodities are manufactured for certain age group and sex. For
instance, cosmetics are meant to be used by women, napkins by infants, shaving cream

10
 by men. So producers consider these factors before deciding how much to produce.
Who shall be his target market?

SUPPLY
 Supply as a commodity is defined as the quantity of that commodity sellers are willing
to put in the market at a given price and at a given time.
 Supply should be distinguished from stock, whereas stock is the total quantity of a
commodity which is available at any specific time, supply is that part of stock which is
offered fro sale at any price.
 For example, the supply of oil is not the estimated resources of all the world’s oil fields,
but only that amount which particular price will bring into the market.
 Supply will always change with price changes. This relationship between supply and
price is called the law of supply.
 The Law states that other things remaining constant, when price rises, supply
increases and when price falls, supply decreases.

Supply schedule.
Is defined as table showing quantities sellers are willing to put in the market at all possible
prices. This is shown below.

Price per unit Quantity

1 2
2 4
3 6
4 8
5 10

From a supply schedule a supply curve can be drawn as shown below.

11
Price
(Kshs) 6

5 *

4 *

3 *

2 *
1 *

0 2 4 6 8 10 Quantity
Supplied

In the above diagram, it can be seen that the supply curve slopes upwards from left to right
showing that sellers are willing to supply more at higher prices and to supply less at lower
prices. It follows therefore that the supply curve for a normal good slopes upwards from
left to right.

Factors that influence supply

1. The price of the commodity
2. Objectives of the firm
3. The technology used
4. The cost of production incurred by producers
5. Taxation policies of the government
6. Weather condition
7. Subsidies
8. Price of competing products
9. Peace and stability
10. Infrastructure

12
Qs  f  p0 , p1 , tech, O, T ,W , S 

1. The price of commodity

At higher prices products are motivated to produce more thereby increasing the supply
of the commodity under consideration. At lower prices less is supplied because
producers see no reason why they should produce more because profitability will be
negatively affected.

2. Objective of the firm

A firm can have various objectives. For example profit maximization; to maximize
profit will require that more be supplied at higher price. However, some welfare
organization doesn’t follow this law. For example, the supply of drugs; supply of drugs
may rise depending on the prevailing situation even though prices are low.

3. Technology used
If better methods of production are used, we again expect output to be economically
produced and so the supply of the commodity in question will increase. More can be
supplied at some price because per unit cost of production would be lower than in the
case where worse methods of production are used.

4. Cost of production
Increase in the cost of production will lower quantity supplied because producers will
find it very expensive to increase output. However, with low cost of production more
is likely to be supplied since the producer will find easy and cheaper ways of producing
more of the commodity in question.

5. Taxation policies of the government

The taxation policies of the government also influence quantity supplied because if the
government raises taxes, the cost of production goes up thereby reducing quantity
supplied. Taxes make commodities be more expensive than competing products e.g.

13
 East African breweries has been urging the government to lower taxes on its products
so that they could compete well against the south African Breweries products.

6. Subsidies
When the government subsidizes the production of a given good, the supply of that
good also increases because the cost of production is reduced by the subsidies given.
Government may decide to incur part of the overall cost of production as a way of
motivating production of certain goods which otherwise would have been very
expensive to produce. Why South Africa goods compete effectively against other
counties’ goods is because of support in the form of subsidies the producers receive
from South Africa government.

7. Weather condition
This commonly affect agricultural produce. When weather condition are good, more is
produced and hence supplied and vice versa.

8. Price of competing products

 For example Kenyan beer Vs South African beer or Aerial soap Vs Omo
 Manufacturers of thee products from Kenya have been complaining of unfair
competition that has been posed by such imported products. Such imported
products have led to the collapse of many local industries. For example,
Mitumba (second hand cloths) whose prices are much lower than locally
produced cloths have led to many textile industries closing down.
 Recall also the closure of Bata Shoes Company of Limuru because of
competition from cheap imported shoes and Jua kali made shoes.
 This is a clear example of how prices of competing products would affect
supply.

9. Peace And Security

10. Development of infrastructure particularly transport and communication.

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MOVEMENT ALONG A GIVEN SUPPLY CURVE AND SHIFT OF A SUPPLY
CURVE.
A movement along a given supply curve is caused by changes in the prices of the
commodity. An upward movement is caused by an increase in price while a downward
movement is caused by a fall in prices.

