4.1.3 Price determination in a competitive market

what is a market?

where buyers and sellers can exchange goods or services

what is a competitive market?

occurs where there is a large number of potential buyers and sellers w/ abundant information about the market

what is demand?

the quantity of a good or service that consumers are willing and able to buy at given prices in a particular time period

what is effective demand?

consumers’ desire to buy a good, backed up by the ability to pay

what does the demand curve show?

the relationship between price and quantity demanded

what’s the law of demand

there is an inverse relationship between price and quantity demanded (QD), ceteris paribus, when price rises, QD falls (vice versa)

what causes a movement along the demand curve?

a change in the price of the good or service

what causes a contraction along the demand curve? (draw it)

an increase in price

what causes an expansion of demand? (draw it)

a decrease in price

what causes a shift in the demand curve?

• real disposable income

• tastes and preferences

• population

• price of substitute products

• price of complementary goods

what is a substitute?

a good that may be consumed as an alternative to another good

what’s a complement good?

a good that tends to be consumed together w/ another good (e.g. toothbrush and toothpaste)

how do disposable incomes affect demand?

rising incomes

• increase D for normal goods (goods where D increases as income increases)

• decrease D for inferior goods (D decreases as income increases)

how do substitute goods influence demand?

an increase in the price of one substitute raises demand for its alternative

how do complementary goods affect demand?

a fall in the price of a complement (e.g. printers) increases D for the related good (e.g. ink cartridges)

draw

1. a right shift in demand

2. a left shift in demand

1. a greater quantity of a good or service is demanded at any given price

2. a lower quantity of a good or service is demanded at any given price

what is the price elasticity of demand (PED)?

a measure of how the quantity demanded of a good responds to a change in its price

how do you calculate the PED?

% change in QD / % change in price

how do you calculate the percentage change?

(change / original) x 100

why is the PED usually negative?

demand falls as price increases for most goods`

what is price inelastic demand?

• the value of PED is between 0 and 1 (ignore minus)

• a % change in price will cause a smaller % change in QD

(smaller PED = more inelastic D for the good)

what is price elastic demand?

• PED > 1 (ignore minus)

• % change in price will cause a larger % change in QD

(higher PED = D more elastic)

what is unitary elastic demand?

PED = ±1 (% change in price == % change in QD)

what is perfectly inelastic demand?

PED is 0 (change in price has no change in QD)

what is perfectly elastic demand?

PED is ± infinity (increase in price → D falls to 0)

what happens to total revenue (TR) if the price reduces? (elastic and inelastic)

elastic - TR increases

inelastic - TR decreases

what happens to total revenue (TR) if the price increases? (elastic and inelastic)

elastic - TR decreases

inelastic - TR increases

what are the determinants of PED?

1. availability of substitutes

2. % of income spent on good

3. nature of product

4. time period

5. market definition

how does the availability of substitutes affect PED?

• the more close substitutes available, the more elastic D becomes

• a rise in price encourages consumers to switch to alternatives

how does the proportion of income spent on the good affect PED?

• goods taking up a large share of income (e.g. housing, cars) are more elastic

• goods taking a small share (e.g. bread, matches) are more inelastic

how does the nature of the product affect PED?

• necessities (e.g. electricity) are typically inelastic

• luxuries (e.g. holidays) are more elastic

how does the time period affect PED?

• in the short run, demand is often inelastic as consumers need time to adjust

• in the long run, demand may become more elastic as substitutes are found or habits change

how does the market definition affect PED?

narrowly defined markets (e.g. heinz beans) usually have more elastic demand than broadly defined markets (e.g. food)

what is the income elasticity of demand (YED)?

measures how much the demand for a good changes with a change in real income

how do you calculate YED?

% change in QD / % change in real income

what is income elastic demand?

• YED > +1

• increase in real income → greater % increase in D

(these products often referred to as luxury goods)

what is income inelastic demand?

• 0 < YED < 1

• increase in real income → smaller % increase in D

(normal / basic goods)

what is negative income elasticity?

• YED < 0

• as incomes rise, demand falls

(inferior goods)

what is the cross elasticity of demand (XED)?

measures how the QD of one goods responds to a change in the price of another good

how do you calculate XED?

% change in QD of good A / % change in price of good B

what is the XED if two goods are substitutes?

positive

what is the XED if two goods are complements?

negative

what’s the XED of independent / unrelated goods?

