Unit 2 - The price system and the theory of the firm (9708)
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Summary AS Level Economics Note Chapter 2
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Unit 2 - The price system and the theory of the firm (9708)
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CIE
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Economics: AS and A Level
These notes cover the whole syllabus of 9708 Cambridge International Examination, AS Level Economics Notes what divided into to 5 Units. You may find each notes have corresponded specifically in each term from syllabus.
Unit 2 - The price system and the theory of the firm (9708)
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Alevel Economic Revision The price system and the micro economy
Revision Material
Edition: 2 April 2020
Chapter 2 The price system and the micro economy
Learning outcomes
Candidates should be able to:
(a) Demand and supply - effective demand
curves - individual and market demand and supply
- factors influencing demand and supply
(b) market equilibrium - meaning of equilibrium and disequilibrium
and disequilibrium - movements along and shifts of the demand and supply curves
- effects of changes in supply and demand on equilibrium price and quantity
- the workings of the price mechanism; rationing, signaling and the transmission of preferences
(c) price elasticity, - the meaning and calculation of elasticity of demand
income elasticity and - the range of elasticities of demand
cross-elasticities of - the factors affecting elasticity of demand
demand - the implications for revenue and business decisions of price, income and cross-elasticities of
demand
(d) price elasticity of - meaning and calculation of elasticity of supply
supply - the range of elasticities of supply
- the factors affecting elasticity of supply
- implications for speed and ease with which businesses react to changed market conditions
(e) interaction of demand - applications of demand and supply analysis
an supply - joint demand (complements) and alternative demand (substitutes)
- joint supply
(f) Consumer and - meaning and significance
producer surplus - how these are affected by changes in equilibrium price and quantity
,(a) Demand and supply curves
1. Introduction to allocation of resources in demand and supply curve
Price mechanism means of allocating resources in a market economy.
The price mechanism describes the means by which millions of decisions taken by consumers and businesses interact to
determine the allocation of scarce resources between competing uses.
It has 3 functions: Signaling function, Transmission of preferences, Rationing function
The signaling function:
- Prices perform a signaling function – they adjust to demonstrate where resources are required, and where they are
not
- Prices rise and fall to reflect scarcities and surpluses
- If prices are rising because of high demand from consumers, this is a signal to suppliers to expand production to
meet the higher demand
- If there is excess supply in the market the price mechanism will help to eliminate a surplus of a good by allowing the
market price to fall.
Transmission of Preferences:
- Through their choices consumers send information to producers about the changing nature of needs and wants
- Higher prices act as an incentive to raise output because the supplier stands to make a better profit.
- When demand is weaker in a recession then supply contracts as producers cut back on output.
- One of the features of a market economy system is that decision-making is decentralized: i.e. there is no single body
responsible for deciding what is to be produced and in what quantities. This is a remarkable feature of an organic
market system.
Rationing Function:
- Prices serve to ration scarce resources when demand in a market outstrips supply.
- When there is a shortage, the price is bid up – leaving only those with the willingness and ability to pay to purchase
the product. Be it the demand for tickets among England supporters for an Ashes cricket series or the demand for a
rare antique, the market price acts a rationing device to equate demand with supply.
- The popularity of auctions as a means of allocating resources is worth considering as a means of allocating
resources and clearing a market.
The price mechanism is a feature of the free market and operates through demand and supply and the self interest
of individuals, government action is minimised. This has the benefits of incentive, efficiency, innovation, choice and
consumer sovereignty. Against this there may be market failure including inequality, lack of public and merit goods,
externalities and instability. Depending upon the degree of failure the mechanism may be more or less effective. The price
mechanism does not solve the basic economic problem but is thought to be effective when operating efficiently.
A free market sets price by the operation of demand and supply. The price of a product determines who has the
purchasing power to afford the good. A higher income means greater ability to purchase so the price system favours the
richer in society. It rations the restricted quantity available between those who might wish to buy. The price also allocates
resources between competing uses. The higher the price the greater the potential reward to factor owners. This will attract
resources to those activities which pay the highest price so determining the employment of factors.
Prices and incentives
Incentives matter, For competitive markets to work efficiently all 'economic agents' (i.e. consumers and producers) must
respond to appropriate price signals in the market.
, 2. Effective of Demand
Law of demand for most goods and services the quantity demanded varies inversely with its price.
Demand curve: a curve showing the relationship between quantity of a product individuals are willing and able to buy over
a range of prices over a period of time, on the assumption that all other factors affecting demand are held constant
Market demand the total demand for a particular product in the market
A greater or smaller quantity is demanded as price change.
3. Factors of influencing demand
- Income
Here we need to distinguish between normal and inferior goods.
A normal good is one for which the demand rises as income rises and falls as income falls. A inferior good is a
good whose demand falls as income rises and rises as income fall. This applies to most goods and services,
purchasing power will increase, the demand will increasing.
- The price of other goods
Many goods are related to one another as substitutes or complements.
Substitutes are goods that are alternatives to one another
Complements are goods that are consumed together.
Coffee and tea are, for many people, substitutes for one another. The demand for coffee will vary directly with the price of tea. If the price of
tea rises individuals will reduce their demand for tea and switch to coffee. The demand for coffee will therefore increase. The opposite will
happen if the price of tea falls.
Fuel is a complement to a motor car. Consequently the demand for fuel is likely to be inversely related to the price of cars. If there is a
significant rise in the price of cars it is likely that the demand will fall and consequently so will the demand for fuel.
If the price of the substitutes increases, the demand will increase. If the price pf complements decreases, the
demand will increase
- Tastes
This relationship is relatively straight forward in that individuals are unlikely to buy goods they do not like. The more
attractive individuals find a particular product the greater their demand for it is likely to be. However, it is important to
remember that our tastes and preferences can be swayed and influenced by intensive advertising and
promotion campaigns.
- Expectations of future prices
Some products are purchased because of their investment potential. Individuals may buy these products in the
hope that their price will rise and they can be sold at a profit in the future.
Examples of such products are houses, shares and antiques. If individuals believe the price of such goods is likely to rise in the future this
may lead to an increase in demand.
Speculators hoarding sugar because they anticipated a rise in price following a poor crop yield is another example.
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