Price

p2 d

p1 c

0 Q1 Q2 Quantity
supplied

 A movement from C to D is caused by a rise in price from p1 to p 2 and a movement

from D to C is caused by a fall in price from p 2 to p1 .

 A shift of the supply curve is caused by change in other factors influencing supply other
than price of the commodity. A shift of the supply curve can either be to the right or
left depending on the direction on which a change has taken place. A shift to the right
shows an increase in supply while a shift to the left shows a decline in supply

15
Price
S2
S
S1

Decrease

Increase in supply

0 Quantity
supplied

ABNORMAL SUPPLY CURVES

There are cases where the law of supply may fail to be obeyed, and more may be
supplied as prices fall and less as prices rises. A case at hand is the one of target
workers. The supply curve of labor for target workers is a downward sloping curve
showing that at higher wages rates, target workers are willing to work for less hours
while at low wage rates target workers are willing to work are willing to work for more
hours. This is because target workers normally set for themselves a target and after
achieving that target they don’t bother to go ahead with work. This is shown below.

16
 Wages

10 *

6
*
4 *

2 *

0 2 4 6 8 10
No. of Hours worked

 Here it is assumed that out target workers has set themselves a target of sh. 20 everyday.
At wage rate of sh. 2 per hour. He shall be willing to work for 10 hours in order to get
sh. 20 per day. When the wage rate is increased to sh. 4 per hour, he is willing only to
work for 5 hours in order to sustain his income of sh. 20 per day. As the wage rate is
increased further to sh. 10 per hour he reduces his working hours further to 2 hours
only. This gives us a downwards sloping supply curve of labor. The higher the wage
rate, the lesser will be the labor supplied and vice versa.
 One reason why this would be possible is that as wage rate increases, the laborer is able
to realize his target within a short time and the rest of his time is spent on leisure.

17
 EQUILIBRIUM
In studying equilibrium, our objective is to determine the market price and quantity and
try to identify the forces that influence such a price and quantity.
 Equilibrium can be defined as a state of rest. It is a situation whereby quantity
demanded Qd  is equal to quantity supplied Qs  i.e. Qd  Qs
 In this case, we say that the market is clearing and there are no economic forces
generated to change this point hence it is stable.
 We determine this graphically by the interpretation point of the demand and supply
curves as below.

Price

Excess supply S
 Equilibrium price = pe
p1
Equilibrium Quantity = Qe

pe E

p2


 D
Excess demand

Quantity
0 Q3 Q1 Qe Q2 Q4

 In the above diagram it can be seen that the forces of demand and supply determine the
price in the market, i.e. a price at which both consumers and sellers are happy and
where quantity supplied equals quantity demanded. That price is known as the
equilibrium price.
 In the diagram, should the price be above the equilibrium price, forces of demand and
supply will work together and lower the price towards the equilibrium price until the
equilibrium price is reached. For example at p1 consumers will only be willing to buy

18
 0Q1 from the market while sellers will by willing to supply 0Q2 . In this case an excess
supply equals to Q1Q2 will be created. Because of this excess supply, sellers will have
to reduce the price in an attempt to encourage consumers to buy more. Prices will be
reduced until pe is reached where quantity demanded equals quantity supplied.

 Should the price be below the equilibrium price (e.g. at p 2 ) again the forces of demand

and supply will work together to ensure pe is restored. At p 2 suppliers are willing to

supply only Q3 because they consider p 2 to be very low. On the other hand, consumers

will be willing to buy Q4 since very many of them can afford to pay p 2 . In this case an
excess demand (shortage) equal to Q3Q4 will be created. Because of shortages,
consumers will compete among themselves for the little that is available and because
of this competition, prices will be pushed upwards towards pe until eventually pe is
reached.

MATHEMATICAL DERIVATION OB EQUILIBRIUM

Demand function: Qd  3550  266 p

Supply function: Qs  1526  240 p

Question: determine the equilibrium market price and quantity.

