Price determination in a competitive market

Market

A situation in which buyers and sellers come together to engage in trade

Competitive market

Where there are a large number of potential buyers and sellers with abundant information about the market

Equilibrium price

The price at which planned demand of consumers equals the planned supply of firms

Demand

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

Law of demand

As the price of a good or service falls, the quantity demanded falls.

Conditions of demand

• Real disposable income

• Tastes and preferences

• Population

• Prices of substitute goods

• Prices of complementary goods

What occurs as a result of a change in the conditions of demand?

A shift of the demand curve for a good or service - rightward means higher demand, leftward means lower demand

Price elasticity of demand (PED)

The responsiveness of the quantity demanded of a good or service to a change in its price

Formula for PED

% change in QD/ % change in P

Why is the value for PED negative?

Due to the inverse relationship between price and demand - however, this is usually ignored

Price inelastic demand

PED is between 0 and 1. The change in price has led to a smaller percentage change in the quantity demanded.

Price elastic demand

PED is greater than 1. The change in price has resulted in a larger percentage change in the quantity demanded.

Unitary elastic demand

PED = 1. The change in price has led to the same percentage change in quantity demanded.

Perfectly inelastic demand

PED = 0. The demand curve will be vertical. The change in price has led to no change in the quantity demanded.

Perfectly elastic demand

PED = infinity. The demand curve will be horizontal. Change in price ha sled to an infinitely large change in quantity demanded.

What happens to revenue if demand is price elastic?

A reduction in price leads to an increase in total revenue

An increase in price leads to a fall in total revenue

What happens to total revenue if demand is price inelastic?

A reduction in price leads to a decrease in total revenue

An increase in price leads to an increase in total revenue

Determinants of PED

• Availability of close substitutes

• Percentage of income spent on the product

• Nature of the product

• Time period

• Broad or specific market definition

Income elasticity of demand (YED)

Measures the responsiveness of demand to a change in real income

Formula for YED

% change in QD/ % change in real income

YED values

Positive - product is a normal good, rise in income = rise in D

Negative - product is an inferior good, rise in income = fall in D

Income elasticity demand

YED>1, increase in real income has led to a greater increase in demand. These are usually luxury goods

Income inelastic demand

YED is between 0 and 1. Increase in real income has led to a smaller percentage increase in demand. These are usually necessities.

Negative income eleasticity

Value of YED is less than 0. Increase in income has led to a fall in demand. These products are inferior goods.

Cross elasticity of demand (XED)

Responsiveness of demand for a product following a change in price of another product

Formula for XED

% change in QD of product A/ % change in P of product B

Positive XED

Products are substitutes

Negative XED

Products are complements

Supply

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

What causes movement along the supply curve?

A change in price:

• Increase in price = extension in supply

• Decrease in price = contraction in supply

What are the conditions of supply?

• Production costs

• Productivity of labour

• Taxes on businesses

• Production subsidies

• Technology

What do the shifts in the supply curve mean?

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

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

Joint demand

Goods that tend to be demanded together

i.e. cars and fuel

Competing demand

AKA substitutes - when demand for cars increases, the demand for public transport decreases

Joint supply

The production of one good also leads to the production of another good

i.e. beef and leather from cattle farming

Composite demand

When a good is demanded for more than one distinct use. Therefore, an increase in the demand for one of the distinct uses reduces the supply available for other uses

Derived demand

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

i.e. an increase in the demand for healthcare is likely to lead to an increase in the demand for doctors and nurses.