CHAPTER FOUR
PRICE DETERMINATION
Price refers to a specific amount of money that buyers are ready to pay for one unit of a product.
How the Price of a Commodity is Determined
The theory of demand and supply, first developed by Alfred Marshall in 1890, shows how consumer preferences
determine consumer demand for commodities, while business costs are the foundation of the supply of commodities.
If we see fall in the price of rice, for instance, it is either because the demand for rice has gone down or because the
supply of rice has gone up. The same is true for every market, from wheat to mangoes: changes in supply and
demand lead to changes in output and prices.
In fact, the market price of a commodity is determined (or reaches its competitive equilibrium) where the demand
curve and the supply curve intersect — where the forces of demand and supply (also known as the impersonal
market forces) are just in balance.
As Paul Samuelson has rightly commented:
“It is the movement of price mechanism, which brings supply and demand into balance or equilibrium.”
The Demand Curve:
In a market-based economy the quantity of a commodity people buy depends on its price. The higher the price of a
commodity, all other things remaining unchanged, the fewer units consumers are willing to buy. The lower its price,
the more units of it are purchased. This definite relationship = between the market price of a commodity and the
quantity demanded of the same, ceteris paribus, is called the demand schedule, or the demand curve.
From this emerges one famous law of economics, viz., the law of downward sloping demand. The law can be stated
as follows: when the price of a commodity. Similarly, when the price is reduced, ceteris paribus, quantity demanded
increases. Fig. 1 shows a downward sloping demand curve which relates quantity demanded to price. The negative
slope of the demand curve illustrates the law of downward-sloping demand.
The demand curve is downward sloping due to substitution effect and income effect. The market demand curve for a
commodity is arrived at by adding up the demand curves of individual consumers.
The Supply Curve:
The supply side of a market typically shows the behaviour of producers—the decisions they take to produce and sell
their products. To be more specific, the supply schedule relates the quantity supplied of a commodity to its market
price, holding equal other things such as costs of production, the prices of related goods and government policies.
In short, the supply schedule (and supply curve) for a commodity shows the relationship between its market price
and the amount of that commodity that producers’ are willing to produce and sell, ceteris paribus.
Fig. 2 shows a typical supply curve which relates quantity supplied to price. Supply depends on cost of production
or, more specifically, on marginal cost (which is the extra cost of producing one extra unit). So long as marginal cost
is less than price, a business firm will find it profitable to supply additional units. In fact, producers supply
commodities for profit.
As Paul Samuelson has rightly commented:
ECONOMICS COURSE NOTES: CHAPTER 4 – PRICE DETERMINATION PREPARED BY MR. ANTONY AMBIA Page 1
, “When production costs for a good are low relative to the market price, it is profitable to supply a great deal, when
production costs are high relative to price, firms produce little, switch to the production of other products, or may
simply go out business.”
Determinants of Cost:
Two major factors affect production costs:
The prices of inputs such as labour, energy, or machinery exert considerable influence on the cost of producing
a given level of output,
Another important determinant of production cost is technological advances, which consist of changes that
reduce the quantity of inputs needed to produce the same amount of output.
Three other factors affecting supply are: government policy (such as environmental regulation), market structure
(whether there is perfect competition and monopoly) and expectations about future prices.
Market Equilibrium:
When the supply and demand curves intersect, the market is said to be in equilibrium. This determines market price
and quantity sold. Consider a hypothetical example. Suppose that in a market for some commodity, the demanders
and suppliers have the particular schedules set forth in and are combined in Table 6.6.
We see that at only one price, Kshs. 3, the equilibrium price, the market is cleared (quantity demanded equals
supplied). At this price, the desires of buyers and sellers are simultaneously satisfied. It was Alfred Marshall who
first demonstrated how the market forces drive the price towards the equilibrium level.
Let us start with an arbitrary price say, Kshs. 5. With this price, 3,000 units are demanded but 6,500 are offered for
sale, leading to an excess supply (sometimes called a surplus) of 3,500 units. When there is excess supply, firms
cannot sell all they wish at that price and they must cut price to clear their stock. Indeed, at any price above Kshs. 3,
there will be an excess supply (i.e., surplus) and price will fall to clear the market.
Alternatively, consider the price Kshs. 1. Consumers are desirous of purchasing 6000 units, but producers are
willing to offer only 3,000 units for sale creating an excess demand (a shortage) of 3,000 units.
Since their demands are not satisfied, consumers bid the price up. As they continue to bid up the price, quantity
demanded decreases and quantity supplied increases until a price of Kshs. 3 is reached and 5,000 units are sold per
unit of time.
In Figure 6.5, DD’ and SS’, the market demand and supply curves, meet at a point E, the equilibrium point. Thus, P e
and Xe are the market-clearing (equilibrium) price and quantity, respectively. Only at a price of P e does quantity
demanded equal quantity supplied.
ECONOMICS COURSE NOTES: CHAPTER 4 – PRICE DETERMINATION PREPARED BY MR. ANTONY AMBIA Page 2
PRICE DETERMINATION
Price refers to a specific amount of money that buyers are ready to pay for one unit of a product.
