1.3 Price determination in a competitive market Flashcards
Law of demand
As price increases, quantity demanded decreases. As price decreases, quantity demanded increases.
Market
anywhere where buyers and sellers come together, a price is agreed and a transaction takes place
Price
amount of money that must be paid to acquire a good or service
Demand
the quantity of a good or service that consumers are willing and able to buy at given prices in a given period of time
Consumer expenditure
the amount of money consumers spend on a given quantity of goods in a given period of time
Rationing function of prices
The rationing function of price is the way in which rising prices reduce demand or limit access to a good or service, ensuring that only those who are willing and able to pay can obtain it.
When a good becomes scarce (e.g. due to a supply shock), its price increases. This discourages some consumers from buying it, thus reducing excess demand. The higher price “rations” the limited supply to those who value it the most (those who are willing to pay more).
Consumer surplus
Consumer surplus is the extra utility consumers receive when they pay a price lower than what they were willing to pay.
Utility
the economic welfare an individual gains from consuming a good
Law of diminishing marginal utility
for one consumer, the marginal utility from a good decreases for each additional unit consumed
Normal good
when the demand for a good increases as incomes rises and demand decreases as income fall
Inferior good
when the demand for a good decreases as income rises and demand increases as income falls
Complementary good
a good which is in joint demand, or which is demanded at the same time as the other good (gloves and scarfs)
Substitute good
a good in competing demand, or which can be used in place of the other good
Direct tax
a direct tax is a tax that is paid directly to the government by individuals or organizations based on their income or wealth
Causes of changes in demand (7)
- change in price or related goods
- changes in incomes
- Fashions, Tastes and preferences
- Advertising and branding
- Demographic change
- External shocks (pandemics, natural disaster)
- Seasonal factors
extension in demand
the increase in quantity demanded due to a fall in price
contraction in demand
the fall in the quantity demanded due to a rise in price
Total revenue
the total amount of money a firm receives by selling goods or services
Total revenue formula
Price x Quantity
Marginal revenue
change in total revenue from an additional unit of output
Marginal revenue formula
change in total revenue / change in quantity
Price elasticity of demand (PED)
measures the extent to which the demand for a good changes in response to a change in the price of that good
PED formula
% change in quantity demanded / % change in price( new-old/old)
Perfectly price inelastic
The quantity demanded does not change in response to price changes; PED = 0
Perfectly price elastic
consumers will only buy at one specific price, and any change in price causes demand to fall to zero (or become infinite if the price drops).
PED = ∞
inelastic PED
PED < 1
elastic PED
PED > 1
Factors affecting PED (5)
- how close substitutes are to product
- availability of substitutes
- change of price of luxuries
- addiction
- whether purchase can be postponed
Income
the flow of money a person or household receives in a particular time period
Income elasticity of demand (YED)
measures the extent to which the demand for a good changes in response to a change in the income of consumers.
YED
% change in quantity demanded / % change in income
What is the YED for normal goods?
positive
What is the YED for inferior goods?
Negative
Cross elasticity of demand (XED)
measures the extent to which the demand for a good changes in response to a change in the price of another good.
XED formula
% change in quantity demanded of good X / % change in price of good Y
What is the XED for complementary goods?
Negative
What is the XED for substitutes?
Positive
Total cost
the whole cost of producing a particular level of output
Producer revenue
the amount of money received by producers from selling a given quantity of goods in a given period of time
Incentive function
when prices for a good/service rise, it incentivises producers to reallocate resources from a less profitable market to this market in order to maximise their profits
Producer surplus
a measure of the economic welfare enjoyed by firms or producers: the difference between the price a firm succeeds in charging and the minimum price it would be prepared to accept
Indirect tax
a tax which can be shifted by the person legally liable to pay the tax onto someone else, for example through raising the price of a good being sold by the taxpayer. They are normally levied on spending
Ad valorem tax
a tax added on as a percentage, such as VAT
Tax per unit
a set tax levied per good sold, regardless of the good’s price, such as passenger duty on airfares; causes a leftward shift in supply curve
Subsidy
a payment made by government or other authority, usually to producers, for each unit of the relevant good they produce; causes a rightward shift of the supply curve
Law of supply
producers offer more of a good as its price increases and less as its price falls
Describe an extension of supply
a movement along the supply curve to the right (higher price & higher quantity supplied).
Describe a contraction of supply
movement along the supply curve to the left (lower price & lower quantity supplied).
