AF1605 Introduction to Economics

Topic 2: The Price Mechanism

Lecturer: Chau Tak Wai

School of Accounting and Finance

v Demand

v Supply

v Market Equilibrium

v Price Ceiling and Price Floor

v Consumer Surplus and Producer Surplus

2
v In the market economy most of the decisions are guided by the
price signal from the market.

v We are interested in how prices and quantity transacted are

determined.

v There are two forces that determine the market price:

v Demand
v Supply

3
v Demand for a particular commodity (good or service) reflects the decisions
of consumers on how much they would like to buy under different
situations.
It can be expressed as a function of various related factors:
Qd = f (own price, x1, x2, x3, …)

v Quantity demanded is the amount of a commodity that people are willing

and able to buy at a specific price and the values of other factors during a
specified time period.

v Demand-Supply analysis highlights the relationship between quantity and

price of the good under study.

v A demand curve/schedule (or simply demand) is the relationship between

the quantity demanded and the price of a commodity when all other
factors influencing the buying plans remain the same.

v Law of demand
v Holding other factors constant, quantity demanded is negatively related
to its price.
4
v Law of demand
v Holding other factors constant, quantity demanded is negatively related to
its price.
v That means, the demand curve is downward sloping.

v Why?

v Law of diminishing returns (marginal benefit): When the quantity consumed

increases, the marginal benefit of the last unit decreases.
v By human nature, we usually find the additional unit less attractive. We will even
get tired of it and no longer wants more if we use it in a high quantity.
v Since people only buy the marginal unit when the marginal benefit (willingness
to pay) is higher than the price, a higher price leads to a lower quantity they
would like to buy -> Law of Demand.
v E.g. If the maximum willingness to pay for the 1st cup of coffee is $20, 2nd cup is
$15, 3rd cup is $10, 4th cup is $5, 5th or more is $0.
If the price is $15, how much would one buy?
If the price is $10, how much would one buy?
If the price is $5, how much would one buy? 5
v Demand can be illustrated by a demand schedule or a demand curve.

A change in price due to a non-

demand factor
ÞMovement along the same
demand curve
Þ a change in quantity demanded
and NOT a change in demand
(curve/schedule)

6
v Quantity demanded at a specific price represents how many units of
the commodity the consumers are willing and able to buy at that
price, given the values of other factors.

v In the example above, the consumer is willing to buy 2 units when

the price falls to $1.

v Put it in another way, the consumer will buy the second unit only
when the price falls to $1, but not higher.

v That means, the maximum marginal willingness to pay (or marginal

benefit) of the second unit is $1.

v $1 is also called the reservation price for the second unit of this
commodity for this consumer.

v Therefore, the demand curve/schedule also carries the information

about the maximum willingness to pay for the marginal unit.
7
Individual Demand and Market Demand
v Individual demand is the relation between quantity
demanded and price for one individual consumer.
v Market demand is that for all consumers in the market. It
is the sum of the quantity demanded of all consumers at
each price in the market.
v The market demand curve is the horizontal sum of the
demand curves of all individual consumers in the market.

8
v A shift of demand curve (or Shift of the demand curve Þ
simply a change in demand) is a a change in demand
change in the quantity that people
plan to buy when any demand
factors other than the price of
this commodity change.

v When demand decreases, the

demand curve shifts leftward from
D0 to D1.
v When demand increases, the
demand curve shifts rightward
from D0 to D2.
v Caution: Don’t call a change in
quantity demanded due to a
change of own price only a change
in demand. This is a movement
along the same demand
curve/schedule only.
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v Change in prices of related goods
v Change in expected future prices
v Change in income
v Change in expected future income
v Change in preferences
v Change in number of buyers

10
v Price of related goods
v A substitute in consumption of a good is another good that serves a
similar purpose in consumption. E.g., MTR and bus are substitutes.
v A complement in consumption of a good is another good that is used
together to serve a purpose. E.g., digital camera and SD cards are
complements.
Demand for the good
If price of substitute increases Increases
If price of complement increases Decreases

v Expected future prices

v A rise in the expected future price of a good increases the current
demand for that good.
v People simply avoids paying a higher price in the future.

