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`1

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

• % 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)