Solution
At equilibrium Qd  Qs

Thus. 3550  266 p  1526  240 p

2024  506 p
2024
pe   sh.4
506

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Qs  1526  2404  2486 units 
Qe  2486 units
Qd  3550  2664  2486 units 

Price

Qs  1526  240 p

pe  sh4

QD  3550  266 p

Quantity
0 Qe  2486

TYPES OF EQUILIBRIUM
1. Stable equilibrium
2. Unstable equilibrium
3. Neutral equilibrium

Stable equilibrium: if there is a force that disrupts the market equilibrium, then there
would be adjustments that bring back to the initial equilibrium. This type of equilibrium is
well explained in the previous section.

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

20
Illustration using demand fro a giffen good

Price S

D
Excess
 demand

p1

p2

D S
0 Qe Q1 Q2 Quantity

 Equilibrium point is pe Qe

 If price increases from pe to p1 , excess demand over supply is created as shown by

the quantity Q2  Q1
 Because of excess demand prices will continue going up and for away from equilibrium
point, hence unstable equilibrium.

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

Effects of shifts of demand/supply curve on equilibrium

The equilibrium price will fall on increase depending on the direction in which the shift
have taken place.

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Price
D0
S0
S1

Excess
 supply

pe

p1
S0

S1 D0

0 Qe Q1 Q2 Quantity

 an increase in supply is represented by a shift to the right.

 Initial equilibrium price and output is pe and Qe , respectively

 At this initial price pe with an increase in supply means output increasing to Q2 while

demand remains Qe .
 Therefore we shall have excess supply.
 To encourage consumers to consume more of the good, adjustment will be such that
prices decline. Prices will continue to decline until a new equilibrium price p1 is
realized.
 Therefore the new equilibrium prices and output will be p1Q1

 Notice, because of all in prices to p1 , quantity demanded will increase from Qe to Q1

.

Therefore we can conclude by saying that an increase in supply leads to low price and
to increase in quantity demanded.

Assignment: explain the effects of a fall in demand on price and output.

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Price

S0
D0

D1
pe
p1

D0

D1
0 Q1 Qe Quantity

DISEQUILIBRIUM
This is a situation where quantity demanded is not equal to quantity supplied. Qd  Qs  ,
and the market does not clear. Hence both consumers and suppliers will have to change
their behavior.

Conditions for disequilibrium

i) Price restriction by government
Government from time to time control prices of different commodities through
maximum price policies and minimum price policies.

Maximum (ceiling) price policy

Here prices are set below equilibrium price because sometimes the equilibrium
price might be regarded as being too high for the poor consumers to afford essential
commodities. In an effort to protect poor consumers from exploitation, the
government fixes a maximum (ceiling) price so that commodities that are regarded
as essential can be within easy reach of the poor consumer. This can be shown in
the diagram below.

23
 Price

D
S
p2

pe

p1 
Excess
demand D

0 Q1 Qe Q2 Quantity

In the above diagram it can be seen that a maximum price p1 has been set below,

the equilibrium price pe . As a result excess demand represented by Q1Q2 is created

since at p1 supplier is willing to supply only Q1 while consumers are willing to

buy Q2 .

However if the ceiling is above pe , say p 2 , it will serve no purpose since the

equilibrium pe Qe will still be maintained. At p 2 there will be excess supply and

the producer would be better off reducing the price to pe to reduce wastage as a
result of over production.

Consequences of maximum price policy

1) Shortages can be created since demand will exceed supply.
2) The government might be forced to ration the little that is available in order to
ensure that at least everybody gets something.
3) Activities like black marketing, smuggling and hoarding are likely to take place
because the price below equilibrium level might be regarded as too low by the
producers.

24
4) The level of investment is likely to be discouraged because of low business
profit private business will be getting very low profits to plough back into their
business.
5) Due to low investment, there might be unemployment. i.e. very few jobs will
be created because there won’t be enough investment to stimulate growth of the
economy.
6) On the positive side we can say that the welfare of the consumer is likely to
increase since the consumer will be able to afford the prices in the market.

Minimum (floor) price policies

Here price are set above the equilibrium price, the reason being that the government
might consider the equilibrium price to be a very low to motivate producers to
continue production effectively. In order to encourage producers to produce more.
The government sets a minimum price.
Minimum price are mainly found in the agricultural sector since the agricultural
sector often suffers from price fluctuation. Below is a diagram which illustrates the
working of minimum price policies.

