1.2- Price determination in a competitive market

what is demand

the quantity of a good or service that consumers are able and willing to buy at a given price during a given period of time

describe movements along the demand curve (explain)

• at price p1, a quantity of q1 is demanded. At a lower price of p2, a larger quantity of q2 is demanded. this is an expansion of the demand.

• at a higher price of p3, a lower quantity of q3 is demanded. this is a contraction of demand

• only changes in price cause movements along the demand curve

shifting the demand curve (explain)

• price changes do not shift the demand curve

• a shift from d1 to d2 is an inward shift in demand, so a lower quantity of goods is demanded at the market price of p1

• a shift from d1 to d3 is an outward shift in demand where more goods are demanded at the market price of p1

what are the factors that shift the demand curve

P- population (higher pop. = more demand)

I- income

R- related goods (substitutes/complements)

A- advertising

T- tastes/ fashions

E- expectations

S- seasons

how does income shift the demand curve

• consumers have more disposable income

• able to afford more goods, so demand increases

• wealth effect occurs, as consumers spend more they perceive their wealth to increase

how do expectations shift demand curve

if people expect the price of shares in a company to increase in the future, demand is likely to increase in the present

what is the law of diminishing marginal utility

states that as an extra unit of good is consumed, the marginal utility (benefit derived from consuming the good) falls. therefore, consumers are willing to pay less for the good

why is the demand curve downward sloping

the number of units demanded increase with a fall in price

explain what price elastic mean

• a price elastic good is very responsive to a change in price

• change in price leads to an even bigger change in demand

• PED is >1

explain what price inelastic mean

• a price inelastic good has a demand that is relatively unresponsive to a change in price

• PED is <1

explain unitary elasticity

• a unitary elastic good has a change in demand which is equal to the change in price

• PED = 1

explain perfect inelastic goods

• has a demand which does not change when price changes

• PED = 0

explain perfectly elastic goods

• has a demand which falls to zero when price changes

• PED = infinity

  

what are the factors influencing PED

necessity, substitutes, addictiveness, proportion of income spent, durability, peak and off-peak demand

how does necessity influence PED

• a necessary good will have a relatively inelastic demand

• Even if the price increases significantly, consumers will still demand. it because they need it

• Luxury goods are more price elastic, if price rapidly increases, the demand will fall significantly

how does substitutes influence PED

• if the good has several substitutes, the demand is more price elastic

• The elasticity can change within markets

• e.g. market for bread is less elastic than the market for white bread. This is because there are fewer substitutes for bread in general but several for white bread

how does elasticity change in the short run and long run

• in the long run, consumers have time to respond and find a substitute, so demand becomes more price elastic

• In the short run, consumers do not have time, so demand is more inelastic

burden of indirect tax on consumers/ firms(explain)

• if a firm sells a good with inelastic demand, tax burden mostly on consumers because they know a price increase will not cause demand to fall significantly

• if a firm sells a good with an elastic demand, firms take most of the tax burden because they know if the price of a good increases, demand will likely fall, lowering overall revenue

what maximises government revenue

a good with inelastic demand

analysis of elasticity of demand and tax revenue diagram (price inelastic)

• an increase in tax will decrease supply from s1 to s2, which increases price from p1 to p2

• demand contracts from q1 to q2

• effective in raising gov. revenue

analysis of elasticity of demand and tax revenue diagram (price elastic)

• not effective in raising gov. revenue, but reduces demand of a particular good

• an increase in tax will decrease supply from s1 to s2, which increases price from p1 to p2

• demand contracts from q1 to q2

what is a subsidy

a payment from the government to firms tp encourage the production of a good to lower their average costs

advantages of subsidies

benefit can go to both the producer in the form of increased revenue or to the consumer in the form of lower prices

calculation of total revenue

average price x quantity

how does elastic demand affect total revenue

• if a good has elastic demand and the firm raises it price, quantity sold will fall, reducing overall revenue

what is income elasticity of demand

income elasticity of demand is the responsiveness of a change in demand to a change in income

how to calculate income elasticity of demand

YED = % change in QD/ % change in income

what is an inferior good

goods which see a fall in demand as income increases. A income increases, consumers switch to branded goods

• YED <0

YED of normal goods

YED is >0

how does income elasticity affect luxury goods

• an increase in income causes an even bigger increase in demand

• YED > 1

• Luxury goods are also normal goods, and they have an elastic income

how do firms react to real incomes rising

firms might switch to producing more luxury goods and fewer inferior goods

what is cross elasticity of demand

the responsiveness of a change in demand of one good to a change in price of another good

formula for cross elasticity of demand

XED and complementary goods (explain)