Producer revenue =
producer surplus + the cost to producers of supplying
Factors affecting supply (8)
- Changes in costs of production
- Introduction of new technology
- Indirect taxes
- Government subsidies
- External Shocks
- changes in productivity
- changes in prices of other goods
- new firms entering the market
Price elasticity of supply (PES)
measures how much the supply of a good changes in response to a change in the price of that good
PES formula
% change in quantity supplied / % change in price
Factors determining PES (6)
- The length of production period
- The availability of spare capacity
- The ease of accumulating stocks
- The ease of switching between alternative production methods
- The number of firms in the market
- The ease of entering the market
Shortage
Excess demand
If there is excess demand, market forces will result in an extension in supply and a contraction in demand, causing a rise in price to its market clearing level. This is because firms will spot this excess demand and recognise that they will have to increase prices in order to ration demand. Furthermore, as firms increase their prices, supplies will be willing to supply greater the good in greater quantities due to the profit motive. Both the contraction in demand an extension of supply will result in the market reaching equilibrium.
Surplus
Excess supply
If there is excess supply, market forces will result in a contraction in supply and an extension in demand, causing a fall in price to its market clearing level. This shortage in demand will result in a decrease in the price of the good as firms will realise that they have to lower their prices if they are to sell all their goods. This is also combined with the fact that when firms start to lower their price, demand will also increase. The combination of a contraction in supply (fewer firms will be willing to supply at the same quantity given a decrease in price) and increase in demand will cause the market to reach equilibrium.
Equilibrium price
price where quantity supplied equals quantity demanded.at this price there is no shortage or surplus, and there is no tendency for the market price to change
Free market forces
forces in free markets which act to reduce prices when there is excess supply and raise prices when there is excess demand
Deadweight loss
the loss of welfare when the maximum attainable level of total welfare is not achieved
Joint supply
when one good is produced, another good is also produced from the same raw materials (e.g. beef and leather)
Joint demand
a good which is demanded at the same time as another good (e.g. printers and ink cartridges)
Competing demand
a good which can be used in place of the other good
Composite demand
demand for a good which has more than one use (e.g. oil for plastics and oil for petrol)
Derived demand
Quantity demand for a good which is an input into the production of another (e.g. houses and bricks)
consequence of tax
The tax burden on the taxpayer
consequence of subsidy
the subsidy burden on the subsidy recipient
Impact of changing price on revenue when demand is price elastic
If price decreases, total revenue increases (because the increase in quantity demanded is large enough to offset the lower price).
If price increases, total revenue decreases (because the decrease in quantity demanded is large enough to outweigh the higher price).
Impact of changing price on revenue when demand is price inelastic
If price increases:
Total revenue increases because the percentage decrease in quantity demanded is smaller than the percentage increase in price.
If price decreases:
Total revenue decreases because the percentage increase in quantity demanded is smaller than the percentage decrease in price.
Impact of changing price on revenue when demand is unitary price elastic
total revenue will remain unchanged as price changes
unitary price elastic
the percentage change in quantity demanded is exactly equal to the percentage change in price.
increase and decrease in demand
A decrease in the demand for a good/service will result in a decrease in quantity (Q to Q1) as well as a reduction in price (P to P1). If the firm was to keep the good/service at the same price then there would be an excess of supply. Therefore by reducing the price it encourages firms to produce less quantity of the good/service thus allowing the market to reach equilibrium.
An increase in the demand for a good/service will result in an increase in the price (P to P2) as well as an increase in quantity (Q to Q2). This is due to the fact that if the price of the good stayed the same then there would be an excess of demand. Therefore by increasing the price it helps to ration the demand for the good/service as well as incentivising suppliers to increase the quantity that they supply.
increase and decrease in supply
An increase in the supply of a good/service will result in a higher quantity supplied (Q to Q1) and a lower price (P to P1). If the price were to remain the same, there would be an excess of supply, leading to unsold goods. By allowing the price to fall, consumers are encouraged to buy more, while producers may reduce future output, helping the market return to equilibrium. The lower price also makes the good/service more accessible, balancing the increased availability with higher demand.
A decrease in the supply of a good/service will lead to a lower quantity supplied (Q to Q1) and a higher price (P to P1). If the price stayed unchanged, demand would exceed supply, creating shortages. The rising price helps ration the limited supply to those willing to pay more, while also incentivizing producers to increase output if possible. This adjustment ensures that the market clears, balancing the reduced supply with the available demand.