0

what is supply?

the quantity of a good or service that firms plan to sell at given prices in a particular time period

what does the supply curve show?

the relationship between price and quantity supplied

what is the law of supply?

• as price increases, the quantity supplied (QS) increases

why does the supply curve slope upwards?

firms are assumed to maximise their profits, so a higher price gives an incentive for firms to increase production

what is the supply curve under perfect competition?

marginal cost (MC) curve

what causes a movement in supply?

a change in price

what causes a contraction of supply?

a decrease in price

what causes an expansion of supply?

an increase in price

what factors cause the supply curve to shift?

1. production costs

2. productivity of labour

3. taxes on businesses

4. production subsidies

5. improvements in technology

what does a rightward shift of supply mean?

a greater quantity of a good or service is supplied at any given price

what does a leftward shift of supply mean?

a lower quantity of a good or service is supplied at any given price

what is the price of elasticity of supply (PES)?

a measure of how the quantity of supplied of a good responds to a change in its price

how do you calculate the PES?

% change is QS / % change in price

why is the PES usually positive?

the higher the price the greater the supply

what is price inelastic supply?

• 0 < PES < 1

  • change in price → smaller % change is QS

what is price elastic supply?

• PES > 1

  • change in price → greater % change in QS

what is unitary elastic supply?

• PES = 1

• change in price → same change in QS

what is perfectly inelastic supply?

• PES = 0

• change in price → zero change in QS

what is perfectly elastic supply?

• PES = infinity

• any fall in price → QS will fall to 0

what are the factors that influence the PES?

• time taken to expand S

  • time consuming → inelastic

• size of spare capacity

  • more → elastic in short run

• available stocks

  • more finished goods → elastic

• ease of switching production

  • easier → elastic

how is supply inelastic in the short run?

• firm’s capacity is fixed

• one factor of production is fixed

• difficult to increase production (takes time)

how is supply elastic in the long run?

• FOPs are variable

• firm can increase in capacity

• firms have longer to react to changes in price and demand

when is a market in equilibrium?

QD = QS, the demand curve crosses the supply curve

what is market disequilibrium?

when QD does not equal the QS

what is excess supply (use diagram)?

• when the price (P₁) is more than the equilibrium price (P_e)

• QD is at Q₁

• high price encourages a greater QS at Q₂ (QS exceeds QD)

• excess supply is Q₂ - Q₁

what is excess demand?

• when the price (P₂) is lower than the equilibrium price (P_e)

• QD is at Q₄

• low price → less incentive for firms to supply → lower QS at Q₃ (QD exceeds QS)

• excess supply is Q₄ - Q₃

what are market forces (or market mechanism)?

the interaction of supply and demand

how do market forces correct excess supply?

• firms forced to reduce their prices

• → contraction in S

• → expansion in D

• excess supply eliminated, equilibrium restored at P_e, Q_e

how do market forces correct excess demand?

• firms increase prices

• → expansion in S

• → expansion in D

• excess demand eliminated, equilibrium restored at P_e, Q_e

what is a change in the market equilibrium price caused by?

a shift in demand or supply

describe an increase in demand

• D increases from D₁ to D₂

• P increases from P₁ to P₂

• supply extends from Q₁ to Q₂, creating a new equilibrium

describe a decrease in demand

• D decreases from D₁ to D₂

• P decreases from P₁ to P₂

• supply contracts from Q₁ to Q₂, creating a new equilibrium

describe an increase in supply

• S increases from S₁ to S₂

• P increases from P₁ to P₂

• demand extends from Q₁ to Q₂, creating a new equilibrium

describe a decrease in supply

• S decreases from S₁ to S₂

• P decreases from P₁ to P₂

• demand contracts from Q₁ to Q₂, creating a new equilibrium

what are the assumptions of the demand and supply model?

1. supply and demand are independent of each other

2. all markets are perfectly competitive

3. ceteris paribus applies

what are changes in a particular market likely to affect?

other markets

what is joint demand?

goods that tend to be demand together (i.e. complementary goods)

what is joint supply?

when the production of one good leads to the production of another good (e.g. beef and leather)

what is composite demand?

when a good is demanded for more than one distinct use

(increase in D for one use reduces S for other uses)

what is derived demand?

when a good or factor of production is necessary for the provision of another good or service