2. Price Determination in a competitive market

market

where buyers and sellers can exchange goods or services

sub-markets

smaller markets that make up a market

Supply

the quantity of a product that a producer is willing and able to supply onto the market at a given price over a given time period

Demand

the quantity of a good/service the consumer are willing and able to buy at a given price, at a particular time

What does a demand curve show?

the relationship between price and quantity demanded

law of diminishing marginal utility

as we consume more of an item, the amount of satisfaction produced by each additional unit of that good declines. (Total satisfaction is maximised when marginal utility is zero)

substitute goods

those which are alternatives to each other — e.g. beef and lamb

competitive demand

occurs when there are alternative services or products a customer can choose from (substitutes)

compliment goods

goods that are often used together, so they’re in joint demand —
e.g. strawberries and cream.

joint demand

when the demand for one product is directly and positively related to market demand for a related good or service

Derived demand

the demand for a good or a factor of production used in making another good or service

composite demand

when goods or services have more than one use so that an increase in the demand for one product leads to a fall in supply of the other (e.g milk or oil)

Price elasticity of demand (PED)

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

PED =

% Δ in quantity demanded / % Δ in price

Elasticity

the responsiveness of x to a change in another variable

revenue

the money that is produced by carrying out normal business operations

revenue (calculation)

price of good x quantity produced and sold

perfectly inelastic

Zero response of quantity demanded to a change in price

Inelastic

Proportionally smaller response of quantity demanded to a change in price (

Unitary

Equal response of quantity demanded to a change in price (exactly 1)

elastic (PED)

Proportionally greater response of quantity demanded to a change in price (>1)

Perfectly Elastic

Buyers are prepared to buy all that they can at some prices but none at all at higher prices (Very rare - extreme reactions) (∞)

Factors affecting PED

• substitutes

• necessity

• time period

• proportion of income

• brand loyalty

• addictiveness or habitual consumption

• durability

Cross price elasticity

measures the responsiveness of demand for good X following a change in the price of a related good Y

Cross price elasticity formula

% Δ in quantity of good X / % Δ in price of good Y

Negative XED

Compliments (rise in demand of Y and fall in demand of X)

Positive XED

Substitutes (rise in demand in both Y and X)

income elasticity of demand (YED)

measures the responsiveness of quantity demanded to a change in income

income elasticity of demand formula

% Δ in quantity demanded / % Δ in income

what does income elasticity do to normal goods?

as someone's income increases they tend to consume more.

what does income elasticity do to inferior goods

as someone's income increases they tend to consume less

what does income elasticity do to luxury goods

not needed by people and are more sensitive to change in income (would be more elastic)

what does income elasticity do to necessity goods

needed for everyday life and so are less sensitive to change in income (would be more inelastic)

The law of supply

as the market price of a commodity rises, so producers expand their supply onto the market as the higher price makes it more profitable to do so

Causes of shifts in market supply

• Productivity

• Indirect tax

• No. of firms

• Technology

• Subsidies

• Weather

• Cost of Production

How does changes in production costs affect supply?

an increase in the costs of production lowers profitability and therefore reduces supply

Costs of Production

Wage costs
Raw materials and components
Energy costs
Cost of borrowing – interest rate

How does indirect tax affect supply?

An indirect tax is a tax on expenditure such as VAT and excise duties. This increases the costs of production, lowers profitability and therefore lowers supply

How does a subsidy affect supply?

A subsidy is a sum of money given by the government to producers and therefore lowers the costs of production and increases supply as it increases profitability.

How do changes in technology affect supply?

New technology can speed up the production process and reduce the costs of production making it more profitable and therefore will increase the supply.

How does the availability of stocks of finished products and raw materials determine supply?

If a firm has stocks of finished products they can be released to the market quickly following an increase in demand. In addition, stocks of raw materials allow a firm to produce products more quickly. The availability of stocks makes the supply elastic.

How does the length of the production period determine supply?

some products take a long time to produce and/or grow and therefore in the short-run the supply is inelastic

How does the possibility of switching resources from one use to another determine supply?

If a firm produces a number of products and the demand for one product rises then the firm is able to expand its output by switching resources from another use.

How does spare capacity determine supply?

a firm is said to have spare capacity when it is not using all of its available resources fully. If there is spare capacity then a business can increase output without a rise in unit costs and thus supply will be price elastic if there is an outward shift of demand.

How does the number of firms in the market determine supply?

The more firms that are in a market and the easier it is to enter the market then generally the easier it is to increase output in response to a rise in price and therefore the more elastic the supply.

why is the supply of agricultural products more inelastic than that of manufactured goods?

• Agricultural products tend to be perishable meaning there would be a small amount of stock as that way less is wasted whereas manufacturing goods tend to last longer.

• It is usually seasonal meaning it takes more time to produce and manufactured goods can be made at any time. Quantity is not as controlled in agricultural goods than manufactured goods.

• Supply of land for agriculture would depend on land, farmers rarely have space to plant extra crops therefore their spare capacity may be less than a factory making manufactured goods.

joint supply

where an increase or decrease in supply of one good leads to an increase or decrease in supply for another