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v Income

Effect of increase in income

Normal good Demand for the good increases
Inferior good Demand for the good decreases

v Normal goods: most goods

Inferior goods: low-quality goods that serve basic functions, e.g. rice.
People switch to better-quality goods when they are richer.

v Expected future income

v Demand will increase for normal goods when income is expected to
increase in the future.
v People save less, or even borrow from the future, to buy more
consumption goods now.
v It has the greatest effect on the demand for big ticket, durable items
such as houses and cars.
12
v Preferences
v People’s preferences may change due to changes in information,
trend or situation, etc.
Examples: preference towards surgical masks, alcohol swab
increased sharply under COVID-19 for its prevention.
Demand on environmentally friendly products increases with a
stronger awareness of the environmental issues.

v Number of buyers
v The greater the number of buyers in a market, the larger is the
demand for any good.
v Example: Larger population

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14
v Which of the following about an increase in demand is not correct?

v A. The demand curve shifts to the right.

v B. An increase in expected future income will increase the demand

for a normal good now.

v C. A decrease in expected future price will increase the demand of

the good now.

v D. An increase in price of a substitute in consumption of a good will

increase the demand of this good.

15
v Supply for a particular commodity (good or service) reflects the decisions
of producers/firms on how much they would like to produce/sell under
different situations.
It can be expressed as a function of various related factors:
Qs = f (own price, z1, z2, z3, …)

v Quantity supplied is the amount of a commodity that people are willing

and able to sell at a specific price and the values of other related factors
during a specified period.

v Demand-Supply analysis highlights the relationship between quantity and

price of the good under study.

v A supply curve/schedule (or simply supply) is the relationship between

the quantity supplied and the price of a commodity when all other
factors influencing the selling plans remain the same.

v Law of supply
v Other things remaining the same, quantity supplied is positively
related to its price.
v The higher the price, the more likely the firm can earn profit from the
last unit, the higher the quantity the firm is willing to sell. 16
v Supply can be illustrated by a supply schedule or a supply curve.
A change in price due to a non-supply factor
ÞMovement along the same supply curve
Þ a change in quantity supplied, not a
change in supply

17
v Quantity supplied at a specific price represents how many units of the
commodity the sellers are willing and able to sell at that price.

v In the example above, the seller is willing to sell 2000 units when the price
rises to $1.5.

v Put it in another way, the seller will sell the 2000th unit only when the price
rises to $1.5 but not lower.

v That means, the minimum marginal willingness to receive to sell the 2000th
unit is $1.5. (Likely, it is the marginal cost of producing that unit.)

v $1.5 is also called the reservation price of the 2000th unit of this commodity
for this seller.

v The supply curve is thus carrying the information about the minimum price
the firm is willing to sell the marginal unit.

v The supply curve is upward sloping because the reservation price (marginal
cost) increases when more output is produced.
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Individual Supply and Market Supply

v Individual supply describes the relationship between

price and quantity supplied for one seller.
v Market supply is that for all sellers in the market. It is
the sum of the quantity supplied of all the
sellers/producers in a market at each price.
v The market supply curve is the horizontal sum of the
supply curves of all sellers/producers in the market.

