4.1.3 Price determination in a competitive market

Question 1

Define demand

Answer 1

Demand is the quantity of a good or service that consumers are able and willing to buy at a given price during a given period of time.

Demand varies with price. Generally, the lower the price, the more affordable the
good and so consumer demand increases. This can be illustrated with the demand
curve.

Question 2

Draw Movements along the demand curve and explain

Answer 2

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At price P1, a quantity of Q1 is demanded. At the lower price of P2, a larger quantity of Q2 is demanded. This is an expansion of demand. At the higher price of P3, a lower quantity of Q3 is demanded. This is a contraction of demand. Only changes in
price will cause these movements along the demand curve

Question 3

Draw what the shifts along the demand curves are and explain

Answer 3

Price changes do not shift the demand curve. A shift from D1 to D2 is an inward shift in demand, so a lower quantity of goods is demanded at the market price of P1. A shift from D1 to D3 is an outward shift in demand. More goods are demanded at the market price of P1.

Question 4

Outline the factors that shift the demand curve

Answer 4

P- Population. The larger the population, the higher the demand. Changing the structure of the population also affects demand, such as the distribution of different age groups.
o I- Income. If consumers have more disposable income, they are able to afford more goods, so demand increases. Also, a consumer’s wealth affects their demand. Consumers generally spend more as they perceive their wealth to increase. Likewise, consumers spend less when they believe their wealth will decrease.
o R- Related goods. Related goods are substitutes or complements. A substitute can replace another good, such as two different brands of TV. If the price of the substitute falls, the quantity demanded of the original good will fall because consumers will switch to the cheaper option. A complement goes with another good, such as strawberries and cream. If the price of strawberries increases, the demand for cream will fall because fewer people will be buying strawberries, and hence fewer people will be buying cream.
o A- Advertising. This will increase consumer loyalty to the good and increase demand.
o T- Tastes and fashions. The demand curve will also shift if consumer tastes change. For example, the demand for physical books might fall, if consumers start preferring to read e-books.
o E- Expectations. This is of future price changes. If speculators expect the
price of shares in a company to increase in the future, demand is likely to increase in the present.
o S- Seasons. Demand changes according to the season. For example, in the summer, the demand for ice cream and sun lotions increases.

Question 5

Define the law of diminishing marginal utility

Answer 5

The demand curve is downward sloping, showing the inverse relationship between price and quantity.

The law of diminishing marginal utility states that as an extra unit of the good is consumed, the marginal utility, i.e. the benefit derived from consuming the good, falls. Therefore, consumers are willing to pay less for the good.

Question 6

Define Price elasticity of demand

Answer 6

The price elasticity of demand is the responsiveness of a change in demand to a change in price

Question 7

What is the Formula for Price elasticity of demand

Answer 7

PED= % Change in the quantity demanded/ % Change in price

Question 8

Describe the diagram and explain when PED is >1

Answer 8

A price elastic good is very responsive to a change in price. In other words, the change in price leads to an even bigger change in demand. The numerical value for PED is >1.

Question 9

Describe the diagram and explain when PED is <1

Answer 9

A price inelastic good has a demand that is relatively unresponsive to a change in
price. PED is <1

Question 10

Describe the diagram and explain when PED=1

Answer 10

A unitary elastic good has a change in demand which is equal to the change in price.
PED = 1.

Question 11

Describe the diagram and explain when PED=0

Answer 11

A perfectly inelastic good has a demand which does not change when price changes. PED = 0.

Question 12

Outline the Factors influencing PED

Answer 12

Necessity:
A necessary good, such as bread or electricity, will have a relatively inelastic demand.
In other words, even if the price increases significantly, consumers will still demand
bread and electricity, because they need it. Luxury goods, such as holidays, are more
elastic. If the price of flights increases, the demand is likely to fall significantly.
2) Substitutes:
If the good has several substitutes, such as Android phones instead of iPhones, then
the demand is more price elastic. The elasticity can also change within markets. For
example, the market for bread is less elastic than the market for white bread. This is
because there are fewer substitutes for bread in general, but there are several substitutes for white bread. Hence, white bread is more price elastic. The closer and
more available the substitutes are, the more price elastic the demand. Elasticity also changes in the long and short run. In the long run, consumers have
time to respond and find a substitute, so demand becomes more price elastic. In the
short run, consumers do not have this time, so demand is more inelastic.
3) Addictiveness or habitual consumption: The demand for goods such as cigarettes is not sensitive to a change in price because consumers become addicted to them, and therefore continue demanding the cigarettes, even if the price increases.
4) Proportion of income spent on the good: If the good only takes up a small proportion of income, such as a magazine which increases in price from £1.50 to £2, demand is likely to be relatively price inelastic. If
the good takes up a significant proportion of income, such as a car which increases in
price from £15,000 to £20,000, the demand is likely to be more price elastic.
5) Durability of the good:
A good which lasts a long time, such a washing machine, has a more elastic demand because consumers wait to buy another one.
6) Peak and off-peak demand:
During peak times, such as 9am and 5pm for trains, the demand for tickets is more price inelastic.

