Price determination in a competitive market
Define demand.
the quantity of a good or service that consumers are willing and able to buy at a given price in a given time period
What are economists interested in?
Economists are interested in effective demand i.e. demand backed up by the ability to pay.
What is the law of demand?
As the price of a good or service decreases, the quantity demanded increases.
What are the factors, other than price, that shift a demand curve?
- changes in income
- population
- fashion, trends, advertising
- price of substitute products
- price of complementary products
How is an increase in demand shown?
By a rightward shift of the demand curve.
How is a decrease in demand shown?
By a leftward shift of the demand curve.
Changes in income.
if income increases, the demand for most products will increase, except for inferior goods (ie supermarket own branded foods).
Population
If the population increases, the demand for most products will increase.
Fashion, trends and advertising
increased advertising will lead to increased demand for a product.
Price of substitute products
(e.g tea and coffee and private transport) If the price of an alternative product (e.g tea) increases, the demand for coffee increases.
Price of complementary products
If the price of a good bought together with another (e.g) fish increases, the demand for chips will decrease.
Define Supply
The quantity of a good or service that a firm is willing and able to produce of a given price in a given period of time.
Law of supply
As the price increases, the quantity supplied increases
How is an increase in supply shown?
A rightward shift of the supply curve
How is a decrease in supply shown?
A leftward shift of the supply curve
What factors, other than price, lead to a shift of a supply curve
- cost of production
- productivity
- indirect taxes
- subsidies
- technology
- weather
Cost of production
An increase in the cost of production (e.g raw materials) will lead to a decrease in supply
Productivity
An increase in productivity will lead to an increase in supply
Indirect taxes
(e.g VAT) An increase in indirect tax will lead to a decrease in supply.
Subsidies
An increased subsidy will increase supply
What is a subsidy
A payment from government to producers
Technology
Improvements in technology will increase supply
Weather
Favourable weather conditions will increase supply
What is a market?
A situation in which buyers and sellers come together to exchange goods or services.
Where can a market occur?
It doesn't need to be in a physical location. It can be and online market or e-commerce.
What does the interaction of demand (buyers) and supply (sellers) create?
The interaction of demand and supply creates an equilibrium price and quantity.
When does market equilibrium occur?
Equilibrium in a market for a good or service occurs when demand equals supply.
What does equilibrium mean?
Equilibrium means state of rest
What causes a change in equilibrium price?
By either a shift of the demand curve, or a shift of the supply curve.
What does an increased demand do to the equilibrium price and quantity?
increase in equilibrium price and quantity
What does a decreased demand do to the equilibrium price and quantity?
it decreases the equilibrium price and quantity
What does a increased supply do to the equilibrium price and quantity?
leads to a decrease in equilibrium price and an increase in quantity
What does a decreased supply do to the equilibrium price and quantity?
leads to an increase in equilibrium price and a decrease in quantity.
When does market disequilibrium occur?
Market disequilibrium occurs when the demand and supply are not equal
Joint demand
goods that tend to be demanded together e.g complementary goods.
Give an example of joint demand
cars and fuel. As the demand for cars increases, the demand for fuel also decreases.
What is the opposite of joint demand?
competing demand.
What is competing demand?
when goods are substitutes and are bought in place of each other. (ie when demand for cars increases, the demand for public transport may decrease)
Joint supply
when the production of one good leads to the production of another
Give an example of joint supply
the production of beef and leather (both from cattle farming)
Composite demand
When a good is demanded for more than one distinct use
Derived demand
When a particular good or factor of production is necessary for the provision of another good or service.
Give an example of derived demand
An increase in healthcare is likely to lead to an increase in the demand for doctors and nurses.
Elasticity
the responsiveness of demand and supply to changes in factors such as price and income.
Price elasticity of demand (PED)
the responsiveness of the quantity demanded of a product to a change in its price.
Formula of Price elasticity of demand (PED)
PED= % change in quantity demanded (QD) /% change in price
perfectly inelastic demand value
0
price inelastic demand value
0-1
unit elastic demand value
1
price elastic demand value
>1
perfectly elastic demand value
infinity
Price elasticity of demand and total revenue
PED of a product, determines consumer spending and therefore total revenue, following a price change.
What happens to revenue is demand is price elastic and price is reduced?
demand is price elastic, a reduced price leads to an increase in total revenue
What happens to revenue is demand is price inelastic and price is reduced?
demand is price inelastic, a reduced price leads to a decrease in total revenue
What happens to revenue is demand is price elastic and price is increased?
demand is price elastic, an increase in price leads to a reduction in total revenue
What happens to revenue is demand is price inelastic and price is increased?
demand is price inelastic, an increase in price leads to an increase in total revenue
Determinants of Price elasticity of demand
- Availability of close substitutes
- Percentage of income spent on the product
- Nature of the product
-Time period
- broad or specific market definition
Availability of close substitutes
If a close substitute exists for a product, an increase in price will lead to consumers buying more of the substitute.
- one or more close substitutes, demand for product is price elastic
- a few close substitutes, demand is more inelastic
Percentage of income spent on product
If product is a large percentage of consumers income, a change in price is going to have a significant impact on disposable income, so demand is usually price elastic.
- Demand for inexpensive products are usually price inelastic
Nature of product
- If product is necessity or has addictive qualities, demand tends to be price inelastic as few alternatives exists in eyes of consumer
- If a product is a luxury, demand tends to be price elastic
Time period
- longer time period between price change makes it easier for consumers to adjust spending patterns and more alternatives become available.
- so demand will be more price inelastic in the short run
- In long run, demand will be more price elastic
Broad or specific market definition
- broad market category (e.g food) usually has price inelastic demand.
- specific product in a market segment (e.g heinz baked beans) usually has a price elastic demand
Income elasticity of demand (YED)
- the responsiveness of the quantity demanded of a product to a change in consumer income
Income elasticity of demand formula
YED = % change in quantity demanded (QD) / % change in income (Y)
negative income elastic demand value
any negative value (inferior goods)
Income inelastic demand value
0-1 (necessities)
Income elastic demand value
1 to infinity (luxury goods)
Cross elasticity of demand (XED)
The responsiveness of the quantity demanded of one good to a change in price of another good
Cross elasticity of demand (XED) formula
XED = % change in QD of good A / % change on P of good B
Price elasticity of supply (PES)
The responsiveness of the quantity supplied of a product to a change in its price
Price elasticity of supply (PES) formula
PES = % change in quantity supplied / % change in price
Perfectly inelastic supply value
0
inelastic supply value
0-1
unit elastic value
1
elastic supply value
1 to infinity
perfectly elastic supply value
infinity
Determinants of Price elasticity of supply
- time taken to expand supply
- size of spare capacity
- available stocks
- Ease of switching production
Time taken to expand supply
supply will often be more price inelastic if increasing production is difficult or time consuming
Size of spare capacity
Supply will often be more price elastic when there are firms with machinery, factory space or labour that isn't fully utilised that will be more able to expand production in the short run
Available stocks
Supply will often be more price elastic when there are firms with stocks of finished/partly finished goods which are able to quickly respond to a price increase.
Ease of switching production
If firms can easily adjust the way they use their factors of production, then supply will be price elastic.
However if a firm has highly specialised equipment and employees, supply will be relatively price inelastic.