Price

D
S
p1 Excess
 supply


pe

S
D
0 Q1 Qe Q2 Quantity

25
 In the diagram it can be seen that a result of fixing a minimum price  p1  above the

equilibrium price  p e  excess supply Q1Q2 is created since consumers are willing

to be buy Q1 , while suppliers are willing to supply Q2

In this case the government has to purchase the excess supply and either store it so
that it can be re-supplied during the period of shortage or export to the outside
market on order to earn the country foreign exchange.

2) Failure to meet production target as another condition to disequilibrium

Failure to meet production target especially in the agricultural sector due to unfavorable
climatic condition among other could lead to disequilibrium in the market.

Let
S p  Planned production

S A  Actual production

Price

D
S
p1 v

pe

p2

0 Q1 S A Qe  S p Q2
 

Quantity
Excess
demand

26
Let S P  S A . That is, owing to unfavorable climatic condition, supposing the producer fails

to meet his targeted production of S P and instead he realizes only S A . This would imply

that there would be shortage as demand would exceed supply Qe  S A  . Because of this
excess demand (shortage) the prices will move upwards. The consumers will be willing to
pay a price p1 for S A units of output. This is shown as point V  p1Q1  along the demand
curve.
On the other hand, if S P  S A , this implies more production than planned, there would be
excess supply and prices would be pushed down wards below the equilibrium.
However, this situation of disequilibrium may not be permanent. Once conditions improve,
equilibrium may be attained. That would be in the long run.

3) Lagged responses as a cause of disequilibrium

Price

S
D1

D0
p2 Increase in demand

pe
D1
D0
S
0 Qe Q2 Q1 Quantity

 Suppose we assume that consumer income has increased. This will lead to the
shift of demand curve to the right from D0 D0 to D1

27
  The effects will be the disturbance of equilibrium from pe Qe and creation of

excess demand over supply Q1  Qe 

 This is so because it will take the producers time before the they produce
enough to meet this excess demand.
 Because of this short-term shortages prices will be pushed upwards towards p 2
 From the law of demand and supply we know that as price increase demand
will decline and supply increase.
 This will continue until a new equilibrium point is attained  p2 Q2 
 It should be noted that before this new equilibrium point was attained there was
a lag. This could be because of inferior technology that could not allow
production to take place on time to avoid shortage. Another reason could be
imperfect knowledge about the market conditions. If consumers could have
perfect knowledge on alternative sources of product such shortage could not
arise.

How disequilibrium concept is applied

The disequilibrium concept can be applied on the cob- Web model.

THE COBWEB THEORY

This model is used to trace the path form disequilibrium to position of equilibrium. in our
previous discussion, we said that one cause of disequilibrium is lagged responses.
The cobweb model assumes that producers output plans are fulfilled but with a time lag.
That is, if a producer is a farmer, he cannot within the short-run increase his output just
because the market is offering very good prices.
This is so because of the nature of the products. The time between planting and harvesting
is long enough risk and uncertainty to prevail.
Thus, producers are assumed to base their production decisions on the previous period’s
prices. However demand depends on the prevailing prices in the market.
Therefore, what is consumed presently is what must have been planted in the previous
period.

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Dt  f  pt ......................................................1
S t  f  pt 1 ....................................................2

Where pt is price in the current year.

pt 1 is price in the previous year.

The cobweb model always begins with a situation of disequilibrium in the market due to
unplanned variation in the supply.
The following diagram can be used to illustrate what the cobweb theory is all about.

Price
Fig a Convergent cobweb

S t  S  pt 1 

p1
p1
p3
p3
p5 p5

p4
p2 p4
Dt  D pt  p2

0 Q1 Q3 Q5 Q4 Q2 1 2 3 4 5
Quantity Time

 Suppose the prevailing price in the market is p1 , quantity demanded will be Q1 .

 Farmers will base their production decision for period 2 on the price of period 1  p1  .

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 Therefore in period 2 farmers will produce output Q2 .

 From the diagram, it can be seen that consumers are willing to buy that quantity at p 2
.
 If farmers base their production decision for the third period on the present price p 2 ,
they will cut down production to Q3 because they consider the price to be too low.