Question 13

Describe the elasticity of demand and tax revenue

Answer 13

The burden of an indirect tax will fall differently on consumers and firms, depending on if the good has an elastic or inelastic demand. It is important to note, however, that taxes shift the supply curve, not the demand curve.

If a firm sells a good with an inelastic demand, they are likely to put most of the tax burden on the consumer, because they know a price increase will not cause demand to fall significantly. An increase in tax will decrease supply from S1 to S2, which increases price from P1 to P2, and therefore demand contracts from Q1 to Q2. This is most effective for raising government revenue.

Question 14

Outline Elasticity of demand and subsidies

Answer 14

A subsidy is a payment from the government to firms to encourage the production of
a good and to lower their average costs. It has the opposite effect of a tax because it increases supply. The benefit of the subsidy can go to both the producer, in the form
of increased revenue (C-P1), or to the consumer, in the form of lower prices (P1-P2).

Question 15

Outline PED and total revenue

Answer 15

Total revenue is equal to average price times quantity sold. TR= P x Q
If a good has an inelastic demand, the firm can raise its price, and quantity sold will
not fall significantly. This will increase total revenue.
If a good has an elastic demand and the firm raises its price, quantity sold will fall.

This will reduce total revenue.

Question 16

Define Income elastic of demand

Answer 16

Income elasticity of demand is the responsiveness of a change in demand to a change in income

Question 17

Give the equation for income elasticity of demand

Answer 17

% change in demand divided by the % change in income

Question 18

Define Inferior goods

Answer 18

Inferior goods are those which see a fall in demand as income increases. For example, the ‘value’ options at supermarkets could be seen as inferior. As income increases, consumers switch to branded goods. YED < 0.

Question 19

Define Normal goods

Answer 19

Normal goods are consumer products such as food and clothing that exhibit a direct relationship between demand and income. As a consumer’s income rises, the demand for normal goods also increases.

With normal goods, demand increases as income increases. YED >0.

Question 20

Outline Luxury goods

Answer 20

With luxury goods, an increase in income causes an even bigger increase in demand.
YED > 1. For example, a holiday is a luxury good. Luxury goods are also normal goods,
and they have an elastic income.

During periods of prosperity, such as economic growth when real incomes are rising, firms might switch to producing more luxury goods and fewer inferior goods, because demand for luxury goods will be increasing.

Question 21

Define cross elasticity of demand

Answer 21

Cross elasticity of demand is the responsiveness of a change in demand of one good, X, to a change in price of another good, Y.

Question 22

What is the equation of Cross elasticity of demand

Answer 22

XED= % change in demand for X / % change in the price of Y

Question 23

Outline Complementary goods

Answer 23

Complementary goods are products which are used together.Complementary goods have a negative XED. If one good becomes more expensive,
the quantity demanded for both goods will fall.

Close complements: a small fall in the price of good X leads to a large increase in quantity demanded of Y. AND Weak complements: a large fall in the price of good X leads to only a small increase in QD of Y.

Question 24

Outline substitutes in Cross elasticates of demand

Answer 24

Substitutes can replace another good, so the XED is positive and the demand curve is
upward sloping. If the price of one brand of TV increases, consumers might switch to
another brand.

Close substitutes: a small increase in the price of good X leads to a large increase in QD of Y AND Weak substitutes: a large increase in the price of good X leads to a smaller
increase in QD of Y.

Question 25

Define supply

Answer 25

Supply is the quantity of a good or service that a producer is able and willing to supply at a given price during a given period of time.

Supply curves are upward sloping because:
o If price increases, it is more profitable for firms to supply the good, so supply
increases.
o High prices encourage new firms to enter the market, because it seems
profitable, so supply increases.
o With larger outputs, firm’s costs increase, so they need to charge a higher
price to cover the costs.

Question 26

Describe the movements along the supply curve

Answer 26

At price P1, a quantity of Q1 is supplied. At the lower price of P2, Q2 is supplied. This
is a contraction of supply. If price increases from P2 to P1, QS increases from Q2 to
Q1. This is an expansion of supply. Only changes in price will cause these movements
along the supply curve. This is based on the theory of the profit motive. Firms are
driven by the desire to make large profits.

