UNIT 4 APPLICATIONS OF

PRICE
THEORIES

Objectives
At the end of this unit, you should be able to:
1. apply theories of demand, supply and price
into practice.
2. explain how the dual price system works.
3. analyse how markets are affected by the
minimum wage system.
4. apply the concept of elasticity of demand
into practice.
5. make wise economic decisions in setting
prices as producers or, on imposing
appropriate taxes on commodities that
should be fair for producers and consumers
by the government.

Dual Price System

Price control is the maximum price
Dual
price
basically
reflects
the
set by
the system
government
that can
be charged
prices
regulated
the government to suit
on any
item to beby
purchased.
both
The the
priceproducers
charge willand
normally
the consumers.
below the
In
Equilibrium
other
words,price
government support prices

for commodities produced by producers

and control prices to be charged by
producers for consumers to purchase.
support
The dual
price
systemprice
is clearly
illustrated
Price
is the
minimum
that can
be charged
two
such practices
exercised
by
for anthrough
item to be
produced
that is, a minimum
price
thetogovernment
known
as charged
price control
payable
the producers.
The price
will normally
support
aboveand
the price
equilibrium
price.

Maximum Price and Minimum

Price
Equilibrium Price
& Quantity

This graph illustrates the

maximum and minimum
price in the dual price
system. The government
fixes P2 price for
consumers. At this price
the consumers buy Q2
units of quantity.
The consumers call P 2
price set by
the
The government
sets
price P3 p
government asanother
the
for the maximum
producers of
quantity.
price.
It is At P3 pric
the producers
are willing
chargeable
by theto produce and
producers
andrequired
payableby
bythe co
Q3 units
of quantity
consumers.
Situations
This P3 the
price
fixed by the
government f
like this results in
producers'
is referred
to as the minimu
shortages
.
which is payable to the producers Situa
this results in surpluses

Minimum Wage System

The dual price system operates in commodity
markets. Likewise the minimum wage system
operates in the labour markets whereby the
government can and do intervene and fix
minimum price of labour.
This is referred to as the minimum wages, and
the employer has the legal obligation to pay the
minimum wages fixed by the government. The
minimum wage rate is normally set above the
competitive wage rate (equilibrium wage rate)
thus resulting in surplus of labour
(unemployment).

Minimum Wage System

Where:
government
fix the
Suppose
W = realthe
wage
rate
wage
rate at W1.
Minimum
Ns = labour
supply
would
be two-fold:
The
Nd result
= Labour
demand
labour curve
will drop
(1)The
In this demand
graph theofdemand
tofor
Nd,
(2) The
supplythe supply
labour
intersects
at point,
H N*,
giving us
ofcurve
labour
will rise
to Ns.
the net
equilibrium
The
result ofcompetitive
this market
wage rate
W*. At W*
wage rate,
Change
is creating
excess
supply
Nd = Ns or N* which means
ofthere
labour
( Ns>N*).
Unemployment
is full
employment
level
Level
is Nd-Ns
of labour.
There is neither
excess demand for labour, nor
excess supply of labour at the
equilibrium market- clearing
wage rate of W*.

Usefulness of the Concept of

Elasticity of Demand
The concept of Elasticity of Demand is very useful to
businessmen and the government. Elasticity of
Demand reveals consumers responses to changes
in the price of a commodity or input. It is therefore
very important that the businessmen and the
government be aware of those responses so that
they can make wise economic decisions in
answering questions such as: when should they
(businessmen) raise or lower prices? When should
the government impose or increase taxes or
subsidies on commodities, and how the tax burden
should be shared between the consumers and
producers? Justice must prevail between the two in
so far as tax impositions are concern.

Sales Tax
When a sales tax is imposed on a
commodity by the government, we find
that sellers will normally attempt to pass
on the whole of the tax to consumers in
the form of higher prices. However, the
seller may not be able to pass on the full
amount of tax to consumers. This is
because the effects of tax are very much
determined by the price elasticity of
demand of the commodity in question

Sales Tax on Commodity with an

Inelastic Demand

In this graph we can see

that before the government
imposes a sales tax the
equilibrium price is P0 and
e case were demand is inelastic the equilibrium output is
Q0. When sales tax is
of the sales tax is born by
imposed, the supply curve
sumer and less is born by producer
shifts up by the amount of
alcohol and cigarettes
the sales tax (from S0 to
S1). As a result of the
difference between what the buyer
supply shift, a new
(0P1) and what the supplier receive
equilibrium price is
), goes to the government as tax established at 0P1.
The buyers pay the new
price 0P1- at that price they
will demand quantity 0Q1.
The suppliers will receive
0P2- at which they will
supply quantity 0Q1.

Sales Tax on Commodity with an

Elastic Demand

n this case were demand is

lastic most of the sales tax

The equilibrium price is P0

before the government imposes
a sales tax. When sales tax is
imposed, the supply curve
shifts up by the amount of the
sales tax (from S0 to S1). As a
result of the supply shift, a new
equilibrium price is established
at 0P1.

