Combined set: topic 3

Market - defintion

A voluntary meeting of buyers and sellers

What makes a market competitive?

A large number of buyers and sellers

Ruling price - definition

Price of goods which is set by the collective supply and demand in a market, rather than from individual decisions.

Demand - definition

The amount of goods/services that a customer is willing and able to buy

What is effective demand?

When a customer wants and can afford a good.

If they can’t afford it but desire it, not effective.

Law of demand - definition

There’s an inverse relationship between price + quantity demanded of a good.

(as long as ceteris paribus)

As price goes up…

Demand goes down ( and vice versa)

What do movements along the line show in a demand curve?

Changes in price of a good/service, which causes the demand for that good to change.

What’s the independent and dependent variable of the demand curve?

Independent - Price

Dependent - Quantity demanded

What does a demand curve shifting mean?

When demand changes not due to price change, but other factors.

How do demand curves shift?

Inwards = lower demand at the same price.

Outwards = higher demand at the same price.

Normal goods - definition

One where if prices rise, demand will fall and vice versa.

Inferior goods - definition

One where demand decreases as incomes increase, as they are affordable but aren’t of high quality

What are the conditions of demand? (7)

(factors other than price that change demand, causing the line to shift)

P- Population

I- Income

R- Related goods

A- Advertising

T- Tastes and fashions

E- Expectations

S- Seasons

Population - explained

The larger the population, the higher the demand

Age demographics change demand too.

Income - explanation

If consumers have more disposable income, they can afford more goods, so demand increases (Positive goods)

Inverse relationship with inferior goods, as incomes increase, demand will fall.

Related goods: two types

Substitute and complimentary.

Substitute goods - definition and explanation

A good that can replace another good, like pepsi and coke.

If coke prices increase, demand for pepsi will increase as it becomes the more affordable option - positive relationship

Complimentary goods - def and explan

A good that goes with another good, like strawberries and cream.

If strawberry prices increase, demand for cream will fall as less will be buying strawberries, so fewer buying cream. - Inverse relationship

Advertising - definition

This will increase customer loyalty to the good, which increases demand.

Tastes and fashions - definition

Curve will shift if consumer’s tastes change, making a product in higher or lower demand.

Expectations - definition

This is the expectation of future price changes.

If people think prices will increase in the future, demand for the good now will increase.

Seasons - explanation

Demand changes according to the season.

What are veblen goods?

A special type of good identitfied by the economist veblen.

The ‘snob effect’ - people pay more for certain products as their price increase, due to the increased status from buying higher priced goods.

What are giffen goods?

Inferior goods which defy the general rule for these types of goods - demand for them increase as incomes increase.

Mainly staple products like bread potatoes and rice, which have no substitutes and are still desired even with higher incomes.

What does the theory of elasticity look at?

The sensitivity of one variable in relation to another

What’s the price elasticity coefficient?

The measure of the response of demand in response to the change of price

Q: What is the equation to calculate the Price Elasticity of Demand (PED)?

A: PED = (% Change in Quantity Demanded) / (% Change in Price)

What do different PED values indicate?

• If PED < -1: Elastic

• If PED is between -1 and 0: Inelastic

• If PED = -1: Unitary elastic

• If PED = 0: Perfectly inelastic

• If PED = ∞: Perfectly elastic

Price elastic good - definition

Change in price leads to an even bigger change in demand.

Price inelastic good - definition

One that is relatively unresponsive to change in priceU

Unitary elastic good defintion

One where the change in demand is equal to the change in price

Perfectly inelastic good - definition

One where its demand doesn’t change when price changes

Perfectly elastic good - definition

One where its demand falls to zero when price changes

How should you change prices to maximise revenue with inelastic vs elastic goods?

Inelastic: Should increase the price, as % demand won’t decrease as much as % price will increase

Elastic: Should decrease the price, as %demand will increase more than % price will decrease.