19
 Shift of the supply curve Þ
v A shift of supply curve (or simply a a change in supply
change in supply) is a change in the
quantity that sellers plan to sell when
any supply factors other than the
price of the commodity change.

v When supply decreases, the supply

curve shifts leftward from S0 to S1.

v When supply increases, the supply

curve shifts rightward from S0 to S2.

v Caution: Don’t call a change in

quantity supplied due to a change of
own price only a change in supply.
This is a change in quantity supplied
along the same supply curve only.
20
v Change in prices of related goods
v Change in prices of resources and other inputs
v Change in expected future prices
v Change in productivity
v Change in number of sellers

21
 Factors for a Shift in Supply Curve
v Price of related goods
v A substitute in production output is a good that can be produced in
place of another good using similar inputs and technology.
v Example: luxury cars and ordinary cars are substitutes in production in
an automobile factory.

v A complement in production output is a good that is produced along

with another good. (By-products / joint supply)
v Example: cream is a complement in production of skim milk in a dairy;
Chicken legs and chicken wings; different layers of oil being refined.
Supply of the good
If price of substitute increases Decrease
If price of complement increases Increase

v Please distinguish substitutes in production vs substitutes in

consumption. Similar for complements.
22
 Factors for a Shift in Supply Curve
v Unexpected increase or decrease in output
v An unexpected increase in output increases the supply
Example: good harvest of agricultural products.
v An unexpected decrease in output decreases the supply
Example: bad harvest of agricultural products; destruction of output due to
natural disasters.

v Input prices
v Input prices influence the (marginal) cost of production.

Supply of the good

If input prices increase Decrease
If input prices decrease Increase
v If there is an unexpected decrease in inputs, input price will increase,
which will lead to a decrease in supply of the output.

v Productivity (Technology)
v An increase in productivity (improvement in technology) lowers the
(marginal) cost of production and increases the supply. 23
 Factors for a Shift in Supply Curve

v Expected future prices

v A rise in the expected future price of a good decreases the
current supply for the good. (Either keeping more inventories or
shifting production to the future.)

v Tax and subsidies on sellers

v Tax decreases supply.
v Subsidy increases supply.

v Number of sellers
v The greater the number of sellers in a market, the larger is
the supply. (Recall horizontal summation)

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25
 Self Assessment

v Q: Which of the following increases the supply of a good?

v A. A decrease in input price

v B. An increase in selling price in production substitutes

v C. An increase in income (for normal goods)

v D. Destruction of the good after the earthquake.

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 Self Assessment

v When people expect that the future price of tissue paper will
increase, which of the following about the current market is
true?

v A. Demand increases and supply is unchanged.

v B. Demand is unchanged and supply decreases.

v C. Demand increases and supply increases.

v D. Demand increases and supply decreases.

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 Market Equilibrium
v Market equilibrium occurs when the
quantity demanded equals the quantity
supplied at the market equilibrium
price.
𝑄! 𝑃" = 𝑄# (𝑃" )

v We call it ”the market clears.”

v Market equilibrium occurs at the

intersection of the demand curve and
the supply curve.

v This equilibrium represents the market

outcome we observe.

v We will use the change in demand

and/or supply to understand the change
in equilibrium price and equilibrium
quantity, and thus the actual price and
quantity in the market observed.
28
v If market price is above the v If market price is below the
equilibrium level, price will fall equilibrium level, price will rise
until the surplus (excess until the shortage (excess
supply) is eliminated. demand) is eliminated.
29
v Increase in demand with supply v Decrease in demand with supply
unchanged will cause increases in unchanged will cause decreases in
equilibrium price and equilibrium equilibrium price and equilibrium
quantity. quantity.
30
v Increase in supply with demand v Decrease in supply with demand
unchanged will cause a decrease in unchanged will cause an increase in
equilibrium price and an increase in equilibrium price and a decrease in
equilibrium quantity. equilibrium quantity.

31
v Increase in demand + Increase in v Decrease in demand + Decrease in
supply supply
→ Equilibrium quantity will increase → Equilibrium quantity will decrease
→ Equilibrium price is uncertain (unless → Equilibrium price is uncertain
you know the actual size of each change)
32
v Increase in demand + Decrease in v Decrease in demand + Increase in
supply supply
→ Equilibrium price will increase → Equilibrium price will decrease
→ Equilibrium quantity is uncertain → Equilibrium quantity is uncertain

33
v When the effect due to the change in demand and the effect due
to the change in supply counteract each other, and we do not
know the size of each effect, the resulting direction of the effect
is uncertain or unknown.

v Note that it is not unchanged.

v However, if we know the size, we can make the judgement.

v For example, if we have a large increase in demand and a

relatively small increase in supply, the new equilibrium price and
quantity can both increase.
v The effects reinforce each other in quantity, while the effect of
demand is larger for price, thus following an increase in price as
a result.

