Topic 8: Price Determination

1. Meaning

Price is the amount of money paid for a good or service. In a free market, price is determined by the interaction of demand and supply.

2. Equilibrium Price

Equilibrium price is the price at which quantity demanded = quantity supplied. The quantity at that price is the equilibrium quantity.

Example

• Equilibrium price = KSh 30; equilibrium quantity = 50 units.

3. Disequilibrium

• Excess demand (shortage): price below equilibrium; Qd > Qs. Price tends to rise.
• Excess supply (surplus): price above equilibrium; Qs > Qd. Price tends to fall.

Market forces move the price back to equilibrium.

4. Effects of Changes in Demand and Supply

5. Functions of the Price Mechanism

1. Rationing: distributes scarce goods to those willing to pay.
2. Allocation of resources: resources move to profitable uses.
3. Signalling: tells producers what consumers want.
4. Incentive: encourages producers to supply more when prices rise.

6. Government Intervention

• Price ceilings (maximum prices): protect consumers (e.g. price controls on staples); may cause shortages and black markets.
• Price floors (minimum prices): protect producers (e.g. guaranteed prices for farm produce); may cause surpluses.
• Subsidies and taxes to influence supply.