1.3 Price determination

5 things that promote dynamic efficiency

R&D, innovation, technology, specialisation, education & training

Why do we want to achieve complete dynamic efficiency?

To maximise welfare and achieve full utility

Market

Where buyers and sellers interact to exchange goods/ services

Demand

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

What will consumers want to maximise when purchasing a good? What will they consider?

Total satisfaction (utility), therefore they will consider:

-How much satisfaction they get from buying and consuming an extra unit of a good

-The market price they have to pay to make this purchase

Law of demand

There’s an inverse relationship between the price of a good and the quantity demanded (ceteris paribus)

Contraction vs expansion in demand

Expansion, more as a result of a drop in prices, contraction is less demand as a result of a rise in prices

Effective demand

Demand supported by necessary purchasing power

Determinants of demand

Change in real income

Change in taste/preference

Change in price of related goods

Change in no. consumers

Future price expectations

Derived demand

demand for a factor of production used to produce another good/service

Composite demand

goods have more than one use- an increase in the demand for one product leaves to a fall in supply of the other

Difference between GDP and National Income

National income measures the total income earned by a country's residents, while Gross Domestic Product (GDP) measures the total market value of goods and services produced within a country's physical borders

Determinants of supply

-production costs

-technological progress

-unit labour costs

-prices of other goods and services

-govt. policy

-no. firms

-future price expectations

-weather

-goods in joint supply

Marginal utility

extra satisfaction gained from consuming a good or service

Standard of measurement of satisfaction

A util

Diminishing marginal utility

Marginal utility of a good/service consumed will decrease as we consume more

Law of supply

There’s a positive relationship between qs and price, ceteris paribus

Supply

Amount of a good/service that a producer is willing and able to sell at a given price in a given time period

Market supply

Combination of all the individual supply for a good/service

Market equilibrium

Point at which demand is equal to supply

Market clearing price

Why may a buyer not buy something if they don’t like the price

If they do not agree on the price, then they do not purchase the good/service and are exercising their consumer sovereignty

When does disequilibrium occur?

Whenever there is excess demand or excess supply in a market

3 functions of the price mechanism

Rationing, signalling and incentive

Rationing function of price mechanism

Some people can afford the g/s but it prevents others from being able to make the purchase

Signalling function of price mechanism

Something about the good/service that’s important to potential customers. Price rise may signal an increase in the cost of production. A price fall could indicate that the seller will no longer continue to provide to good or service

Incentive function of price mechanism

For a supplier to provide it. As prices rise, the supplier may make more profits and therefore receive a greater reward for investing in the supply of the product/service

Consumer surplus

Consumer surplus is the difference between the amount the consumer is willing to pay for a product and the price they have actually paid

Producer surplus

Producer surplus is the difference between the amount that the producer is willing to sell a product for and the price they actually receive

PED calculation

% change in QD / % change in price

PED

how responsive the change in quantity demanded is to a change in price

PES

how responsive the change in quantity supplied is to a change in price

PES calculation

% change in QS / % change in price

Factors influencing PED

Availability of substitutes

Habit/addiction

Price of product as a proportion of income

Necessity

Time period (consumers less responsive to price changes in short run)

Income elasticity of demand calculation

% change in QD / % change in income

Income elasticity of demand (YED)

how responsive the change in quantity demanded is to a change in income

PED value of 0

perfectly inelastic

PED value of 1

unitary elasticity

YED value of 0-1

Normal necessity

YED value of >1

normal luxury

YED value of <0

inferior good

Factors influencing YED

Things that cause changes in wages or salaries of workers

e.g. stage in economic cycle, minimum wage legislation, taxation, increased international trade

Cross price elasticity of demand (XED)

How responsive the change in quantity demanded for good A is to a change in price of good B

XED calculation

% change in quantity demanded of good A / % change in price of good B

XED<0

complimentary goods

XED=0

unrelated goods

XED>0

substitute goods

Why is knowledge of PED important

-important to firms to maximise revenue

-important to govt to raise tax revenue (can tax price inelastic goods without harming the firm or their own revenue too much) or distribute subsidies (subsidising elastic goods will lead to a greater than proportional increase in demand)

Why is knowledge of XED important

Firms can adjust pricing strategies for complimentary/ substitute goods to maximise revenue and understand importance of competitors’ price changes on their demand levels

Why is knowledge of YED important

They seek to maintain sales and maximise profits through periods of recession or economic growth so should provide more inferior goods during a recession

Total revenue rule of PED

The total revenue rule states that in order to maximise revenue, firms should increase the price of products that are price inelastic in demand and decrease prices on products that are price elastic in demand