34
 A Four-step Approach in Demand-Supply Analysis

v Two uses of Demand-Supply Analysis

v Given the change in demand and/or supply factor, we can predict the
change in price and quantity in a market.
v Given the observed change in price and quantity in a market, we may
try to explain it with the change of demand and/or supply factor.

Always apply this FOUR step approach:

v 1. Identify which factor(s) has changed that shifts demand
and/or supply curve.

v 2. Determine how the curves are shifted.

v 3. Draw the demand-supply diagram.

v 4. Determine the change in equilibrium price and equilibrium

quantity.
35
v What is the effect of African swine fever on the market of pork?
(Assume that it does not affect the quality of pork available in the
market and the swine fever does not infect human.)

v 1. Factor changed?
v Unexpected decrease in output. Why?

v 2. How curves are shifted?

v Supply curve shifts to the left (Supply decreases)

v 3. Draw a demand-supply diagram

v 4. Determine the change in equilibrium price and equilibrium quantity

v Equilibrium price increases and equilibrium quantity decreases.

v Reminder: Do not say that when supply decreases, then demand

decreases. Demand curve does not shift unless there is a change in
demand factors.
36
v Many schools in Hong Kong go for online teaching in Sep 2020 in full
scale (which is more intense than before). How does it affect the market
for personal computer used for online classes?

v 1. Factor changed?

v 2. How curves are shifted?

v 3. Draw a demand-supply diagram

v 4. Determine the change in equilibrium price and equilibrium quantity

37
 Self Assessment

v Which of the following event alone will decrease the equilibrium

price and increase the equilibrium quantity of orange juice?

v A. More people think orange juice is good to their health.

v B. There is a good harvest of orange worldwide.

v C. There is a ban on imports of orange juice due to trade war.

v D. There are some reports claiming that there is deadly virus

found on the surface of oranges.

38
v A price ceiling or price cap is a government regulation that places an
upper limit on the price at which a commodity can be traded.

v An example is a price ceiling on housing rent control.

v Trading above the price ceiling is illegal, but it is not binding if the price
is below the ceiling.

v There will be no effect on the market equilibrium if the price ceiling is

set at a level which is above the equilibrium price.

v The price ceiling is effective if it is set below the market equilibrium

price.

39
v If the price ceiling is set at a level
which is below the equilibrium
price, there will be shortage (excess
demand) in the market.

v In the case on the right, the price

ceiling is set at $400 per month,
which is below the equilibrium
price of $550 per month.

v The market quantity transacted is 3

thousand units. The excess demand
is 3 thousand units. It is also 1
thousand units below the
equilibrium quantity.

v There would be other non-price

competition to allocate the goods:
v Queuing
v Rationing
v Lottery
40
v A price floor is a government regulation that places a lower limit on
the price at which a commodity can be traded.

v An example is a minimum wage in labor markets.

v Trading below the price floor is illegal, but it is not binding if the price
is above the floor.

v There will be no effect on the market equilibrium if the price floor is

set at a level which is below the equilibrium price.

v The price floor is effective if it is set above the market equilibrium

price.

