2. The price systems and the microeconomy Flashcards
The price mechanism and markets
In market economies, the price mechanism is essential to the allocation of resources. The price mechanism sends out a signal from consumers to producers. If there is oversupply in a market, consumers are sending a signal to producers that fewer resources should be allocated to a product. In the case of a shortage, the signal from consumers is that more resources need to be allocated to the product. The price mechanism is self-regulating, which means that it does not require any involvement from the government while the mechanism is working efficiently.
whenever people come together for the purposes of exchange or trade, there is a market.
Demand
Demand refers to the quantity of a product that buyers are willing and able to buy at different prices per period of time, ceteris paribus or other things equal.
Demand curve
there is an inverse or negative relationship between price and quantity demanded. This means that:
changes in price cause a change in the quantity demanded. This is shown by movements up and down the demand curve. It is assumed that all other factors affecting demand remain unchanged.
Do not confuse ‘quantity demanded’ and ‘demand’. Demand refers to the whole demand schedule and does not change when the price of the product changes. A price change causes a change in the quantity demanded.
The factors that affect demand
Income
The ability to pay is vital when considering the importance of effective demand. For any individual, the demand for goods and services depends upon income.
The price availability of related products
* Substitutes are alternative goods that satisfy the same want or need. A change in the price of one is likely to have an effect on the demand for the other and on any other similar cola or chocolate products. The extent of the change in demand depends on the degree of substitutability (how close a substitute is to the product). Coca-Cola and Pepsi are very close substitutes;
* Complements are goods that have a joint demand as they add to the satisfaction that consumers get from another product. A increase in the price or availability of either one of
these products will have an positive effect on the demand for a
complementary good.
Fashion, taste and attitudes
a matter of individual choice and behaviour. As a consumer, you are unique and have your own particular likes and dislikes. For some products, an individual’s attitude might have been built up over time or it could have been influenced by what they have read or what advertisers would like consumers to believe about their product.
Factors affecting supply
Costs:
Supply decisions taken by firms are always driven by the
costs of producing and distributing their products to customers. For many types of firm, labour costs are an important item. In other firms, the cost of energy or transport may be more important, or the productivity of workers can have a huge impact on costs. Replacing labour by capital can also reduce costs in some types of firm.
The size and nature of the industry:
If an industry is growing in size, then more products will be supplied to the market. This growth may well attract new entrants; the competition will increase and prices may fall resulting in some firms leaving the industry altogether. In some industries supply could be deliberately restricted to keep up prices.
The change in price of other products:
Most firms need to be continuously aware of competitors. So, if a competitor lowers its price, it could mean that less products will be supplied by other firms who keep their price unchanged. Alternatively, if a competitor increases its price, other firms may gain and will be able to supply more products provided they can keep their costs under control.
Government policy:
Governments influence companies and their supply of products in many ways. A new tax on a product may result in a reduction in supply; subsidies will usually result in an increase in supply.
Other factors:
In agricultural markets, supply is always affected by uncertain weather conditions. Storms or frost may affect the supply of coffee or grapes; drought affects cereal crop yields whereas good weather can lead to bumper harvests of corn and wheat.
Causes of a shift of demand curve
A shift to the right
- an increase in income
- an increase in the price of substitutes
- a decrease in the price of complements
- a favourable change in fashion, taste and attitudes.
Causes of a shift in the supply curve
A shift to the right
- a decrease in costs of production
- growth in the size of the industry
- a decrease in the price of competitor’s goods
- decrease in an indirect tax or increase in subsidy.
Elasticity
Elasticity measures the responsiveness of one variable (such as quantity demanded for a product) after a change in another variable (such as the price of that product), ceteris paribus . The elasticity measure is a coefficient or number.
The concept of elasticity is one which deals with change, in particular how individuals, firms and governments make choices after there has been change. The source of change is usually over time and is due to changes in the factors that determine (affect) the demand for products such as their prices, incomes or the prices of competitors’ products.
Factors affecting price elasticity of demand
The availability and attractiveness of substitutes
The greater the number of substitute products and the more closely substitutable those products are, the more it can be expected that consumers will switch away from a particular product when its price goes up (or towards that product if its price falls).
It is important to distinguish between the substitutability of products within the same group of products and substitutability with goods from other product groupings. As we classify products into groupings – such as ‘fruit juices’ or ‘all soft drinks’ – demand will start to become more price inelastic. So, the narrower the definition of the market, the likelihood is that the PED will be greater.
- The quality and extent to which information is available about products
- The extent to which people consider the product to be a necessity or a luxury.
- The addictive properties of the product (whether the product is habit-forming).
- The brand image of the product.
