Price determination in a competitive market

Effective demand

• Demand backed by the ability to pay

Market demand

• Quantity of goods/services that all consumers in the market wish to and are able to buy at different prices

Law of demand

• As price falls,demand increases

• inverse relationship

• Hence downward sloping

What causes a movement along the demand curve?

• Price change

Define extension

• Fall in price

• more goods demanded

Define contraction

• Rise in price

• Less goods demanded

Define ceteris paribus

• All other factors remain constant

What factors cause demand curve to shift?

• Price of substitute goods

• External factors (economic shocks)

• Population

• Trends

• Income

• Complementary goods

Equilibrium price

• Price at which demand for goods = supply of goods

Normal good

• A good for which demand increases as income increases

Inferior goods

• A good for which demand decreases as income increase

Exceptions of the law of demand

• Speculative demand

• Price as an indicator of quality

• Veblen goods

Speculative demand

• If housing, shares or foreign currency starts to rise, people speculate that prices will rise even further

• So demand increases

Price as indicator of quality

• A higher price may signify high quality when info about the good is limited

Veblen goods

• A good that is marketed as exclusive

• The high price is the selling point

Price elasticity of demand (PED)

• Measures the change in demand in response to price change of the good

• % change in Q demanded / % change in price

Elastic demand

• A change in price leads to a bigger % change in demand

• PED> 1

Inelastic demand

• Change in price leads to a smaller change in demand

• PED< 1

Unit elastic demand

• Change in price induces exactly the same change in demand

• PED = 1

• Perfectly elastic demand

• Demand is highly sensitive to price change

• e.g. A slight decrease in price would lead to an infinite quantity demanded

• PED= infinite

Completely inelastic demand

• Demand does not change regardless of price change

• PED=0

Factors determining PED

• Substitutability

• Percentage of income= Goods that take up a large amount of income are elastic

• Necessities or luxuries

• Width of market definition=when a market is narrow(specific) demand is elastic because there are substitutes. Contrastingly a broad markets are inelastic because there are fewer close substitutes)

• Time= Demand is elastic in the long run, because it takes time to adjust. But response is greater in the short run because consumers may choose to economise in the first few weeks

Market supply

• Quantity of goods and services that all firms plan to sell at different prices

Law of supply

• As a goods price increases more is supplied

Why do supply curves slope upward

• To illustrate the assumption that the primary objective of all firms are to maximise profit

What causes the supply curve to shift?

• Cost of productions

• Technical progress

• Taxes imposed by gov

• Subsidies

What is expenditure tax?

• VAT and duties imposed by the government that increase the cost of production

• Expenditure tax is known as indirect tax as consumers indirectly pay this tax in the form of a higher price

Define ad valorem tax

• It is VAT

• The amount of VAT paid depends on the value of the good

• e.g. If VAT is 20% tax on gold worth £1 is 20p

• Tax on gold worth £2 is 40p

What is specific/unit tax

• Tax that does not depend on the price of the good

Define shifted incidence of tax

and unshifted incidence of tax

• Part of the tax passed onto consumers

• Part of the tax paid by firms

What does a firms ability to pass incidence of tax to consumers depend on?

• Ability to pass on tax is highest when demand is inelastic

• And non existent when demand is perfectly elastic

Price elasticity of supply (PES)

• Measures how the supply of a good responds to a change in the price of a good

• % change in Q supplied / %Change in price

Unitary supply curve

• Change in price leads to a proportional change in supply

Factors determining PES

• Length of production process

• Availability of spare capacity

• Accumulating stock

• Ease of switching between methods of production

• Ease of entering the market

Length of production period effect on PES

• If raw materials can be converted into finished goods quickly supply will tend to be more elastic

Effect of spare capacity on PES

• If spare capacity like labour and raw materials is readily available

• Production can be increased quickly

• More spare capacity = PES is elastic

Effect of accumulating stock on PES

• When stock of unsold finished goods are stored

• Firms can responds quickly to price/demand changes

• Making PES elastic

• (If prices fall, firms can divert production away from sales and into stock accumulation)

Effect of easily switching between methods of production on PES

• When firms can efficiently switch between how they produce goods (capital/labour intensive)

• Supply is elastic

Effect of easily entering the market on PES

• If there are a lot of firms in the market, a new firm can enter easily

• Making PES elastic

• (*Because with more firms, supply of goods increases)

Income elasticity of demand (YED)

• Measures how demand responds to a change in income

• % change in Q demanded / % change in come

What is YED for normal and inferior goods?

