15 min read
Mathew Wahome
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
| Price (KSh) | Qd | Qs | Result |
|---|---|---|---|
| 10 | 90 | 10 | Shortage of 80 |
| 20 | 70 | 30 | Shortage of 40 |
| 30 | 50 | 50 | Equilibrium |
| 40 | 30 | 70 | Surplus of 40 |
| 50 | 10 | 90 | Surplus of 80 |
- 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
| Change | Effect on price | Effect on quantity |
|---|---|---|
| Demand increases (supply constant) | Rises | Rises |
| Demand decreases | Falls | Falls |
| Supply increases (demand constant) | Falls | Rises |
| Supply decreases | Rises | Falls |
5. Functions of the Price Mechanism
- Rationing: distributes scarce goods to those willing to pay.
- Allocation of resources: resources move to profitable uses.
- Signalling: tells producers what consumers want.
- 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.