Micro: Price determination in a competitive market

Movements on the demand curve

• movements are caused by changes in price.

• if the price of a good increases, the quantity demanded will decrease - resulting in a contraction in demand.

• if the price of a good decreases, the quantity demanded will increase - resulting in an extension in demand.

• all while assuming ceteris paribus

Shifts on the demand curve

The demand curve shifts when price stays the same but other factors change:

• Population - as pop. increase = demand shifts right.

• Advertising - more advertising = more demanded.

• Substitutes - more substitutes = less demand for that good.

• Income - higher income = more demanded.

• Fashion trend - something in trend = more demanded.

• Interest rates - high IR = demand shifts left.

• Complementary - complementary good price increases = demand decreases of actual good.

Movements on the supply curve

• movements are caused by changes in price.

• if the price of a good increases, the quantity supplied will increase - resulting in an extension in supply.

• if the price of a good decreases, the quantity supplied will decrease - resulting in a contraction in demand.

• all while assuming ceteris paribus

Shifts on the supply curve

The supply curve shifts when price stays the same but other factors change:

• Productivity - higher productivity = more supply.

• Indirect tax - more tax = supply shifts left.

• Number of firms - more firms = more supply.

• Technology - more technology to improve efficiency / innovation = supply shifts right.

• Subsidies - more subsidies = more supply as costs are lower.

• Weather - bad weather = reduce supply.

• Cost of production - higher COP = supply shifts inwards.

Calculating price elasticity of demand

PED = percentage change in quantity demanded / percentage change in price

PED = the responsiveness of quantity demanded of a good, to a change in its price.

Relatively elastic

• when PED is greater than 1 (ignoring negative signs)

• percentage change in quantity demanded is higher than percentage change in price.

• usually elastic for luxury goods

Relatively inelastic

• when PED is between 0 and 1 (ignoring minus signs)

• percentage change in quantity demanded is less than percentage change in price.

• usually inelastic for necessity goods.

Factors that affect PED

• Substitutes - more substitutes = more price elastic.

• Percentage of income - the higher the percentage of income a good takes = more price elastic.

• Luxury / necessity - a luxury good is price elastic, a necessity good is inelastic.

• Addictive - the more addictive a good = more price inelastic.

• Time period - short-run is inelastic, long-run is elastic (due to more substitutes).

Income elasticity of demand YED

YED = percentage change in quantity demanded / percentage change in income.

• if YED > 0 , then it’s price elastic

• if YED < 0 , then it’s price inelastic

• if YED is positive , then normal/luxury goods are demanded.

• if YED is negative , then inferior/giffen goods are demanded.

Cross elasticity of demand

XED = percentage change in quantity demanded of good A / percentage change in price of good B

• if XED is positive, then the 2 goods are substitutes.

• if XED is negative, then the 2 goods are complementary.

• if XED = 0, then the 2 goods are unrelated/independent.

Price elasticity of supply

PES = the responsiveness of quantity supplied of a good, to a change in its price.

• if PES > 0, then price elastic.

• if PES between 0 & 1, then price inelastic.

Factors that affect PES

• Production lag - a longer production lag = more price inelastic supply will be.

• Stocks - larger level of stocks = price elastic.

• Spare capacity - more spare capacity = price elastic.

• Substitutability of factors of production - more substitutable the FOP’s = more price elastic.

• Time - short-run is inelastic, long-run is elastic.

Equilibrium & disequilibrium

Equilibrium - when quantity demanded and quantity supplied are equal.

Disequilibrium - when quantity demanded and quantity supplied are unequal.

Excess supply:

• if prices are set higher, then demand decreases and supply increases = excess supply.

• so, prices need to be forced down to contract supply and extend demand, back to the equilibrium price.

Excess demand:

• if prices are set lower, then demand increases and supply decreases = excess demand.

• so, prices need to be pushed to contract demand and extend supply, back to the equilibrium price.

Terms to know about demand & supply changes

• Substitute goods - goods which are alternatives to each other e.g., beef & chicken.

• Complementary goods / joint demand - goods which are often used together e.g., tea and milk. these goods are in joint demand.

• Derived demand - when demand for one good comes from the demand of another good e.g., demand for fencing leads to the demand for wood.

• Composite demand - the demand for a good with multiple uses e.g., oil for fuel or making plastic.

• Joint supply - the production of one good involves the production of another e.g., increased price of petrol = increased demand for oil drilling.