• complementary goods have a negative XED

• If one good becomes more expensive, the quantity demanded for both goods will fall

  • Close complements- a small fall in price x leads to a large increase in QD of Y

  • weak complements- a large fall in the price of good x leads to only a small increase in QD of Y

relationship between XED and substitutes

• substitutes can replace another good, so the XED is positive and demand curve is upward sloping

• close substitutes- a small increase in price of good X leads to a large increase in QD of Y

• weak substitutes- a large increase in the price of good c ;eads to a smaller increase in QD of Y

relationship between unrelated goods and XED

has a XED of 0

why are firms interested in XED

allows them to see how many competitors they have. therefore, they are less likely to be affected by price changes by other firms, if they are selling complementary goods or substitutes

define supply

the quantity of a good or service that a producer is willing and able to supply at a given price during a given period of time

why are supply curves upward sloping

• if price increases, more profitable for firms to supply the good so supply increases

• High prices encourage new firms to enter the market, because it seems profitable so supply increases

• with larger outputs, firm’s costs increase, so they need to charge a higher price to cover the costs

movements along the supply curve analysis

• price p1, quantity of q1 is supplied

• at the lower price of p2, q2 is supplied (contraction)

• if prices increase from q2 to q1

price mechanism of rising demand (explain)

• Price rises

• Signals excess demand and need for greater resources

• Incentivises firms to increases their output to increase profit

• Ration resources discouraging consumption

• Allocate resources efficiently at equilibrium

price mechanism of rising supply (explain)

• Prices fall

• Signals excess supply and need for fewer resources

• Incentivises firms to decrease their output to increase profit

• Ration resources encouraging consumption

• Allocate resources efficiently at equilibrium

factors that shift the supply curve

• Productivity

• Indirect taxes

• Number of firms

• Technology

• Subsidies

• Weather

• Costs of production

how does productivity affect supply

Higher productivity causes an outward shift in supply, becuase average costs for the firm fall

how do indirect taxes affect supply

inward shift in supply

how does technology affect supply

more advanced technology causes an outward shift in supply

how do costs of production affect supply

• if costs of production fall, the firm can afford to supply more

• If costs rise such as with higher wages, there will be an inward shift in supply

shifting along the supply curve analysis

• price changes do not shift the supply curve

• shift from 21 to s2 is an outward shift, larger quantities of goods are supplied at the market price of p1

• a shift from s3 to s1 is an inward shift in supply -more goods are supplied at the market price of p1

define price elasticity of supply

the responsiveness of a change in supply to a change in price

formula for PES

PES = % change in quantity supplied / % change in price

elastic supply

• firms increase supply quickly at little cost

• PES >1

inelastic supply

• expensive for firms to take a long time

• PES <1

  

perfectly inelastic

• PES = 0

• Supply is fixed, so there is a change in demand, it cannot be met easily

perfectly elastic

• PES = Infinity

• any quantity demanded can be met without changing price

factors influencing PES

1. time scale

2. spare capacity

3. level of stocks

4. substitute factors

5. barriers to entry to market

how does substitute factors affect PES

• if labour and capital are more mobile, supply is more price elastic because resources can be allocated to where extra supply is needed

how do barriers affect PES

• High barriers to entry means supply is more price inelastic, because it is difficult for new firms to enter and supply the market

where is the equilibrium on a diagram

when supply meets demand

excess demand diagram analysis

• at q2, price is at p2 which is below market equilibriumDemand is now greater than supply, which can be calculated by q3-q2. This is a state of disequilibrium

• demand price does not equal supply price and quantity demaded does not equal quantity supplied

what is the result of excess demand on markets

• there is a shortage in the market

• prices increase, so firms supply more

• As prices increase, demand will contract

excess demand diagram analysis

• supply is now at q2 and demand is at q1

• there is a surplus of q2-q1

• prices will fall back to p1 as firms lower their prices and try to sell their goods

• the market will clear and return to equilibrium

when are new market equilbriums made

when the demand or supply curves shift due to PIRATES or PINTSWC reasons

what are the different types of demand

derived, composite, joint

what is derived demand

• this is when demand for one good is linked to the demand of a related good

  • e.g demand for bricks is derived from demand of building new houses

what is composite demand

when a good demanded has more than one use

• e.g milk

what is joint demand

when goods are bought together

e.g a digital camera and sd card

what does joint supply mean

increasing the supply of one good causes an increase or decrease in supply of another good