4.1.3 - Price determination in a competitive market

Demand =

The total amount of goods and services that consumers are willing and able to pay at any given price over a given period of time.

Market =

A place or mechanism by which buyers and sellers meet to trade or exchange goods or services

Resource Market =

a market in which households sell and firms buy resources or the services of resources (CELL)

Product Market =

the market in which households purchase the goods and services that firms produce and sell

Free/Competitive Market =

The market forces of supply and demand dictate the price paid (price mechanism)

Notional Demand =

The desire or want for a product

Effective Demand =

When a consumer is willing and ABLE to pay for a good/service

Derived Demand =

When the demand for one good/service is because of the demand for another good/service

Ceteris Paribus

Other things being equal

Rational Choice Theory =

In economics, we assume that all individuals make logical decisions that will maximise their personal benefit i.e. self-interest

Reasons why the Demand Curve is Downward Sloping

• Income Effect = At lower prices, buyer's income appears larger

• Law of Diminishing Marginal Utility = Utility/satisfaction fallls as consumption increases, so price they are willling to pay also falls

• Substitution Effect = If product is now cheaper than an alternative, consumers may switch their spending from alternative to cheaper product

Factors which causes a shift in Demand (other than price):

SUITCASED

‎

Seasonality

USPs

Income

Tastes

Complements

Advertising

Substitutes

External Shocks

Demographics

Normal Good =

A good that consumers demand more of when their incomes increase

Inferior Good =

A good that consumers demand less of when their incomes increase

Extension vs Shift of Demand Curve

• Change in Price causes an extension/contraction of demand

• Any other factor (SUITCASED) influencing demand causes a shift

Price Elasticity of Demand (PED) =

The extent to which the quantity demanded for a good changes in response to a change in price of that good.

PED =

% change in quantity demanded / % change in price

Factors determining the PED:

• Time period following a price change

• Habit forming

• Income - % of consumer's income that is spent on the good

• Substitutes - price & availability

• Peak Demand - circumstances changing a good/service's demand

• Off Peak Demand

• Necessity or Luxury

• Breadth of Definition - generic categories of goods is inelastic, specific goods more elastic

Perfectly Elastic Demand (PED)

- PED = ∞

- Flat horizontal demand curve

- When there is a small change in price, demand rises from 0 to infinity

Elastic Demand (PED)

- PED < -1

- Less steep slope demand curve

- When price changes, demand changes more proportionately

Unit Elastic Demand (PED)

PED = -1

When price changes, demand changes equally proportionately

Inelastic Demand (PED)

-1 < PED < 0

- Steep slope demand curve

- When there is a large change in price, demand changes less proportionately

Perfectly Inelastic Demand (PED)

PED = 0

Vertical demand curve

When price changes, demand does not change.

If price of an inelastic product increases, the effect on revenue is:

Positive, as the increase in price is larger than the decrease of quantity demanded

If price of an elastic product increases, the effect on revenue is:

Negative, as the increase in price is smaller than the decrease of quantity demanded

Income Elasticity of Demand (YED) =

The extent to which the quantity demanded for a good changes in response to a change in income

YED =

% change in quantity demanded / % change in income

If YED > 0 (positive), what type of good is it?

Normal Goods

- As incomes rise, quantity demanded for good increases

Necessities YED

0 < YED < 1

(inelastic)

Luxury goods & services YED

YED > 1

(elastic)

If YED < 0 (negative), what type of good is it?

Inferior Goods

- As incomes rise, quantity demanded for the good decreases

Cross Elasticity of Demand (XED)

The extent to which the quantity demanded for good A changes in response to a change in the price of another good (B)

XED =

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

Substitute Goods XED (competitive demand)

XED > 0

(positive)

- Increase in price of good A will lead to an increase in demand for rival good B

Complementary Goods XED (joint demand)

XED < 0

(negative)

- Increase in price of good A will lead to a decrease in demand for complementary good B

No Relationship Between Goods

XED = 0

Higher XED means

More elastic

Elastic shown on a graph

Low gradient

Inelastic shown on a graph

Large gradient, steep

Why is there a positive correlation between price and quantity supplied? (Why is Supply sloped Upwards?)

• Profit motive = Assume that firms want to maximise profits so higher prices encourage more supply

• Survival = At a higher price level, less efficient producers can still cover their costs and make profits so survive --> more supply

• New Entrances = Higher prices increases incentive to enter new market

Factors causing a shift in Supply Curve

CONGEST

‎

Cost of production

Other related products (prices of them) - products in joint supply & competitive supply

Number of firms - more firms increases supply

Government policy - subsidies, indirect tax, regulations

Expectations about future prices

Shocks - External shocks

Technology - improvement in tech --> more efficient and cost effective production

Supply =

The total amount of a product that producers are willing and able to supply at various price over a period of time.

