We are still on our journey investigating how a society can deal with the economic problem of scarce resources and unlimited needs and wants.
This scarcity problem forces us to make choices, and every choice we make has a cost – the opportunity cost – which is the best alternative we give up by making this choice. We have seen that because of this scarcity problem, every society needs to answer the following three fundamental questions:
- What should be produced?
- How should it be produced?
- For whom should it be produced?
We have identified the market system as a possible way to deal with these questions, and indicated that in a market system it is the price mechanism that helps society to deal with these fundamental questions. To explain how the price mechanism operates, we have developed a model – the demand and supply model.
In this model, we have shown how the price of a good or service is determined by the interaction between the forces of demand and supply. We have explained demand with the aid of a demand curve and supply with the aid of a supply curve, and indicated how the equilibrium price and quantity are formed in the market.
With this model, we have shown that prices have a signalling and rationing function in that they rise and fall to indicate excess demand (shortage) and excess supply (surplus), and how through price changes, this excess demand or excess supply is eliminated.
For instance, if households have a higher demand for goods and services, the demand for these goods and services increases. An excess demand is thus created, which causes the price to rise and the quantity demanded and supplied to adjust. A signal has thus been sent from the households to the producers.
Increase in demand
However, if there is a decrease in the supply of a good or service, the supply from producers' decreases. An excess demand is thus created, which causes the price to rise and the quantity demanded and supplied to adjust. A signal has therefore been sent from producers to households.
Decrease in supply
In this topic called price elasticity, we will take a closer look at the demand for a good or service by investigating the relationship between a change in price and the change in quantity demanded. This will give us a better understanding of how households and firms are influenced by a change in the price of a good or service.