 With this quantity in the market p3 will be offered by the consumer.

 Again if farmers base their decision for the fourth period on the present price i.e. p3 ,

they will produce Q4 , but with Q4 produced, consumers will be willing to pay only p 4
.
 This process goes on as shown in the diagram until eventually equilibrium price is
achieved.
 From the diagram, it can be seen that the fluctuation tend to converge towards the
equilibrium, hence, this situation is known as convergent or a situation of stable
equilibrium.

Just like we have convergent fluctuation we can also have divergent fluctuation.

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Price
Fig b Divergent cobweb

S t  S  pt 1 
Dt  D pt 

p3
p3
p1
p1

p2
p2
p4
p4

0 Q3 Q1 Q2 Q4 1 2 3 4 5
Quantity Time

From the same procedure as in figure a, fluctuation in price tend to become wider over
successive period. In other words, the fluctuation tends to run away from equilibrium
prices. Such a situation is known as divergent situation in that it diverges from the
equilibrium price. Such a situation is known as a divergent situation in that it diverges
from the equilibrium price. It has also been called by some economists a situation of
unstable equilibrium.

WEAKNESSES OF COBWEB THEORY

1. It assumes that producer (farmer) are irrational and hence base their production
decision on the previous prices without thinking of price changes but this is rather
unrealistic because in reality farmers always think about changes in prices in the future.
2. The theory also assumes that all the quantity produced is sold in the market but this is
also unrealistic because in the true sense some agricultural products are assumed for
subsistence needs while others are stored waiting for sale in the future when prices are
considered high.

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It is thus clear from the previous discussion that the elasticity of demand depends not only
on the ratio of price to quantity demanded, but also on the slope of the demand curve.

DISTINCTION BETWEEN POINT ELASTICITY AND ARC ELASTICITY OF

DEMAND.
The two are different ways of computing elasticity of demand.

1. Point elasticity
Point elasticity is the proportionate change in quantity demanded resulting from a
proportionate change in price at a particular point. Along the demand curve.
When calculating point elasticity, it is assumed that the slope of the demand
function is known.
From the formular for elasticity,

Q p
 pp  
p Q

Q
As noted earlier is the reciprocal of the slope of the demand function.
p
Given a demand function Q  b0  b1 p.

Q
is found by getting first derivative of Q with respect to p
p
p
Thus point of elasticity  pp  b1 
Q

Example
Demand schedule
Price Quantity

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 0 40
1 35
2 30
3 25
4 20
5 15
6 10
7 5
8 0

Price

a
6
p  8
slope  
4 b Q 40

D
Quantity
0 10 20 40

Find point elasticity of demand when

1. p6
2. when p  4

Q p 40 6
E pp       3
p Q 8 10

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 40 4
E pp     1
8 20

Notice price elasticity has been calculated for different points along the demand.
p
For convex slope would vary at different points along the curve.
Q
p
To get the slope of the curve we differentiate the equation (get )
Q
Q p
Point elasticity e pp  
p Q

Arc Elasticity
Arc elasticity is a measure of the average elasticity; i.e. the elasticity at the mid point of
the chord that connects 2 points (A and B) along the demand curve defined by the initial
and the new price levels.

Price

A
p1

B
p2 D

Quantity
0 Q1 Q2

Using example in above demand schedule.

Assume initial price p1  5 , which then increases to p1  6

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p1 Q1
5 15
p2 Q2
6 10

Q  Q2  Q1  10  15  5
p  p 2  p1  6  5  1

p1  p 2  11
Q1  Q2  25

 5  11  1
 Ep      2
1  25  5

Income Elasticity of Demand

This can be defined as the responsiveness of quantity demanded to change in income in %
term it can be defined as:
% change in quantity demanded
EY 
% change in Income

Q Y
So that E I  
Y Q
Where
Q is change in quantity demanded.
Q is original quantity demanded.
Y is change in income
Y is original income.