41
v If the price floor is set at a level
which is above the equilibrium price,
there will be surplus (excess supply)
in the market.

v e.g. Minimum wage which is set at a

level above the equilibrium wage
may cause unemployment.

v In the case on the right, at the

minimum wage of $10 per hour,
3,000 jobs are available.

v There is an excess supply of 5

thousand jobs. The new number of
jobs is also 3 thousand below the
equilibrium level.

v Possible outcome:
v Sellers need to compete or search
harder that incur more costs. 42
 Examples of Price Floor
Statutory Minimum Wage (SMW) has come into force since 1 May 2011.
With effect from 1 May 2019, the SMW rate will be raised from $34.5 to
$37.5 per hour. Local low-skill workers
The Minimum Allowable Wage (MAW) for foreign domestic helpers (FDHs)
in Hong Kong is currently set at HK$4,520 per month.
Local domestic helpers but
not those from overseas.
(Note: Local helpers and
foreigner helpers are
substitutes.)

Who are the HK government trying to protect in the above two cases
of price regulations?
Do you know why and how it
works? 43
v A quota is a government regulation
that places an upper limit on the
quantity at which a commodity can be
traded.

v The motive is to either restrict the

quantity it can be sold because it is
somewhat harmful (e.g. carbon
emission that leads to global warming,
or cigarettes), or to raise the market
price to help existing sellers (e.g.
restricting the size of imports).

v It is effective when the quota is set

below the market equilibrium quantity.

v The supply curve is vertical once the

quota line lies above the original
supply curve.

v The market price is then higher than

the original equilibrium price. 44
§ Can the price ceiling help the buyers?
§ In what sense yes and in what sense no?

§ Can the price floor help the sellers (e.g. workers for
minimum wage)?
§ In what sense yes and in what sense no?

45
a) What is the supply curve in this case?
b) What is the market equilibrium price?
c) If there is a price ceiling at $1300, how large is the excess demand or
excess supply? 46
v Consumers and producers/sellers can enjoy a surplus when they engage in
market transaction of a commodity.

v Recall: a consumer can enjoy a surplus if one has a higher value enjoyed for
the units of commodity one buys than the price paid to buy them.

v Similarly, a producer can enjoy a surplus if one can sell the units of the good
and receive a price higher than the (marginal) cost they need to pay in
producing them.

v Then, how can we measure them more exactly?

v Can we measure them using information about the demand and supply
curves?
v If so, how?

47
v Consider the following case with
discrete price and quantity.
Price Quantity Unit Value
v Consider the demand schedule for ($) demanded (Marginal
Lillie. Benefit) ($)

v Note that she starts to buy the first 10 0

unit only when the price falls to $9, 9 1 1st 9
but not higher, so her maximum
8 2 2nd
willingness to pay for the first unit is
$9, which is her value (marginal 7 3 3rd
benefit) for the first unit. 6 4 4th
It is also called the reservation price
for the first unit. 5 5 5th

v Similarly, for the second unit, she is

willing to buy only when the price
falls to $8, so her value or marginal
benefit for the second unit is $8.
48
v As a result, the demand
schedule/curve reflects the
value/marginal benefit for the last
unit of purchase.
Price Quantity Unit Value
v The demand schedule/curve is the ($) demanded (Marginal
marginal benefit curve for the Benefit) ($)
consumer(s). 10 0
v Then, what is the consumer surplus? 9 1 1st 9
8 2 2nd 8
v Definition: Consumer surplus is the
marginal benefit from a good or 7 3 3rd 7
service in excess of the price paid 6 4 4th 6
for it for a particular unit, summed
over each unit consumed. 5 5 5th 5
'

𝐶𝑆 = ((𝑀𝐵$ − 𝑃)
$%&

49
v As a result, the demand
schedule/curve reflects the
value/reservation price for the
last unit of purchase.
Price Quantity Unit Value Consumer
v The demand schedule/curve is the ($) demanded (Benefit) Surplus
($) for this
marginal benefit curve for the
unit
consumer(s).
10 0
v In this case, suppose the market 9 1 1st 9
price is $6. What is the consumer 8 2 2nd 8
surplus for this consumer? 7 3 3rd 7
6 4 4th 6
v Lillie will buy up to 4 units. 5 5 5th 5