How the Price of a Commodity is Determined
The theory of demand and supply, first developed by Alfred Marshall in 1890, shows how consumer preferences
determine consumer demand for commodities, while business costs are the foundation of the supply of commodities.
If we see fall in the price of rice, for instance, it is either because the demand for rice has gone down or because the
supply of rice has gone up. The same is true for every market, from wheat to mangoes: changes in supply and
demand lead to changes in output and prices.
In fact, the market price of a commodity is determined (or reaches its competitive equilibrium) where the demand
curve and the supply curve intersect — where the forces of demand and supply (also known as the impersonal
market forces) are just in balance.
As Paul Samuelson has rightly commented:
“It is the movement of price mechanism, which brings supply and demand into balance or equilibrium.”
The Demand Curve:
In a market-based economy the quantity of a commodity people buy depends on its price. The higher the price of a
commodity, all other things remaining unchanged, the fewer units consumers are willing to buy. The lower its price,
the more units of it are purchased. This definite relationship = between the market price of a commodity and the
quantity demanded of the same, ceteris paribus, is called the demand schedule, or the demand curve.
From this emerges one famous law of economics, viz., the law of downward sloping demand. The law can be stated
as follows: when the price of a commodity. Similarly, when the price is reduced, ceteris paribus, quantity demanded
increases. Fig. 1 shows a downward sloping demand curve which relates quantity demanded to price. The negative
slope of the demand curve illustrates the law of downward-sloping demand.
The demand curve is downward sloping due to substitution effect and income effect. The market demand curve for a
commodity is arrived at by adding up the demand curves of individual consumers.
The Supply Curve:
The supply side of a market typically shows the behaviour of producers—the decisions they take to produce and sell
their products. To be more specific, the supply schedule relates the quantity supplied of a commodity to its market
price, holding equal other things such as costs of production, the prices of related goods and government policies.
In short, the supply schedule (and supply curve) for a commodity shows the relationship between its market price
and the amount of that commodity that producers’ are willing to produce and sell, ceteris paribus.
Fig. 2 shows a typical supply curve which relates quantity supplied to price. Supply depends on cost of production
or, more specifically, on marginal cost (which is the extra cost of producing one extra unit). So long as marginal cost
is less than price, a business firm will find it profitable to supply additional units. In fact, producers supply
commodities for profit.
As Paul Samuelson has rightly commented:
ECONOMICS COURSE NOTES: CHAPTER 4 – PRICE DETERMINATION PREPARED BY MR. ANTONY AMBIA Page 1
, “When production costs for a good are low relative to the market price, it is profitable to supply a great deal, when
production costs are high relative to price, firms produce little, switch to the production of other products, or may
simply go out business.”
Determinants of Cost:
Two major factors affect production costs:
The prices of inputs such as labour, energy, or machinery exert considerable influence on the cost of producing
a given level of output,
Another important determinant of production cost is technological advances, which consist of changes that
reduce the quantity of inputs needed to produce the same amount of output.
Three other factors affecting supply are: government policy (such as environmental regulation), market structure
(whether there is perfect competition and monopoly) and expectations about future prices.
Market Equilibrium:
When the supply and demand curves intersect, the market is said to be in equilibrium. This determines market price
and quantity sold. Consider a hypothetical example. Suppose that in a market for some commodity, the demanders
and suppliers have the particular schedules set forth in and are combined in Table 6.6.
We see that at only one price, Kshs. 3, the equilibrium price, the market is cleared (quantity demanded equals
supplied). At this price, the desires of buyers and sellers are simultaneously satisfied. It was Alfred Marshall who
first demonstrated how the market forces drive the price towards the equilibrium level.
Let us start with an arbitrary price say, Kshs. 5. With this price, 3,000 units are demanded but 6,500 are offered for
sale, leading to an excess supply (sometimes called a surplus) of 3,500 units. When there is excess supply, firms
cannot sell all they wish at that price and they must cut price to clear their stock. Indeed, at any price above Kshs. 3,
there will be an excess supply (i.e., surplus) and price will fall to clear the market.
Alternatively, consider the price Kshs. 1. Consumers are desirous of purchasing 6000 units, but producers are
willing to offer only 3,000 units for sale creating an excess demand (a shortage) of 3,000 units.
Since their demands are not satisfied, consumers bid the price up. As they continue to bid up the price, quantity
demanded decreases and quantity supplied increases until a price of Kshs. 3 is reached and 5,000 units are sold per
unit of time.
In Figure 6.5, DD’ and SS’, the market demand and supply curves, meet at a point E, the equilibrium point. Thus, P e
and Xe are the market-clearing (equilibrium) price and quantity, respectively. Only at a price of P e does quantity
demanded equal quantity supplied.
ECONOMICS COURSE NOTES: CHAPTER 4 – PRICE DETERMINATION PREPARED BY MR. ANTONY AMBIA Page 2
