2. PRICE SYSTEM AND THE MICROECONOMY Flashcards
Effective demand
Demand supported by the ability and willingness to pay
Individual Demand/Supply
Demand or supply for a good from one consumer or producer
Market Demand/Supply
Total demand or supply for a good across all consumers or producers in the market
Determinants of Demand
Price of the good
Income levels
Prices of related goods
- Substitutes (e.g higher price of tea -> higher demand for coffee)
- Complements (e.g lower price of cars -> increase demand for fuel
Taste and preferences
Expectations of future prices
Determinants of supply
Production cost
Technology
Prices of related goods
- Joint supply
- Competitive supply
Gov policies
Producer expectations
Joint supply
A situation where an increase in the supply of one leads to a decrease in supply of another by-product (vice versa)
Competitive supply
Alternative products a firm could make with its resources
Movement along demand/supply curve
Caused by price changes of the good itself
Shift in demand/ supply curve
Caused by non-price factors (e.g., income, tastes, or production costs) Price of itself does not affect
PED
Measures the responsiveness of QD for a good or service to a change in its price
PED calculation
% change in QD/ % change in price
PED >1
Elastic
QD is highly reponsive to price change
E.g luxury goods
PED <1
Inelastic
QD less responsive to change in price
Necessities
PED = 1
Unitary Elastic
Proportional response; a 10% price change leads to a 10% quantity change
PED = 0
Perfectly Inelastic
No response to price changes
PED = ∞
Perfectly Elastic
Demand is infinite at a particular price and drops to zero if the price changes
Importance of PED
For firms: Helps set prices to maximize revenue
For gov: Used for taxation strategies, especially on inelastic goods like tobacco
Factors affecting PED
Availability of substitutes (more subs = higher elasticity)
Nature of good
Proportion of income spend (higher proportion = higher elasticity)
Time period
Addiction/ habits
Income elasticity of demand
Measures the responsiveness of demand for a good or service to changes in consumer income
Positive YED
Normal goods
YED calculation
% change in QD/ % change in consumer income
YED>1
Luxury good
Demand increases more than income increas
Negative YED
Inferior goods
Importance of YED
For Firms: Helps predict changes in demand during economic growth or recession
For gov: Assists in planning welfare programs and tax policie
Cross elasticity of demand
Measures the responsiveness of demand for one good to a change in the price of another related good
XED calculation
% change in QD of good A/ % change in price of good B
Positive XED
Substitutes
Negative XED
Complements
Importance of XED
For firms: Helps understand competition & pricing strategies
Helps decide on complementary good pricing
For gov: Understanding how price controls on one product affects others
Price elasticity of supply
Measures responsiveness of quantity supplied to price changes
PES calculation
% change in QS/ % change in price
Factors affecting PES
Time: More time allows greater adjustments in supply.
Spare capacity: More capacity increases elasticity.
Stock levels: High stocks increase elasticity.
Ease of factor substitution: Flexibility of resources increases elasticity.
Joint demand
Complements
Demand for one good increases demand for its complement
Alternative demand
Substitutes
Demand for one good decreases demand for its substitute
Derived demand
Demand for a good depends on demand for another
e.g demand for steel increase w demand for cars
Joint supply
Production of one good leads to production of another
Functions of price in resource allocation
Rationing
Signalling
Incentivizing
Rationing in resource allocation
Prices ration scarce resources among competing uses
High prices during a drought ration water supply
Signalling in resource allcation
Prices signal information to buyers and sellers about market conditions
Rising oil prices signal increased scarcity
Incentivizing
Prices incentivize changes in behavior
Higher wages attract more workers
Consumer surplus
Difference between what consumers are willing to pay and what they actually pay
Willing to pay $10, but market price is $7
Producer surplus
Difference between the price producers receive and the minimum price they’re willing to accept
Willing to sell for $5 but receives $7
When does consumer surplus increase
Lower prices or greater demand
prices decrease, consumers pay less than their willingness to pay, increase consumer surplus
demand increase, more consumers, willing to pay more than actual market price
When does producer surplus increase
Higher prices or lower costs
higher price for their goods, increase diff between production cost & selling price
production cost fall, minimum price are willing to accept decrease, increase production surplus
