demand, supply & price mechanism

What is a shortage?

A situation where quantity demanded exceeds quantity supplied at the prevailing market price (Qd > Qs).

What is the price mechanism?

The interaction of demand and supply that determines market prices and allocates scarce resources through signalling, rationing and incentive functions.

What are the 3 functions?

- Signalling function: Changes in prices signal changes in relative scarcity to consumers and producers. Price ↑ → signals greater scarcity → producers encouraged to increase supply.

- Rationing function: Prices allocate scarce goods to consumers who are willing and able to pay. Price ↑ → quantity demanded contracts → limited supply is rationed among consumers.

- Incentive function: Changes in prices motivate consumers and producers to adjust their behaviour. Price ↑ → producers incentivised to increase Qs (higher potential profits), while consumers are incentivised to decrease Qd (higher opportunity cost of consumption).

Remember:

• Signalling = INFORMATION about scarcity.

• Rationing = ALLOCATION of scarce goods.

• Incentive = MOTIVATION to change behaviour.

What are substitutes in consumption?

Goods that can replace one another to satisfy similar wants. An increase in the price of one good increases demand for its substitute, ceteris paribus.

What is Price Elasticity of Demand (PED)?

The degree of responsiveness of quantity demanded to a change in the good's own price, ceteris paribus.

PED = %ΔQd / %ΔP

What is Price Elasticity of Supply (PES)?

The degree of responsiveness of quantity supplied to a change in the good's own price, ceteris paribus.

PES = %ΔQs / %ΔP

What is Cross Elasticity of Demand (XED)?

The degree of responsiveness of quantity demanded of one good to a change in the price of another good, ceteris paribus.

XED = %ΔQd of Good A / %ΔP of Good B

What is total consumer expenditure?

The total amount consumers spend purchasing a good.

Total Expenditure = Price × Quantity