Inelastic vs elastic graph

Unitary elasticity graph

Perfectly elastic vs inelastic demand graphs

Factors influencing PED (6)

1. Necessity

2. Substitutes

3. Addictiveness/ habitual consumption

4. Proportion of income spent on the good

5. Durability of the good

6. Peak and off-peak demand

How does the necessity of a good influence PED?

Necessities: Will have a relatively inelastic demand, as even if prices increases, people will still need them.

Luxuries: elastic, if prices increase demand will fall significantly.

Substitutes: How does it influence PED?

If goods have several substitutes then demand is more price elastic, as many other options if prices increase.

Long term: consumers have more time to respond and find a substitute so more elastic

Short term: more inelastic

Addictiveness: : How does it influence PED?

Not sensitive to a change in price, as people are addicted to them no matter what.

Proportion of income spent on good:: How does it influence PED?

If its low value, like an increase from £1.50 to £2, more inelastic than a high value good increasing from £15000 to £20000.

Durability of good: How does it influence PED?

If a good lasts a long time, demand is more elastic as consumers wait to buy another one

Peak/off peak demand: How does it influence PED?

During peak times for train tickets, e.g. demand is more inelastic as people have to buy them even if prices go up.

Total revenue equation

Average price x quantity sold

What is income elasticity of demand?

How sensitive quantity demanded is to changes in consumer income

What is the income elasticity of demand equation?

YED = % Δ in quantity demanded/ % Δ in income

Y = income

What are the YED values of inferior goods and why?

Negative values - as income increases, demand decreases, inverse relationship

Low quality goods like own brand items.

Between 0 and -1 - inelastic

Less than -1 - elastic

What’s the YED value for normal goods

Between 0 and 1 - Demand increases with income, but at a decreasing rate

Inelastic, but positive relationship - necessities

Whats the YED value for luxury goods?

>1 - demand increases significantly with income.

Elastic and positive relationship

What does the YED graph look like for normal (necessity) goods (0-1) and luxuries (1+)

What does the YED graph look like for inferior goods?

This graph: inelastic inferior

Elastic would be a less steep line

What is Cross price elasticity of demand?

The responsiveness of the quantity demanded of one good to a change in the price of another related good.

What does XED analyse the relationship between?

Complementary and substitute goods

XED formula

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

Meaning of different XED values

Positive: Substitute

0-1 (inelastic) : weak substitute, >1 (elastic) is strong substitute

Negative complement

0- -1 (inelastic) : weak complement, < -1 (elastic) is strong complement

Why is XED for substitutes positive

Increase in the price of once product will lead to more demand for its substitute as people seek alternatives.

What does a strong substitute mean?

Goods are closely related, so consumers are more likely to switch between products.

What does an XED graph look like for a substitute?

If it was a less closely related substitute, line would be steeper, as Good A has a lesser effect on good B

Why is the XED for complementary goods always negative?

Example: if prices of smartphones increase, they will have a lower demand, so cases will also see a drop in demand.

What do XED graphs for complements look like?

Negative gradient

A weak complement would have a less steep line, as the goods have a lesser relationship with each other.

What does an XED of 0 mean?

The goods are unrelated, there’s no relationship between the two goods

The closer to 0, the weaker the relationship between two goods.

Supply - definition

Quantity of a good or service that a supplier is willing and able to produce at a given price during a given time period

What does a supply curve look like

Why is a supply curve upwardly sloping?

Price and quantity supplied have a positive relationship.

Why do price and QS have a positive relationship?

If price increases, it’s more profitable for firms to produce the good, so supply increases

High prices also attract more new firms as it is profitable

With larger outputs, firms’ costs increase so prices must rise

What do movements along the curve show?

An increase/ decrease in price, which cause an increase / decrease in quantity demanded

Extension/contraction

What do shifts in a supply curve show?

