2. Competitive Markets

Market

where buyers and sellers can exchange goods or services

Demand

the quantity of a good that consumers are **willing** and **able** to buy at a **given price**, at a **particular time**

Law of demand

↑P → ↓Qd or ↓P → ↑Qd

Demand schedule

a set of consumer spending preferences at different prices

Determinants: Demand

* price
* substitutes
* tastes/ fashions
* quality/ durability
* value for money
* exchange rates
* interest rates
* real income

Examples: Interrelated markets

1. competitive demand
2. joint demand
3. derived demand
4. composite demand

Competitive demand

substitute goods (↑Qda → ↓Qdb)

Joint demand

complementary goods (↑Qda → ↑Qdb)

Derived demand

↑Qd of a good as it’s used to make another good (e.g. labour)

Composite demand

goods with many uses (e.g. oil, handyman)

Price elasticity of demand (PED)

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

Equation: PED

PED \= %ΔQd/%ΔP

Value: Price elastic demand

PED > -1 (%ΔP < %ΔQd)

Value: Price inelastic demand

0 < PED < -1 (%ΔP > %ΔQd)

Value: Perfectly price elastic demand

PED = -∞ (↑P → Qd=0)

Value: Perfectly price inelastic demand

PED \= 0 (%ΔP → %ΔQd\=0)

Value: Unitary price elastic demand

PED = -1 (%ΔP = %ΔQd)

Determinants: PED

* type of good/ service
* time
* number of substitutes
* proportion of income spent

Determinants: PED - Type of good/ service

superior/ normal = elastic, inferior = inelastic

Determinants: PED - Time

long-run \= elastic, short-run \= inelastic

Determinants: PED - Number of substitutes

more \= elastic, fewer \= inelastic

Determinants: PED - Proportion of income spent

dearer \= elastic, cheaper \= inelastic

Income elasticity of demand (YED)

a measure of how the quantity demanded of a good responds to a change in **real** income

Equation: YED

YED \= %ΔQd/%ΔY

Value: Income elastic demand

YED \> +/-1 (%ΔY < %ΔQd)

Value: Income inelastic demand

0 < YED < +/-1 (%ΔY \> %ΔQd)

Value: Perfectly income elastic demand

YED \= +/-∞ (↑Y → Qd\=0)

Value: Perfectly income inelastic demand

YED \= 0 (%ΔY → %ΔQd\=0)

Value: Unitary income elastic demand

YED \= +/-1 (%ΔY \= %ΔQd)

Value: YED - Normal goods

0 < YED < 1

Value: YED - Superior goods

YED \> 1

Value: YED - Inferior goods

YED < 0

Cross elasticity of demand (XED)

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

Equation: XED

XED \= %ΔQda/%ΔPb

Value: XED - Substitute good

XED = +ve (↑Pa → ↑Qdb)

Value: XED - Complementary good

XED \= -ve (↑Pa → ↓Qdb)

Supply

the quantity of a good that producers are **willing** and **able** to supply at a **given price**, at a **particular time**

Law of supply

↑P → ↑Qs or ↓P → ↓Qs

Supply schedule

a set of producer supply preferences at different prices

Determinants: Supply

* price
* costs of production
* exchange rates
* interest rates
* research and development
* capital depreciation
* taxes/ subsidies
* productivity
* number of suppliers

Example: Interrelated markets

joint supply

Joint supply

production of one good involves the production of another (e.g. livestock)

Say’s law

supply creates its own demand as the reward for each factor of production is used to purchase a good/ service

Price elasticity of supply (PES)

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

Equation: PES

PES \= %ΔQs/%ΔP

Value: Price elastic supply

PES \> 1 (%ΔP < %ΔQs)

Value: Price inelastic supply

0 < PES < 1 (%ΔP \> %ΔQs)

Value: Perfectly price elastic supply

PES \= +/-∞ (↓P → Qs\=0)

Value: Perfectly price inelastic supply

PES \= 0 (%ΔP → %ΔQs\=0)

Value: Unitary price elastic supply

PES \= 1 (%ΔP \= %ΔQs)

Determinants: PES

* time
* level of stock/ spare capacity
* mobility of the factors of production
* unemployment
* type of good

Determinants: PES - Time

long-run \= elastic, short-run \= inelastic

Determinants: PES - Level of stock/ spare capacity

high \=elastic, low \= inelastic

Determinants: PES - Mobility of the factors of production

mobile \= elastic, immobile \= inelastic

Determinants: PES - Unemployment

high \= elastic, low \= inelastic

Determinants: PES - Type of good

non-perishable \= elastic, perishable \= inelastic

Market forces

the interaction of demand and supply in a free market economy

Equilibrium

Qd \= Qs

Disequilibrium

Qd ≠ Qs

How does the ‘invisible hand’ concept correct a surplus?

↓P (signalling) → demand extends + supply contracts → market equilibrium

How does the ‘invisible hand’ concept correct a shortage?

↑P (signalling) → demand contracts + supply extends → market equilibrium

Features: Surplus - Firm

* falling prices
* lower revenues
* more waste
* decreased profits

Features: Shortage - Firm

* rising prices
* higher revenues
* less waste
* increased profits

Assumptions: Market equilibrium

* supply and demand are independent of each other
* ceteris paribus
* all markets are perfectly competitive

Assumptions: Competitive markets

* large number of buyers and sellers
* no single producer or consumer can influence the **allocation of resources** or the **price**

Assumption: Competitive markets - Consumers

aim to maximise welfare by buying in order to maintain or improve their quality of life

Assumption: Competitive markets - Producers

aim to maximise profits by providing consumers with what they want at the lowest possible price

3 functions of price

1. incentive
2. signalling
3. rationing

Price mechanism

when changes in demand/ supply of a good/ service lead to a change in price and the quantity brought/ sold

The ‘invisible hand’ concept

allocation of resources by moving surplus to shortage to achieve **consumer satisfaction** and **improved profits**

Price mechanism - Incentive

influences how much producers make and how much consumers buy

Price mechanism - Signalling

changes in price show changes in supply/ demand

Price mechanism - Rationing

allocates scarce resources by changing price as demand/ supply changes

Pros: Price Mechanism

* allocates efficiently
* zero cost
* consumer sovereignty
* prices are at minimum
* efficiency is at maximum

Cons: Price Mechanism

* inequality in wealth/ income
* under-provision of merit goods
* over-provision of demerit goods
* low skilled workers will be unemployed
* public goods won’t be produced

Dynamic pricing

changes in price reflect changes in demand

Surge pricing

immediate change in price to reflect significant changes in demand (e.g. London tube strikes, 2017 (400%↑P))

Consumer surplus

the difference between the price that a consumer is willing to pay for a good or service and the price that they actually pay

Producer surplus

the difference between the price that a producer is willing to supply a good or service at and the price that they actually receive for it

Subsidies

the government pays a producer to decrease price in order to encourage demand

High PED - Subsidies

majority **producer** gain

Low PED - Subsidies

majority **consumer** gain

Indirect taxation

the government place a tax on a good to increase price in order to discourage demand

High PED - Indirect taxation

majority **producer** burden

Low PED - Indirect taxation

majority **consumer** burden