Question 27

Outline the shifts in the supply curve

Answer 27

Price changes do not shift the supply curve. A shift from S1 to S2 is an outward shift in supply, so a larger quantity of goods is supplied at the market price of P1. A shift from S3 to S1 is an inward shift in supply. More goods are supplied at the market price of P1.

Question 28

Outline the factors that shift the supply curve

Answer 28

P- Productivity. Higher productivity causes an outward shift in supply,
because average costs for the firm fall.
o I- Indirect taxes. Inward shift in supply.
o N- Number of firms. The more firms there are, the larger the supply.
o T- Technology. More advanced the technology causes an outward shift in
supply.
o S- Subsidies. Subsidies cause an outward shift in supply.
o W- Weather. This is particularly for agricultural produce. Favourable
conditions will increase supply.
o C- Costs of production. If costs of production fall, the firm can afford to
supply more. If costs rise, such as with higher wages, there will be an inward
shift in supply.
o Also, depreciation in the exchange rate will increase the cost of imports,
which will cause an inward shift in supply.

Question 29

Define price elasticity of supply

Answer 29

The price elasticity of supply is the responsiveness of a change in supply to a change in price.

Question 30

What is the equation for Price elasticity of supply

Answer 30

PES = (% Change in Quantity Supplied) / (% Change in Price).

Question 31

What are the factors that influence PES

Answer 31

1) Time scale: In the short run, supply is more price inelastic, because producers cannot quickly increase supply. In the long run, supply becomes more price elastic.

2) Spare capacity:
If the firm is operating at full capacity, there is no space left to increase supply. If there are spare resources, for example in a recession there are lots of spare and unemployed resources, supply can be increased quickly.

3) Level of stocks:
If goods can be stored, such as CDs, firms can stock them and increase market supply easily. If the goods are perishable, such as apples, firms cannot stock them for long so supply is more inelastic.

4) How substitutable factors are:
If labour and capital are mobile, supply is more price elastic because resources can be allocated to where extra supply is needed. For example, if workers have
transferable skills, they can be reallocated to produce a different good and increase the supply of it.

5) Barriers to entry to the market:
Higher barriers to entry means supply is more price inelastic, because it is difficult for new firms to enter and supply the market.

Question 32

Describe when PES >1

Answer 32

If supply is elastic, firms can increase supply quickly at little cost. The numerical value for PES is >1.

Question 33

Describe when PES <1

Answer 33

f supply is inelastic, an increase in supply will be expensive for firms and take a long
time. PES is <1.

Question 34

Outline Equilibrium price and quantity

Answer 34

This is when supply meets demand. On the diagram, this is shown by P1 and Q1. At market equilibrium, price has no tendency to change, and it is known as the market clearing price

Question 35

Outline and describe a matching diagram for Excess demand

Answer 35

At Q2, price is at P2 which is below market equilibrium. Demand is now greater than
supply, which can be calculated by Q3-Q2. This is a state of disequilibrium. The demand price does not equal the supply price, and the quantity demanded does not equal the quantity supplied.

This is a shortage in the market. This pushes prices up and causes firms to supply more. Since prices increase, demand will contract.

Once supply meets demand again, price will reach the market clearing price, P1.

Question 36

Outline Excess supply

Answer 36

This is when price is above P1.
Supply is now at Q2 and demand is at Q1. There is a surplus of Q2- Q1. Price will fall
back to P1 as firms lower their prices and try to sell their goods. The market will clear
and return to equilibrium.

Question 37

Outline the new market equilibriums

Answer 37

When the demand or supply curves shift due to the PIRATES or PINTSWC reasons, new market equilibriums are established.

For example, if there was an increase in the size of the population, demand would shift from D1 to D2.

Price would increase to P2 and suppliers would supply a larger quantity of Q2. A new market equilibrium is established at P2 Q2

Question 38

Define derived demand

Answer 38

This is when the demand for one good is linked to the demand for a related good. For example, the demand for bricks is derived from the demand for
the building of new houses. The demand for labour is derived from the goods the labour produces. For example, if the demand for cars increases, the demand for the labour to produce those cars will increase

Question 39

Outline Composite demand

Answer 39

This is when the good demanded has more than one use. An example could be milk. Assuming there is a fixed supply of milk, an increase in the
demand for cheese will mean that more cheese is supplied, and therefore less butter
can be supplied.

Question 40

Define Joint demand

Answer 40

This is when goods are bought together, such as a digital camera and a memory card. An increase in demand for digital cameras is likely to lead to an
increase in demand for memory cards.

Question 41

Define Joint supply

Answer 41

This is when increasing the supply of one good causes an increase or decrease in the supply of another good. For example, producing more lamb will increase the supply of wool