Price determination in a competitive market

Demand definition

The quantity of a good or service that a consumer is willing and able to buy at a given price at a point of time

Determinants of demand

• Changes in the price of substitute goods

• Changes in the price of complement good

• Personal disposable income

• Tastes and preferences

• Population Size

• Advertising

Supply definition

The quantity of a good or service that producers are willing and able to sell, at a given price, over a given period of time

Laws of Supply

• 'As the price of a product rises, the quantity supplied of the product will usually increase, ceteris paribus'

• Supply slopes upwards -> Firms have profit max objective

• Assume firms don't change size, cost of producing extra units of the good generally increases as firms produce more of the good

• Supplier initially uses most efficient FOPs first, meaning first units sold cheaper however higher quantity means less efficient resources are employed which means his cost for the extra units go up and he needs a higher price for a larger quantity

Determinants of supply

• Improvements in technology

• Changes in the cost of productions e.g. wages or raw materials

• Taxes imposed on firms e.g. VAT

• Subsidies

• Firms entering/leaving the market

Equilibrium Price

Price at which the quantity demanded is equal to the quantity supplied. Also known as the market-clearing price

Consumer Surplus definition

The difference between how much buyers are willing to pay for the good and for what they actually pay. It is the area above the market price and bordered by the demand curve and the price axis. 

Producer Surplus

The difference between the price a firm succeeds in charging and the minimum price it would be willing to accept

Elasticity definition

Measures the proportionate responsiveness of the second variable to the change in the first variable

Price Elasticity of Demand definition and formula

Measures the extent to which the demand for a good changes in response to a change in the price of that good. PED = %Change in q.d/ %Change in price

Factors affecting PED

• Luxury or necessity

• Availability of substitutes 

• The 'width' of the market definition

• Proportion of income spent on the good

• Time period

What does it mean when PED > 1?

Elastic meaning that when the price of a product increases/decreases, the quantity demanded changes significantly in the opposite direction

What does it mean when PED < 0?

Inelastic meaning that quantity demanded changes only slightly in response to a change in price

What does it mean when PED = 1?

Unitary meaning that %change in q.d. is exactly equal to %change in price

What does it mean when PED = ∞?

Perfectly elastic meaning that q.d. is infinetly responsive to any changes in price where the slighest increase in price results in q.d. dropping to 0 and any decrease leads to an infinitely large q.d. 

What does it mean when PED = 0?

Perfectly inelastic meaning q.d. does not repsond at all to changes in price

Income Elasticity of Demand (YED) definition and formula

Measures how much demand for a product changes in response to a change in consumers' income. YED = % Change in q.d / % Change in income

What does it mean YED is between -1 and +1

Income inelastic (demand changes less than proportionately to income changes - demand still rises with income, but only a little)

What does it mean when YED is less than -1 or greater than +1?

Income elastic (demand changes more than proportionately to income changes - as income ↑, demand rises more significantly)

What does it mean when YED > 0?

Normal good

What does it mean when YED < 0?

Inferior good

What does it mean when YED > 1?

Luxury good

Price Elasticity of supply definition and formula

Measures the responsiveness of supply to changes in price. PES = % Change in q.s. / % Change in price

Factors affecting PES

• Spare capacity - The ease of switching between alternative methods of production

• Availability of FOPs (State of economy e.g. recession or boom)

• Stockpiles and Perishability

• Time Period

• The number of firms in the market and the ease of entering the market

What does it mean when PES < 1?

Inelastic meaning that producers are not very responsive to changes in price
A significant increase/decrease in price leads to only a small change in quantity supplied

What does it mean when PES > 1?

Elastic meaning that producers can significantly increase/decrease the quantity they supply in repsonse to a change in price
Small ↑ in price leads to a relatively large increase in q.s. same as as small ↓ in price

What does it mean when PES = 1?

Unitary where %change in q.s. is exactly equal to the %change in price

What does it mean when PES = 0?

Perfectly inelastic supply meaning that the q.s. remains constant regardless of any change in price

What does it mean when PES = ∞?

Perfectly elastic means that producers can respond instantly and infinitely to any change in price

Cross Elasticity of Demand (XED) definition and formula

Measures how much demand for a product changes in response to a change in price of another good. XED = % Change in q.d. of good X / % Change in price of good Y

What does it mean when XED is between -1 and +1?

Cross inelastic

What does it mean if XED is less than -1 or greater than +1?

Cross elastic

What does it mean if XED is positive?

Substitute goods - the closer the substitute, the higher the value

What does it mean if XED is negative?

Complement goods - the stronger the complement, the lower tha value

What does it mean if XED = 0?

Unrelated goods

 Complement Goods definition

When goods are in joint demand. When a consumer demands one good they are likely to demand the other e.g. printers and ink cartridges

Substitute Good definition

Alternative goods that can be used for the same purpose. e.g. PS4 & XBOX

Derived Demand definition

When demand for one good (often labour market) is as a result of demand for another good e.g. production of cars, leads to demand for factory workers

Composite Demand definition

When a good is demanded for two or more distinct uses e.g. milk for cheese or butter

Competing Supply definition

When raw materials are used to produce one good they cannot be used to produce another good e.g. wheat for flour or for biofuel

Joint Supply definition

When two or more goods are produced together e.g. beef and leather

What is a contraction in demand?

When a rise in price leads to less being demanded

What is an extension of demand?

When a fall in price results in more of the good being demanded