Arc income elasticity of demand can be calculated as:

Q Y1  Y2 
EY  
Y Q1  Q2 

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 Income elasticity of demand for most commodities is positive, indicating higher purchases at
higher income. Income elasticity for a few commodities is known as inferior goods.
 Degree of income elasticity varies in accordance with the nature of commodities consumers
consume in general. Where the commodity id a basic necessity, the demand is not very
responsive to change in income. Basic necessities like food are usually bought in fairly constant
amount and on regular basis. In this case EY  1
 However, in the case of luxuries, the demand is very responsive to change in income. Sales of
such goods increase rapidly with increase in income. In this case EY  1

Cross elasticity of Demand

 The demand for one product can be influenced by the demand. For example, the demand for
good product depends on the demand for pork, mutton and fish etc. if the price of beef rises
while prices of substitutes (pork, mutton and fish) remains unchanged, consumers will
substitute beef with the cheaper product.

 In some cases, an increase in price of one product can lead to s reduction in demand for other
products. This is true of complementary products e.g. electricity and electronic gadget, petrol
to automobile etc. in this case the products are considered to be complementary or used
together rather the substitutes.
 Therefore, cross elasticity is the percentage change in quantity demanded of good x due to 1
% change in the price of good Y it measures the degree of responsiveness of demand for one
product to changes of the price of its substitutes or complementary goods
 For instance, cross elasticity of demand for tea (T) is the percentage change in its quantity
demanded with respect to one (1) percent change in price of its substitute coffee (C).

Point cross elasticity is calculated by the formula

QT pc
Et ,c  
pc QT

Where

36
 pC is price of coffee

QT is quantity of tea.

Cross elasticity of demand can either be positive or negative.

 A high positive cross elasticity means that the commodities are cross substitutes. If price of
butter increases, the price of its substitutes (margarine) held constant, the quantity demanded
of margarines would increase.
 A negative cross elasticity means that the goods are complementary in the market, thus a
decrease in the price of one stimulates the sale of the other.
 A cross elasticity of zero means that the goods are independent of each other in the market.

Numerical example

QY  5000  0.5 pY  2.3 pW  0.2 p X  0.000001p Z  0.0037 I

Compute different price elasticity and state the relationships between the commodities Y, W, X
and Z.

Solution
Take first derivative of commodity Y with respect to all other products.

QY
 0.3
pW
QY
 0.000001
p Z

QY
 0.2
p X

pW p X p
We know with certainty that the ratios , and Z are all positive.
QY QY QY

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 Q y pw p
EY ,W    0.3 w
p w Qy Qy

From this example it is clear that good y and w are complementary goods since E y , w is negative.

Q y px p
E y,x    0.3 x
p x Qy Qy

E y , x , is positive implying that x and y are substitutes.

Good z and y are independent and are not related to each other.
Assignment
From the above example given

p y  30,000 Qy  15,000 incomeI   60,000

Compute
1. price elasticity of demand
2. Income elasticity of demand
3. Interpret your results
4. From income elasticity of demand, what type of product would y be (luxury or
necessity good)?

DETERMINANTS OF PRICE-ELASTICITY OF DEMAND

The following are the main determinants of price elasticity of demand.
 Availability of close substitutes to the commodity.
 Nature of a commodity
 Proportion of income which consumers spend on a particular commodity.
 Range of uses of a commodity.
 Habits

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1. Availabity of close substitutes-The higher the degree of the closeness of the substitutes, the
greater the elasticity of demand of the good or service. For instance, coffee and tea may be
considered as close substitute for each other. Therefore, 1 percent increase in price of say
coffee, would lead to more than proportionate decline in quantity demanded of coffee.

2. Nature of a commodity-Demand for luxury goods (e.g. refrigerator, TV etc) is more

elastic because their consumption can be dispersed with or postponed when their prices rise.
On the other hand, consumption of necessities (e.g. foodstuffs), essential for life, cannot be
postponed and so their demand is inelastic.
3. Proportion of income which consumers spend on a particular commodity-If
proportion of income spent on a commodity is large, its demand will be more elastic, and vice
versa. A classic example of such commodities is salt, which claims a very small proportion of
income whereas clothes, and other durable consumer goods claim a large proportion of
income.
4. Range of uses of a commodity- The wider the range of uses of a product , the higher the
elasticity of demand. As the price of a multi-use commodity decreases, people extend their
consumption to its other uses, thereby increasing the demand. For instance, milk can be taken
as it is, it may be converted into cheese, ghee and butter. The demand for milk will therefore
be highly elastic.

