3 The Market System and the Competitive Process

Question 1

What is price elasticity of demand?

Answer 1

This is a measure of the percentage change in the quantity of a good demanded divided by the percentage change in it’s price.

Question 2

What is the formula for price elasticity of demand?

Answer 2

% change in qty demanded/ % change in price = (Q2 - Q1)/ Q1 divided by (P2 - P1)/P1

Economists don’t normally include minus signs (follow instructions)

Question 3

What is the ARC PED?

Answer 3

The ARC Ped looks at the average PED between two points on the demand curve (look at the formula on page 26

Question 4

What is ‘elastic’ demand?

Answer 4

this is position where the quantity demanded changes by a bigger percentage than the price change (PED > 1) A lot of advantages if a lot more ppl buy the goods when we lower the price.

• Lowering of a price for a product that has elastic demand will => overall increase in revenue since % increase in quantity will be greater than the % decrease in price

Question 5

What is ‘inelastic’ demand?

Answer 5

where the demand change is smaller percentage than the price change (PED < 1)

• Makes sense to increase the price if the demand for a product is inelastic - the quantity demanded will not drop

Question 6

What are the main factors affecting the PED?

Answer 6

a) the number of substitutes for a good/uniqueness of the product
b) the cost of switching between different products
c) the degree of necessity or whether the good is a luxury
d) the % of a consumer’s income allocated to spending on the good
e) the time period allowed following a price change
f) whether the good is subject to habitual consumption
g) peak and off-peak demand
h) the bread of definition of a good or service

Question 7

What is perfectly inelastic demand?

Answer 7

An extreme situation where a change in price will have no effect on the quantity demanded (look at graph on page 27)

Question 8

What is perfectly elastic demand?

Answer 8

an extreme situation where a market participant is a price taker and has to accept the market price. If they raise their price they will sell nothing

Question 9

What is unitary elastic demand?

Answer 9

The elasticity of demand is 1 at any point on the demand curve (known as a rectangular hyperbola). A change in price will have no effect on revenue i.e. Price x Quantity = Constant

Question 10

What is the relationship with total revenue?

Answer 10

a) If total revenue increases after a price cut, demand is elastic
b) If total revenue increases after a price rise, demand is inelastic

Question 11

What is the price elasticity of supply? (PES)

Answer 11

This measures the relationship between change in quantity supplied and a change in price of that good

PES = % change in qty supplied/ % change in price

Elasticity of supply is positive - an increase in price is likely to increase quantity supplied to the market and vice versa

Question 12

What are the factors which determine elasticity of supply?

Answer 12

a) Spare capacity
b) Stocks
c) Ease of factor substitution
d) Time period

Question 13

What is the momentary time period?

Answer 13

A time period that is short enough for supply to be fixed i.e. supply cannot respond at all to a change in demand

Question 14

What does it mean when supply is perfectly inelastic?

Answer 14

A shift in the demand curve has no effect on the equilibrium quantity supplied onto the market. E.g. tickets for sports.
- Also SRAS of agricultural products where elasticity of supply = zero when supply curve is vertical

Question 15

What does it mean when supply is perfectly elastic?

Answer 15

• Firm can supply any amount at the same price.
• Firm can supply at a constant cost per unit, has no capacity limits to its production.
• Change in demand alters the equilibrium quantity but not the marketing clearing price e.g. market for commodities e.g. wheat/corn

Question 16

What happens when supply is relatively inelastic?

Answer 16

A change in demand affects the price more than the quantity supplied. The reverse is the case when supply is relatively elastic.
- IF THE SUPPLY CURVE GOES THROUGH THE ORIGIN = UNIT ELASTITY (ELASTICITY OF SUPPLY = 1)

Question 17

What is the impact of maximum price controls?

Answer 17

(look at grph on pg 31)

• a price above Pe has no effect on the market
• normal equil Pe = Qe
• Pmax => demand rising at the lower price but amount suppliers are willing to produce will fall to Qe => excess demand.
• Excess demand => queuing for the goods, potential creation of a black market for the goods - some pay large sums for poplr products
• Govt may intervene to ensure supply is kept up e.g. rationing

Question 18

What are minimum price controls?

Answer 18

(Look at diagram on pg 32)
e.g. A minimum wage is common example
- if a min wage is imposed of Pmin, the quantity of people demanded at this price will fall to Qlow. There would also be an excess of supply for jobs of Qhigh - Qlow => ppl more willing to supply their labour for the higher price.
=> unemployment, although those in employment enjoy a higher standard of living

Question 19

What is an externality?

Answer 19

• Impact on any third party not involved in the transaction.
  => result is true social cost or social benefit of a transaction may not be taken into account in the output decision. (based on private costs & benefits)
• If the marginal social cost was considered and added to the MPC then this may => different pricing and output decision.

Question 20

What are 3 examples of negative externalities?

Answer 20

1. Manufacturer that causes air pollution
2. Accidents caused by alcohol or drug abuse
3. Noisy neighbours playing music too loudly

Question 21

What are these negative externalities called when they affect society as a whole?