• YED is always positive for normal good and negative for inferior good

• As Q demanded of an inferior good falls as income rises and Q demanded for a normal good rises with income

Normal goods

• Can be luxury or basic goods

• Luxury goods YED is greater than +1

• Basic goods YED is between 0-+1

• (YED increases more than proportionately for luxury goods)

Cross elasticity of demand (XED)

• Measures the extent to which the demand for a good changes in response to a change in price of another good

• % change of Q demanded for good A / % change in price of good B

What are the different possibilities of XED

• Substitute goods will have a positive XED

• Complementary goods will have a negative XED (Because if price of 1 increases, demand for both decreases)

• Unrelated goods will have an XED of 0

Close substitutes and their XED

• Close substitutes will have a higher XED than weaker substitutes

Strong complements and their XED

• Strong complements have a lower XED

• XED of -1.6 shows stronger complementary goods than an XED of -0.28

Define market equilibrium

• Demand = supply

What can market disequilibrium be caused by?

• Excess demand or excess supply

Disequilibrium caused by excess demand

• Excess demand can be caused by price being below market equilibrium.P1 is below Pe

• Excess demand causes disequilibrium as supply does not increase at the same rate

• Prices must rise to ration demand and achieve equilibrium .Higher prices reduce demand and incentivise firms to produce more

• There will be an extension of supply and contraction of demand

Disequilibrium caused by excess supply

• At P1 prices are above market equilibrium. Firms are supplying more

• This causes disequilibrium as there is excess supply and not enough demand

• Prices must be reduced to stimulate demand and for firms to produce less

• There will be an extension of demand and a contraction of supply

What is consumer surplus?

• Difference between the price consumers are willing to pay and the price they actually end up paying (for a good/service)

Consumer surplus diagram

• Distance from a to b shows that consumers were willing to pay more than P1

• But because they were able to buy the good for less, utility gained which is demonstrated by the consumer surplus is high

• If prices were to rise consumer surplus would decrease.

Define producer surplus

• The difference between the price producers are willing to supply a good for and the market price.

Producer surplus diagram

• The distance between a and b shows that producers were willing to supply goods below market price (P1)

• But as they are able to sell it at a higher price, they gain profit and thus gain producer surplus

• If prices rise, surplus rises.

What can be understood by “interrelationship between markets”

• Refers to how different markets influence and interact with each other

What is joint demand?

• Goods that are bought in conjunction (complements) e.g. Printer and ink

• If the price of printers increase, Q demanded is lower. So demand for ink experiences a leftward shift

Define competitive demand

• Goods that can be interchanged (substitutes)

• E.g coke and Pepsi

• If price for coke increases, there will be a contraction of demand. But Pepsi will see a rightward shift in the demand curve

Define derived demand

• Some goods/services are demanded because they are needed for the production of another good. E.g house and bricks

• If the demand for houses increases, so does the demand for bricks. The demand for bricks is derived from the demand of houses.

Define composite demand

• A product is in composite demand when it is demanded for several different uses.

• E.g. Milk → Cheese and Butter

• If demand for cheese increases, more of it will be produced. More milk is used in the production of cheese.

• Therefore supply for butter will shift left as there is not enough milk to produce butter

Diagram for composite demand

Define joint supply

• An increase/decrease in the supply of one good leads to an increase/decrease in the supply of a by product

• E.g. Honey → Beeswax

• If demand for honey increases. Production of it will increase. As there is more quantity of honey produced, supply of beeswax increases as it is a by product of the honey.

Diagram for joint supply

Define competitive supply

• Goods are in competitive supply when raw materials that are used to produce one good can’t be used to produce another

• E.g. Timber and paper both need wood

• If demand for timber increases, more of it will be produced and there will be less wood available to produce paper so supply shifts left

Diagram for competitive supply

Why are agricultural markets prone to disequilibrium?

• The supply curve can shift randomly due to climatic factors. Drought can reduce crop yield