v Summing up the consumer

surplus for each unit, her
consumer surplus is $6. 50
v Consider the price and quantity are
continuous/infinitely divisible. (Adjustment
can be arbitrarily small. e.g. possible to
have 4.9999.)
v Note: quantity is in thousands here as it is
measured for the whole market. It can
reasonably be treated as continuous.
v There is a consumer who is willing to buy
the 10 thousandth unit only when the price
falls to $10 (but not for $10.01).
v Thus, the consumer who is willing to buy
the 10,000th has a value (marginal benefit)
of $10 for it.
v This means the marginal benefit for the 10
thousandth unit in the market is $10.
v The demand curve is then the marginal
benefit curve.
51
v Recall: Consumer surplus is the
marginal benefit from a good or service
in excess of the price paid for it for a
particular unit, summed over the
quantity consumed.
v Each unit of quantity is now very small.
Essentially, it is the area between the
demand curve and the horizontal line at
the market price.
v In this example, consumer surplus is the
green area: CS = [(20 – 10) x 10]/2= $50
thousand.

v This is also equivalent to the total

benefit enjoyed by the consumers (area
below the demand curve from 0 to ten
thousand) minus the expenditure they
need to pay (blue area). 52
 Self Assessment

v Peter is willing to pay at most $25 for the first cup of coffee from
the café a day, $16 for the second cup, $5 for the third cup and
$0 for fourth and beyond. If the coffee is sold $13 a cup in the
café, how large is the consumer surplus if Peter chooses his
number of coffee to buy based on rational choice?

v A. $41
v B. $15
v C. $12
v D. none of the above

v Note: the consumer surplus is simply the economic surplus (for

the consumer) we have in Topic 1 in this case.

53
v Producers can earn a surplus when they
can sell at a price higher than their cost
of producing the unit.
v We will provide more details in Topic 4
and 5.
v You may use a similar logic: when the
quantity supplied is n when the price is p,
then the producer is only willing to sell
the nth unit just when the price rises to p.

v This means the firm can only cover its

cost in producing the nth unit when the
price is p. Thus, the marginal cost of
producing the nth unit is p.
v Thus, the supply curve is also the
marginal cost curve.
54
v Definition: Producer surplus is the price of a
good in excess of the marginal cost of
producing it at a particular unit, summed
over each unit produced.
$
𝑃𝑆 = $(𝑃 − 𝑀𝐶! )
!"#

v In the continuous case here, it is essentially

the area between the supply curve and the
horizontal line representing the market price.

v From the diagram, it is the blue area. PS =

[(10 – 2) x 10 thousand ]/2 = $40 thousand.

v It is also equivalent to the total revenue

received (price x quantity) minus the total
variable cost incurred (pink area).
55
v Using the supply schedule on Price Quantity Unit (Marginal) Producer
the right with discrete price ($) supplied Cost ($) Surplus for
and quantity, what is the total this unit
producer surplus for this 2 0
seller if the market price is 3 1 1st
$6? 4 2 2nd
5 3 3rd
6 4 4th
7 5 5th

56
v Summary

v Discrete case: quantity change by integer, usually information given in the

form of a table of numbers.

v Continuous case: quantity can change in very very small unit, usually
information given in the form of equations.
Discrete Case Continuous Case
Consumer Surplus $ The area between the demand
𝐶𝑆 = $(𝑀𝐵! − 𝑃) curve and horizontal line for
!"# market price
Producer Surplus $ The area between the supply
𝑃𝑆 = $(𝑃 − 𝑀𝐶! ) curve and the horizontal line
!"# for market price

v Please distinguish these two cases and apply the method accordingly. For
example, do not fit an equation for the discrete case to do your calculations.
57
v Demand
v Demand and Quantity demanded
v Factors that shift the demand curve

v Supply
v Supply and Quantity supplied
v Factors that shift the supply curve

v Market Equilibrium
v Equilibrium price and equilibrium quantity
v A 4-step approach for demand-supply analysis

v Price Ceiling and Price Floor

v Consumer Surplus and Producer Surplus

58