1.3.3 Price Determination Flashcards
Price Determination
The process of how the forces of demand for goods and services and the supply of goods and services in a market interact to determine the price
Excess supply
When the quantity supplied is greater than the quantity demanded; disequilibrium is usually caused by setting a price that is too high to attract enough customers to buy the quantity that suppliers are offering.
Excess demand
When the quantity demanded outstrips the quantity supplied. There is a shortager of the product. Raising the price will call the customers to buy less to restore the equilibrium.
Equilibrium price
The price at which quantity supplied and quantity demanded are equal in a market, leaving neither excess supply nor excess demand
Market clearing
Obtaining a balance between quantity supplied and quantity demanded, normally arriving at the equilibrium price
Profit signalling mechanism
The way that potential profits will attract entrepreneurs to a growing market: losses will lead businesses to consider leaving a market. This process shifts resource use towards the products most in demand.
profit
money gained by producers –> the incentive to enter markets
Losses
money lost by producers lead firms to close down or reduce production.
Ceteris Paribus assumption
Freezes all variables other than the one being studied, avoiding complications and allowing us to examine individual changes.
how do profitable prices/a rise in price of a product affect PRODUCER behaviour
A profitable price attracts producers to supply to a market.
- A rise in price is likely to attract more suppliers and more output
- Supply curves show us that the quantity supplied tends to increase as the price level increases.
- The prospect of profit - a powerful incentive - attracts suppliers
how do lower prices influence CONSUMER behaviour
Lower prices tend to attract more buyers to a product, as the opportunity cost of the product falls.
- Demand curves show us that more will normally be bought at a lower price than a higher price.
how does price determination work
Prices are determined by the interaction of demand and supply. It is the combination of demand and supply, with a competitive market, which sets the market price.
- When demand and supply curves intersect, we have a market.
- The point at which the curves cross show the equilibrium quantity for sale and purchase, and it also shows the equilibrium price.
how is market equilibrium created
At price p, the amount demanded by consumers is q and the amount producers are willing and able to supply is q
The quantity demanded is equal to the quantity supplied, thus creating the MARKET EQUILIBRIUM
in what scenario will supply and demand curves not cross
If there is supply for a product where there is little to no demand, so the curves do not cross
describe EXCESS SUPPLY
At any price above the equilibrium level, quantity supplied exceeds quantity demanded (Qs>Qd) : there is excess supply:
- Sellers have a surplus which can only be sold by reducing price, ie a sale
If there is excess supply, stock remains unsold:
–> Producers will have to lower the price to encourage consumers to buy more
–> As the price falls, demand will extend until the quantity demanded equals the quantity supplied and equilibrium is reached (eg bikinis in a summer sale)
describe EXCESS DEMAND
At a price under the equilibrium, there is excess demand as consumers want more than firms will supply (demand>supply; Qd>Qs)
- Firms could sell out, but without getting the best possible price
This happens for things such as concert tickets → prices bid-up as they are offered for resale on ebay/ticketmaster etc.
–> As price of tickets rises, people are tempted to offer tickets for sales
–> supply extends, and fewer people are prepared to pay for the higher price so demand contracts until equilibrium is reached
how do market forces deal with excess S/D
Only at the equilibrium price there is market clearing:
- The amount that sellers wish to supply just balances the amount that buyers demand
- In a competitive market, excess supply and excess demand will usually not last for long → market forces will lead to a change in price
what do changes in non price determinants do
shift one of the curves and so cause a shift to a new equilibrium price and quantity
what do changes in supply do to price and quantity supplied
An increase in supply should lead to a rise in quantity supplied but fall in price (a fall in component costs can lead to an increase in computer tablets supply)
a fall in supply should bring a fall in quantity supplied but a rise in price (a rise in wages could cause a fall in supply, as wages are a major cost)
increase supply scenario
Eg APPLES AND FINE AUTUMN WITH A BUMPER HARVEST
An increase in apples causes an increase in their supply#
This shifts the Supply curve to the right
There is a new equilibrium with a lower price, as quantity supplied increases
This therefore causes demand to extend as consumers are willing to buy more at a lower price
decrease supply scenario
Eg BREAD AND INCREASE OF FLOUR PRICE
As the price of flour increases, the costs of production for bread increases, decreasing the amount of bread supplied
This causes the supply curve to shift left
There is a new equilibrium, where price is higher as quantity supplied decrease
This therefore causes demand to contract as consumers are less prepared to buy goods at higher prices
what do changes in demand do to price and quantity demanded
A rise in demand (e.g. tattoos become more popular) should lead to a rise in both price and quantity demanded.
By contrast, a fall in demand should result in both price and quantity demanded falling.
increase in demand scenario
Eg CROCS
We can see an increase in the demand for crocs
As more consumers want them the demand curve will shift to the right
There is a new equilibrium with a higher price p1 because quantity demanded has increase
This therefore causes supply to extend as producers are prepared to supply more at a higher price
decrease demand scenario
Eg. INCOME TAX AND HOLIDAYS
An increase in income tax means people would have less to spend on their holidays, as their disposable incomes decrease
Demand decreases and the demand curve shifts to the left
There is a new equilibrium where price of holidays decreases, as quantity demanded decreases
This therefore causes supply to contract as producers are less prepared to
how does increasing demand affect profit and the market
When the equilibrium price changes because demand has changed, this can trigger the profit signalling mechanism
Price increase, when demand rises, is likely to increase profit and this can both attract new producers and encourage existing firms to increase output
Short run: Brings an extension along the supply curve
Long run: new entrants will shift the supply curve to the right
UK demand for private health care –> resource allocation
Healty demand allows private clinics to make a profit, to build new premises and to offer attractive salaries to recruit staff
Profits have drawn more resources into this sector → an increase in demand has increased profits and this has acted as a signal for firms to increase supply
why does price change
- Price change is due to a change in supply conditions, demand, or in both.
- Where prices stay unchanged over a long period of time, this is the result of suppliers choosing stability, absorbing any cost changes and living with reduced profit.
ceteris paribus
- Our price determination model simplifies reality, making unrealistic assumptions, and only one variable at a time is considered
- Rely on a ‘ceteris paribus’ assumption which means that everything stays unchanged except the thing we focus on
Eg looking at the supply market and assuming demand remains the same even though they can be simultaneously changing - We assume that supplying businesses are motivated by profit and that competition forces them to react to changing conditions in predictable way
why is the price determination model not always correct
- Wholesale contracts are fixed for some time by ‘future contracts’
- Major energy suppliers buy from the same producers owned by the same organisation, Reducing the impact of competition