The relative expense of the product
A rise in price reduces the purchasing power of a person’s income and their ability to pay for products. The larger the proportion of income, the larger the impact is on the consumer’s income as a result of a change in the product’s price. So, the greater the relative proportion of income accounted for by the product, the higher the PED.
The time period
In the short run, perhaps weeks or months, people may find it hard to change their spending patterns. In the longer run, if the price of a product goes up and stays up, then over time people will find ways of adapting and adjusting, so the PED of a product is likely to increase over time. In other words, it changes from being price inelastic to price elastic as consumers look at what else is available in the market.
PED and a downward-sloping linear demand curve
When prices are high and the quantity demanded is low, a large change in price will not be a large percentage change; the percentage change in quantity demanded will be higher and significant in percentage terms. This results in demand being price elastic on the upper part of the demand curve. The reverse applies and explains why PED is inelastic in the lower portion of the demand curve.
Income elasticity of demand(YED)
Income elasticity of demand (YED) measures the responsiveness of the quantity demanded for a product following a change in income.
* A normal good is one where the quantity demanded increases as income increases.
* An inferior good is one where the quantity demanded decreases as income increases or increases as income falls.
* A neccessity good will have inelastic income elasticty
* Luxury or superior good will be elastic
A necessity good for one family could be a normal good for a better-off family. For example, rice or flour are likely to be necessity goods for low-income families yet are more likely to be inferior goods for those with higher incomes.
Cross elasticity of demand (XED)
Cross elasticity of demand (XED) measures the responsiveness of the quantity demanded for one product following a change in the price of another product.
XED < 0 = Complements -> If substitute becomes more expensive, the quantity demanded of both goods falls
XED > 0 = Substitutes -> If substitute becomes more expensive, the quantity demanded of X rises; consumers switch to the alternative
Price Elasticity of Supply (PES)
PES > 1 = Elastic Supply -> Firms can increase supply quickly at little cost
PES < 1 = Inelastic Supply -> Supply will be expensive for firms, hence can not variate quickly
PES = 0 = Perfectly Inelastic Supply -> Supply is fixed, hence any change in demand won’t change the current supply
Factors affecting price elasticity of supply
1. Time Scale -> Determines whether a good’s supply is more likely to respond to a change in price
* Short Run -> Price Inelastic Supply, since producers cannot quickly increase supply
* Long Run -> Price Elastic Supply
2. Spare Capacity -> Availability of resources determines whether producers can supply more or less of their product
* Full Capacity -> Price Inelastic Supply, since there is no spare resources left to increase supply
* Spare Resources -> Price Elastic Supply, since there are lots of spare and unemployed resources
3. Level of Stocks -> Amount of storage determines whether producers can allow themselves to increase supply
* Storable Goods -> Price Elastic Supply, since firms can allow themselves to stock additional supply
* Perishable Goods -> Price Inelastic Supply,s since firms cannot stock them for long
4. Flexibility of Factors of Production -> Determines whether producers can reallocate their resources to where extra supply is needed
* Flexible FOPS -> Price Elastic Supply
* Fixed FOPS -> Price Inelastic Supply
5. Market Barriers of Entry -> Determines the accessibility that producers have to enter a brand new market/industry
* Higher Entry Barriers -> Price Inelastic Supply; producers struggle to enter into the product’s market
* Lower Entry barriers -> Price Elastic Supply
Relationship between markets
1) Joint Demand
When goods are complements (goods that are bought together) Gas Fuel & Car:Increase in Car demand is likely to lead to an increase in the demand for gas fuel \n
2) Alternative Demand
When goods are substitutes (goods that are alternatives for each other) iPhone v/s Samsung:Increase in iPhone demand is likely to lead to a fall in the demand for Samsung phones \n
3) Derived Demand
When the demand for a good produces a corresponding demand for another related good PC’s & Microchips:Increase in PCs’ demand is likely to lead to an increase in the demand for microchips \n
4) Joint Supply When increasing the supply of one good influences the supply of another good Lamb Supply & Wool Supply:Increase in Lamb supply is likely to lead to an increase in the supply of wool \n
The functions of price in resource allocation
1)Rationing -> Price increases by default when resources are scarce
Increase in Price -> Discourages demand, consequently rations resources
Eg. Plane Ticket Rise as Seats are Sold -> Because spaces are running out
Disincentive to Purchase the Tickets -> Results in rationing the tickets
2)Signalling -> Price acts as a signal to consumers and new firms entering the market
Price Variations -> Indicate where resources are needed in the market
3)Incentivising -> Consumers can inform producers the products they desire by making choices
High Prices -> Encourage firms to increase their output, since they can make more profit
Low Demand -> Results in lower prices, which disincentivize firms’ output production