Answer 21

Demerit goods

Question 22

How can governments rectify market failure of negative externalities?

Answer 22

1. Imposing a sales tax on goods with negative externalities (see graph on pg 32)
   - This would decrease supply as higher cost for producer, and increase price of product from Pe to P1

Question 23

How does the amount tax borne by the consumer and supplier depend on elasticties of supply and demand?

Answer 23

If demand is inelastic then more of the tax will be borne by the consumer, likewise if supply is elastic.
- Govt could also impose costs on business, e.g. fining companies that breach environmental law

Question 24

What are examples of positive externalties?

Answer 24

1. Education - A trained labour force => increased efficiency and productivity
2. Improved health care - reduces absenteeism at work
3. Individual planting an attractive garden => benefits for others that are living in the area => increased property value

Question 25

How can govt encourage positive externalities?

Answer 25

1. introduce subsidies
   - these have opposite effect of an indirect tax.
   - Reduces cost and supply curve shift outwards => lower equilibrium price
   - Amount passed on to consumer again depends on the elasticity of supply/demand

~ IF DEMAND IS INELASTIC OR SUPPLY ELASTIC, A GREATER PORTION OF SUBSIDY WILL BE PASSED ONTO THE CONSUMER ~

Question 26

What are economies of scale?

Answer 26

As a business gets larger can make cost savings e.g.

• Internal e of s => bulk buying (trading), more efficient machinery (technical), cheaper finance costs on loans (financial) and management specialisation (managerial)
• External e of s => benefits arising due to general growth in the industry e.g. greater pool of skilled staff, development of better support infrastructure

Question 27

What is the impact of economies of scale?

Answer 27

They will reduce average costs in the long run but in the short run could lead to diseconomies of scale

Question 28

What are diseconomies of scale?

Answer 28

Once business gets too large it may actually start suffering from diseconomies of scale - result from difficulties arising from large org & staff communication etc

Question 29

What is perfect competition?

Answer 29

No single producer or consumer has the market power to influence prices

Question 30

What are the conditions of perfect competition?

Answer 30

a) Atomicity - large number of small producers and consumers, each so small that its actions have no significant impact on others. Firms are Price Takers.
b) Homogeneity - goods and services are perfect substitutes => no product differentiation
c) Perfect and complete info - all firms & consumers know the prices set by all firms
d) Equal Access => all firms have access to production technologies and resources are mobile
e) Free Entry => a firm may enter or exit market as it wishes
f) Individual buyers and sellers act independently - market is such that there is no scope for groups of buyers and/or sellers to come together

Question 31

What is a monopoly?

Answer 31

Only one supplier of a good/service which has no closely competing substitutes. E.g. rail operator

Question 32

What is a natural monopoly?

Answer 32

Where there is a natural factor which makes it inefficient and too costly to have a new market entrant. Other types include firms merging together to make a dominant player

Question 33

What is an oligopoly?

Answer 33

1. A few suppliers only
2. Effective barriers to entry
3. Strong sense of interdependence between the market participants
   - Imperfect comp & small number of producers selling essentially similar goods => firms acting in a collusive or non-collusive way
   - Defined by the four-firm concentration ratio, for the supermarket industry this is over 70%

Question 34

What is collusion?

Answer 34

• Members form a cartel to set prices and output to achieve joint profit maximisation (competition act 1980 might investigate)

Question 35

What are the conditions needed to create a cartel?

Answer 35

1. The firms in the cartel being able to control supply to the market
2. Agreeing on a price
3. Agreeing on how much of the output each firm should produce

Question 36

What is non-collusive?

Answer 36

• Products offered are differentiated and barriers to entry are strong.
• Firms utilise non-price competition in order to accrue greater revenue and market share.
• Oligopolists avoid competing on price because a unilateral price changes brings in disadvantage to the supplier concerned.

Question 37

What is the impact on sourcing overseas?

Answer 37

• If an industry is able to obtain products from low cost emerging economies => improved margins and attract a lot of competition into market => erode margins and price competition
• May not just be sourcing materials overseas, but also outsourcing parts of the business or relocating parts of the business overseas e.g. customer care

Question 38

What is outsourcing?

Answer 38

• External party to perform particular activities rather than undertake them in-house. May involve an unconnected party, or joining a network.
• Medium sized accountancy firms and service centres for example

Question 39

What is off-shoring?

Answer 39

• Where part of the business or indeed the whole business is transferred to another country which has a lower cost base

Question 40

What is the influence of e-business on costs and competitive behaviour?

Answer 40

E-business derived from E-mail and e-commerce = conduct of business on the internet, buying and selling but also servicing customers and collaborating with business partners

Question 41

What effect does price have on e-commerce?

Answer 41

substitutes are easier to find, means that products themselves will have increased price elasticities of demand. The market itself for a particular product will likely become more competitive

Question 42

What effect does cost have on e-commerce?

Answer 42

• E.g. amazon selling books via the Kindle platform - little incremental cost with selling multiple copies of a particular book online.
• May be high fixed costs but the negligible VC’s mean that the supply curve is more elastic