Competitive Supply =

Alternative products that a business could make with its factor resources of land, labour and capital

Joint Supply =

Where production of one good automatically leads to supply of another using same raw materials (e.g. beef and leather hides)

Indirect Tax =

A tax levied by the government on producers of a particular good or service (e.g. VAT)

• Acts as a CoP so shifts Supply left

Subsidy =

Money provided by a government to a producer in order to encourage the production of certain goods or services

• Shifts supply right

Productivity =

Output per unit of input. The rate at which goods or services are produced

External Shock =

An unpredictable event which are outside of the businesses control but can have a direct impact on the level of supply (or demand)

Price Elasticity of Supply

The extent to which the quantity of supply of a good changes in response to a change in the price of that good.

PES =

% change in quantity supplied / % change in price

What value range should PES always be?

PES >= 0

Perfectly Elastic Supply

- PES = ∞

- Flat horizontal supply curve

- When there is a small change in price, supply rises from 0 to infinity

Elastic Supply

PES > 1

Less steep slope supply curve

When price changes, supply changes more proportionately

Unit Elastic Supply

PES = 1

When price changes, supply changes equally proportionately

Inelastic Supply

0 < PES < 1

- Steep slope supply curve

- When price changes, supply changes less proportionately

Perfectly Inelastic Supply

PES = 0

- Vertical Supply Curve

- When price changes, supply does not change

Factors determining the PES

PSSST

‎

Production period - Goods that take longer to produce are more inelastic as it's difficult to raise Qs quickly

Spare capacity - Availability of spare capacity, if there are unsued resources it is easier to increase production

Stock - Ease of accumulating stocks; if the good allows easy accumaltion of stock (e.g. in warehouse) supply is more elastic

Switching - Ease of switching between alternative FoP; if a firm can raise production by employing more labour and employing more capital, supply more elastic

Time to adjust - Supply more elastic over longer time frame as more time to raise production

Market Equilibrium =

When planned demand equals planned supply, so no excess demand or supply. (point where demand curve crosses supply curve)

Market Disequilibrium =

Exists at any price other than equilibrium price.

• Either excess demand or supply exists in the market

If price is set below equilibrium...

then quantity demanded will be greater than quantity supplied (excess demand)

If price is set above equilibrium...

then quantity demanded will be less than quantity supplied (excess supply)

What happens to price and quantity if: "An increase in the raw material costs" (Chain of Analysis)

• An increase in raw material costs will cause an increase in costs of production.

• As a result, producers become less willing and able to supply at any given price over a given period of time. This is shown in a shift of the supply curve to the left (S1 to S2).

• As a result, at P1, there is less quantity of supply than demand and thus a disequilibrium exists.

• In order to maximise profits, firms will increase the price (P1 to P2)

• This causes an extension of supply and a contraction of demand, which means equilibrium is regained at E2.

• The overall consequence is that the equilibrium price increases from P1 to P2, and the equilibrium quantity decreases from Q1 to Q2.

What happens to price and quantity if: "A product becomes more fashionable" (Chain of Analysis)

• A product becoming more fashionable means consumers have more desire for the product.

• This causes consumers to be more willing and able to buy at any given price over a given period of time. This is shown by a shift of the demand curve to the right (D1 to D2.)

• As a result, at P1, there is more demand than supply for the product, therefore a disequilibrium exists.

• In order to maximise profits, the firm will increase the price from P1 to P2

• This causes an extension of the supply curve and a contraction of the demand curve, causing an equilibrium to be regained at E2.

• The overall consequence is that equilibrium price increases from P1 to P2, and equilibrium quantity increases from Q1 to Q2.

Joint Demand

= Goods that are demanded together (complement goods)

• Good A Demand ↑ , Good B Demand ↑

Competitive Demand

= Goods that are substitutes

• Good A Price ↑ , Good B (substitute) Demand ↑

Composite Demand

= A good is demanded for more than one purpose. An increase in demand for one use will lead to a decrease in supply of good for another use. (e.g. steel used for building & cars)

• Good A Demand ↑ , Supply for Good B ↓

Derived Demand

= When the demand for one good/service is because of the demand for another good/service

• Good A Demand ↑ , Good B Demand ↑

Joint Supply

= When the production of one good leads to the supply of another good using the same raw materials

• Good A Supply ↑ , Good B Supply ↑

• Good A Demand ↑, Good B Supply ↑