5. Habit: some goods are consumed because of habit e.g. smoking, in this case we find that price
changes leave quantity demanded more or less unaffected. In this case their demand is said to
inelastic.

Elasticity of supply.
 This is the percentage change in the quantity supplied of a commodity resulting from a 1%
change in price.
 Elasticity of supply is usually positive because a higher price gives producers an incentive to
increase output.

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 Like elasticity of demand, elasticity of supply can also be referred with respect to such
variables as interest rates, wage rates, price of raw materials and other intermediate goods etc.
 Symbolically, elasticity of supply ( E sp ) can be expressed as follows.

Qs p
E sp  
p Q

 When a small change in price bring about a very big change in quantity supplied, then we say
that quantity supplied is elastic. On the other hand, if a big change in price brings about a small
change in quantity supplied, then we say that supply is inelastic.

Determinants of elasticity of supply

1. Availability of factors of productivity
this can be looked at as the ease with which factors of production could be shifted from one
use to another.
It can also be looked at as the number of available resources. When factors of production are
available, supply will highly be elastic and vice versa.
Suppliers will be able to meet demand in good times.

2. Excess capacity of unsold stock (Buffer-stock)

if there exist a lot of stock, incase prices increase, supplier would be able to respond very fast
by increasing supply. In such a case supply is said to be highly elastic.
3. Time factor
This refers to the time it takes to produce and supply a product in the market. In the short run,
supply of most items that take a long time to produce is inelastic. But, in the long run supply
is inelastic.

4. Nature of a commodity
durable/ stockable commodities as clothes etc. have greater elasticity of supply than perishable
goods as milk. This is so because, incase the price of perishable items is low, producers will
still be forced to supply the items. Because it cannot be stored for future sale when the prices
would increase.

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 Usefulness of the concept of elasticity
1. Useful in taxation.
If it is the aim of the government to raise revenue it has to put into consideration elasticities of
the commodities to be taxed, especially price elasticity of demand.
In order to raise revenue the government has to impose heavy taxes on goods which have
inelastic demand. E.g. cigarettes and beer. This is because after taxes are imposed on such
goods consumers will continue to demand the goods in large quantities as before and therefore
the government is able to collect more revenue.
On top of this, the burden of taxes on goods which have inelastic demand falls more on
consumers because sellers are able to pass a greater part of the tax to the consumers through
high prices.
This leaves the production of such goods more or less un affected thus making it possible for
the government to raise enough revenue.
This is shown in the diagram below.

Price
D0
S1
S0

p1 C
p0 E
B
v1 S1
A
S0 D0
Quantity
0 Q1 Q0

The original equilibrium price before the imposition of tax was p0 and the new equilibrium price

after tax is p1 .

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 Distance AC on the diagram represents the tax imposed on the good.
AB of the tax is met by the consumers.
It can be seen from the diagram that the quantity in the market fell by a small proportion Q1Q0
It can thus be said that when a commodity has inelastic demand it pays the government to tax that
commodity heavily because the greatest part of the tax is met by consumers, thus leaving the
production of that good more or less unaffected, hence enabling the government to collect more
revenue from that good.

2. Elasticity is important in international trade

Before a country devalues her currency so as to encourage export and discourage imports, it has
to put into consideration the elasticity of demand and supply for her export and imports.
For devaluation to succeed, exports must be highly elastic so that after devaluation, greater
quantities can be sold in the foreign market. Similarly, the export must have elastic supply in order
to meet increased demand in foreign markets.
On the import side, imports must have elastic demand so that after devaluation greater quantities
of imports can be abandoned.
We can therefore say that before any country devalues her currency, it is important to consider
elasticity of demand and supply for export and imports.

3. Elasticity also tells us the degree to which goods are related.

High cross elasticity between two commodities shows that the two commodities are very related.
This is a useful concept especially for formulating pricing strategies. Such elasticity is especially
important in studying how unfair competition of dumped goods affects performance of domestic
industries. This would thus enable the government know how much import duty to impose on such
goods as to protect local industries from collapsing.

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