The buyers pay the new

price 0P1- at that price they
will demand quantity 0Q1.
The suppliers will receive
0P2- at which they will
supply quantity 0Q1.
The difference between
what the buyers pay (0P1)
and what the suppliers
receive (OP2) is the sales
tax (P1P2) which goes to the
government.

Subsidies
A subsidy is a payment by the
government to producers to
encourage production and
consumption and lower the price at
which a commodity is offered for
sale. The effectiveness of a subsidy
will depend on the elasticity of
demand.

Subsidy of a commodity with an

Inelastic Demand

The equilibrium price before

the government pays
subsidy is P0, and the
equilibrium
output
isthe
Q0.buyers
The difference
between
what
When
paid, the
Pay (OPI)
andsubsidy
what theis
supplier
receive
curve(P1P2)
shiftspaid
down
(0P2) supply
is the subsidy
by by
the
the amount
of like
thethis
subsidy
Government.
In cases
most of th
(from
S0
to S1).
a result
Subsidy
(PP1)
goes
to theAs
consumer
of the
supply
shift,
a new
And only
a small
amount
(PP2)
receives
equilibrium
price
is
By the supplier
established at 0P1.
The buyers pay the new
price 0P1- at that price they
will demand quantity 0Q1.
The suppliers will receive
0P2- at which they will
supply quantity 0Q1.

Subsidy of a commodity with an

Elastic Demand
The equilibrium price is
before the government
pays subsidy P0 and the
equilibrium output is Q0.
When subsidy is paid, the
supply curve shifts down by
the amount of the subsidy
(from
S0 to S1).
Asthe
a result
The difference
between
what
buyer
of the supply shift, a new
Pay (0P1) and
what the price
supplier
equilibrium
is receive
(0P2) is the established
subsidy (P1P2)
paid by
at 0P1.
the government.
In this pay
casethe
like
The buyers
new
price
0P1- at(PP1)
that price
most of the
subsidy
goesthey
to the
quantity
0Q1.
Producers will
anddemand
only small
amount
( PP2)
will receive
receives byThe
the suppliers
consumers
0P2- at which they will
supply quantity 0Q1.

Summary
Demand curves are downward sloping because
as price falls demand increases and, as price
increases demand falls. This shows a negative or
inverse relationship between price and quantity
demanded. The sloppiness of the demand curves
represents the behaviour of consumer demand to
changes in price. The extent of consumer behaviour
to price changes is determined by price elasticities
of demand.
Supply curves are upward sloping because as
price falls supply falls and, as price increases supply
also increases. This shows a positive relationship
between price and quantity supplied. The sloppiness
of the supply curves represents the behaviour of
producers to changes in price of the product. The
extent of producer behaviour to price changes is
determined by price elasticities of supply.

Summary Cont
The intersection of demand and supply determines the
equilibrium price and quantity in the market. The
equilibrium price shows the price level in the market
where consumers are willing and able to pay for the
product and, producers are willing and able to sell the
product.
The intersection of supply and demand also
determines the amount of consumer and producer
surplus that accrues to consumers and producers
respectively. Consumer surplus is the difference
between the sum of all marginal utilities at each
respective prices and the total cost of buying a
product at the equilibrium price. Producer surplus
represents the difference between producers total
revenue and, its total cost of producing an supplying
the product.

Summary Cont
Whenever there is a change in the price of a product, this
will result in an extension or contraction in demand
and/or supply. Whenever there is a change in other factors
(rather than the change in the price of a product) that
affects demand or supply, this will result in a shift in
demand or supply.
Changes in consumer behaviour in consuming a particular
product resulting from other factors such as change in the
price of related goods can be determined by cross price
elasticities. Cross price elasticities shows changes in
consumer demand resulting from changes in the price of
related goods. These goods can be either substitute or
complementary goods. When cross price elasticity is
positive the related good is a substitute and, when
negative it is said to be a complementary good.
Other elasticities such as arc elasticities and income
elasticities shows changes in consumer demand with
respect to price but in this case not price at a particular
point but price over a range and, changes in income
respectively.

Summary Cont
A maximum price is a price set by government
below the market equilibrium price. This normally
results in shortages in the market. It is also called
a price ceiling.
A minimum price is a price set by the government
above the market equilibrium price. This normally
results in surpluses in the market. It is also called a
price floor.
The dual price system operates in commodity
markets.
The minimum wage system operates in the labour
markets whereby the government can and do
intervene and fix minimum price of labour.
If the minimum wage is set above market equilibrium
wage rate, unemployment results.

Summary Cont
f the minimum wage set below the market
equilibrium wage rate, over employment
results.
The concept of Elasticity of Demand is very
useful to businessmen and the government.
Elasticity of Demand reveals consumers
responses to changes in the price of a
commodity or input.
When a sales tax is imposed on a
commodity by the government, we find that
sellers will normally attempt to pass on the
whole of the tax to consumers in the form
of higher prices.

Summary Cont
Producers are most burdened with
impositions of sales tax in cases where
the elasticity of demand of the good is
elastic.
Consumers benefit more than
producers from subsidies imposed on
goods with relative inelastic demand.
Producers benefit more than
consumers from subsidies imposed on
goods with relative elastic demand.

Reference
Foundation Economics by H.G.
Mannur
Chapter 4- 5