Post 2. A programme in Microeconomics - starting with price formation

Economics is a social science that studies human behaviour as a relationship between ends and scarce means which have alternative uses. Consequently, economics examines the problems that arise when individuals and firms have consumption desires that are constrained by access to resources. This is called "the economic problem" is often referred to as infinite wants and finite resources.

Infinite wants are the limitless desires to consume goods and services. Finite resources are the limited amount of resources that enable the production and purchase of goods and services. Resources refer to factors of production which are needed to make goods and services: land, labour, capital and enterprise.

The first tool to use when we wish to understand how prices are formed in relatively free market is called the supply curve. The supply curve shows in a chart form or in a graphic form the quantities of a particular good (product) that will be offered at different price points. Here is an example:

(Adapted from: Economics, Michael Parkin). The supply curve can be seen to run upwards from bottom left to top right, showing the higher quantities that will be offered for sale at higher prices. The reason for this can be found in the profit motive which underlies all human behaviour. The greater the benefit for a particular action to be performed, the higher the likelihood that that action will take place and; or put in another way - people will do those things that lead to them gaining some value or benefit. In economic terms one can say the higher the value obtained (the price) the more of a particular good will be offered for sale on the market. Higher prices lead to larger profit margins and if higher margins can be obtained the more of a particular product will be produced and sold. We also know that the more of a product you have the lower the marginal value to you - therefore the benefit that you attain at higher prices are even greater. There is however the matter of the law of diminishing returns which has the implication that because of the fact that in the short term the producer, if he wants to increase output to maximise his profit he will face, beyond a certain point, an increase in total cost which will require a higher price for a profitable sale to take place. These two factors explain the upward slope of the supply curve. The second tool to use when we wish to understand how prices are formed in relatively free market is called the demand curve. The demand curve shows in a chart form or in a graphic form the quantities of a particular good (product) that will be purchased at different price points. Here is an example:

(Adapted from: Economics, Michael Parkin). The demand curve can be seen to run down from top left to bottom right, showing the higher quantities that will be purchased at lower prices; or the converse thereof which says "As prices rice less of a particular product will be purchased. The reason for this can also be found in the profit motive which underlies all human behaviour. The greater the benefit for a particular action to be performed, the higher the likelihood that that action will take place and; or put in another way - people will do those things that lead to them gaining some value or benefit. In economic terms one can say the higher the value obtained (the product) in relation to the cost the more of a particular good will be purchased on the market. Higher prices lead to a smaller benefit to the consumer (and lower prices to a higher benefit)and put differently, if a higher benefit can be obtained in relation to the cost the more of a particular product will be bought and consumed. Two for the price of one is better that only one! We also know that the lower the price of a product the more of that product you will be able to purchase at a given price. The value in relation to the price will be more desirable. - therefore the benefit that you attain at lower prices are higher. These two factors explain the downward slope of the demand curve. This results in the formulation of another economic law - the law of demand The Law of Demand: Other things remaining the same, If the price of a good rises, the quantity demanded of that good decreases. If the price of a good falls, the quantity demanded of that good increases. So, the demand curve normally runs downwards from the left to the right because new buyers can only be persuaded to buy and others to buy more of a product at a lower price. To summarise then - in the event of a change in price there will be a movement along the supply or demand curves. The quantity demanded or quantity supplied will move in relation to the changes in price. If there are any other influences other than in price, it will result is shifts of the corresponding curves. This can be illustrated like this:

(Adapted from: Economics, Michael Parkin) or like this:

What causes these shifts - read about it here(graph of market forces and market clearing price to follow - to be included (19 September 2015). (18 Sept 2015) Allright now we have supply curves and demand curves - it still does not tell us how the price of a particular product gets established on a market, in short the answer is that it is the result of thee interplay between the forces at work on that market. Let us take a situation where a particular price is reigning on a market. (If we say reigning, what we really mean is that that was the price at which the last trade took place. Now before we go any further we have to pause a bit and set some ground rules. The ground rules here are the particular conditions under which trade takes place - and to simplify matters we assume what economists call perfect market conditions - now what are these perfect market conditions? They are theoretical constructs not found in real markets, though approximations may exist - such as a stock exchange or a street market may satisfy some or most of the conditions. The important ones are a)that there are many buyers and many sellers and not one buyer or seller (or group) is big enough to be able to exert an influence on the market.b) Entry into the market is free and easy, c)price levels are available for all to see and d) time lags does not exist (this last one does obviously not exist in the real world, though modern electronic markets come pretty close)and e)want to maximise their respective utilities. There are other conditions, and for a more detailed discussion go here. So in this market there at a particular point is this reigning price. This price is depicted as $ 1,50 on the chart below - as you can see we have now combined the previous demand and supply graphs onto one - called the supply and demand system.

Now at this price there is an oversupply, a surplus. What now causes the price to fall is the desire of the entrepreneur to maximise profit (condition d) in the assumptions listed above - rather than not sell the item he would rather drop the price and when the price fall the demand increases at that price point. Similarly at a low price, say $ the purchaser will bid the price up rather than not have the item. So you can see that below the intersection of the supply and demand curve there will be a tendency for the price to go up and above this point there will be the tendency for the price to come down - at this point , which we call the market clearing price there will be an equilibrium between these opposing market forces.