A change in quantity supplied at the same price, caused by other factors

Leftward shift = Inward (less QS)

Rightward shift = outward (more QS)

What are factors that shift the supply curve (7)

1. Changes to costs of production

2. Government policy

3. Technology

4. Change in no. of firms in the industry

5. Weather events

6. Future price expectations

7. Goods in joint or competitive supply

Changes to costs of production: How do they affect supply?

If prices to produce increase, firms will respond by decreasing supply

Inverse relationship

Government policies: Two types

1. Subsidies

2. Taxes

Subsidies: How do they affect supply?

Impacts cost of production, more subsidies = cheaper to produce = more supply

Positive relationship

Taxes: How do they affect supply?

Opposite to subsidies, higher taxes = higher cost of production = lower supply

Inverse relationship

Technology: How does it affect supply?

New technology increases productivity and efficiency, which decreases production costs, so supply increases

Aging technology has the opposite effect, more inefficient

Changes in the number of firms in the industry: How do they affect supply?

More firms in an industry = higher supply, as more producers

Direct relationship

Weather events: How do they affect supply?

Extreme weather can cause a supply shock usually in agricultural markets, which will decrease supply

Conversely, good conditions will increase supply of crops

Future price expectations: How do they affect supply?

If firms expects the price of a good/service to increase in the future, they will increase supply and vice versa.

Direct relationship

What are goods in joint supply and how does this affect supply?

Ones involving a process which yields multiple outputs, like beef and leather

If supply of beef increases, maybe due to price, supply of leather will also increase.

Positive relationship

What are goods in competitive supply and how does this affect supply?

When alternative products can be made with the same resources, e.g. a farmer can grow wheat or potatoes

When supply of one good (potatoes) increases, the supply of the other good (wheat) will decrease.

Inverse relationship

What is price elasticity of supply (PES)

Measures the responsiveness of supply to a change in price

How to calculate PES

% change in quantity supplied/ %change in price

What is true for all goods’ PES value?

Will be positive, as supply and price have a positive relationship

What does a PES of 0 show?

Perfectly inelastic, supply will never change no matter the price

What does a PES between 0-1 mean?

Relatively inelastic - % change in quantity supplied is less than % change in price

What does a PES of 1 show?

Unitary elasticity - price and quantity supplied increase by the same %, directly proportional

What does a pes > 1 mean?

Relatively inelastic - QS will increase by more than price increases (% wise)

What does a PES of infinity mean?

Perfectly elastic - %change in QS will fall to 0 for any % change in price

What are the 5 factors that influence PES?

1. Mobility of the factors of production

2. The rate at which costs of production increase

3. Ability to store goods

4. Spare capacity

5. Time period

Mobility of the factors of production - how does this affect PES?

If producers can quickly switch their resources between products, then PES will be more elastic as quantity supplied can change easily

Rate at which costs of production increase how does this affect PES?

If the rate of marginal (one unit extra) cost increase is low, PES will be more elastic, as cheap to supply more

Ability to store goods: how does this affect PES?

If goods can be easily stored then PES will be elastic as supply can quickly be increased

Spare capacity: how does this affect PES?

If there’s capacity to produce more than current levels, then PES is elastic as supply can quickly be increased

Time Period: how does this affect PES?

In the short run, PES is often inelastic, as hard to increase supply quickly

In long run, PES is usually elastic, as time to change factors of production`

So what is the essence of the determinants of PES?

How easy it is for a firm to change how much of a good they produce in response to a change in price.

What is the market system

The interaction of supply and demand through negotiations between buyers and sellers, who meet an agreed upon price that works for both parties

Equilibrium price - definition

When demand = supply

Also known as market-clearing price

Disequilibrium - definition

Any price above or below the equilibrium price creates this, occuring when there’s excess supply or demand

Excess demand and supply - definitions and graph

Excess demand: when demand> supply - caused by low prices

Excess supply: when supply> demand - caused by high prices

How do markets respond to excess demand?

There’s a shortage in the market, more is demanded than suppliers can produce.

This pushes prices up and causes firms to supply more (expands), since prices increase, demand will contract causing the price to return to the equilibrium price