4.1.3 Price determination in a competitive market

Question 1

Define demand

Answer 1

the quantity of a good or service consumers are willing and able to buy at a given time price in a given time period

Question 2

Outline the law of demand

Answer 2

there is an inverse relationship between price and quantity demanded (due to the income and substitution effect)

Question 3

Define the substitution effect

Answer 3

ceteris paribus, as prices rise, other goods and services become relatively cheaper (more competitive), incentivising the consumption of those goods and services reducing the willingness for consumers to purchase the higher priced item

Question 4

Define the income effect

Answer 4

ceteris paribus, as prices rise, the proportion of income required to purchase a good or service increases, reducing the willingness and the ability of consumer to buy the good or services, reducing quantity demanded

Question 5

Outline non price factors that shift the demand curve (PASIFIC)

Answer 5

Population
Advertising
Substitute’s price
Income
Fashion/trends
Interest rates
Complement’s price

Question 6

How can population shift the demand curve? (PASIFIC)

Answer 6

an increase in population due to a rise in net immigration for example will increase the willingness and ability of consumers to buy goods and services, increasing demand and shifting the demand curve to the right from D1 to D2

Question 7

How can advertising shift the demand curve? (PASIFIC)

Answer 7

if there is positive advertising for a good or service, at the same price more people may be willing to consume it increasing the demand for the product shifting the demand curve to the right from D1 to D2

Question 8

How can the price of substitute goods shift the demand curve? (PASIFIC)

Answer 8

if the price of substitute goods or services increases, the competitiveness of the good where price has remained the same increases. Therefore the willingness and the ability to consume the good increases, shifting the demand curve to the right from D1 to D2

Question 9

How can income shift the demand curve? (PASIFIC)

Answer 9

the willingness and the ability to consume the good increases shifting the demand curve to the right from D1 to D2

Question 10

How can fashion/trends shift the demand curve? (PASIFIC)

Answer 10

if there is a change in fashion/tastes towards the consumption of a certain good or service, the willingness to consume it increases shifting the demand curve to the right from D1 to D2

Question 11

How can interest rates shift the demand curve? (PASIFIC)

Answer 11

if interest rates decrease, the cost of borrowing for consumers decreases, making it cheaper for consumers to borrow to spend
for goods like houses and cars that are often financed using credit, the willingness and the ability to consume increases shifting the demand curve to the right from D1 to D2

Question 12

How can price of complement goods shift the demand curve? (PASIFIC)

Answer 12

if the price of a complementary good decreases, the willingness and the ability to buy the first good increases, shifting the demand curve to the right from D1 to D2

Question 13

What is price elasticity of demand (PED) a measure of?

Answer 13

the responsiveness of quantity demanded of a good or service given a change in price

Question 14

PED formula (you queue before you pee!!!)

Answer 14

% change in quantity demanded / % change in price

Question 15

Define elastic demand

Answer 15

demand where a % change in price causes a greater % change in Qd

Question 16

Define inelastic demand

Answer 16

demand where a percentage change in price causes a lower % change in Qd

Question 17

Define perfectly elastic demand

Answer 17

demand with an infinitive PED represented by a horizontal line

Question 18

Define perfectly inelastic demand

Answer 18

demand with a PED of zero, for which a change in price causes no change in quantity demanded

Question 19

Define unitary elastic demand

Answer 19

where a % change in price causes the same % change in Qd

Question 20

What are the determinants of PED? (SPLAT)

Answer 20

1) Substitutes, the more close substitutes there are for a given good or service the more price elastic demand will be. VICE VERSA

2) Percentage of income, the greater the % of income that a price change takes, the more price elastic demand will be, vice versa

3) Luxury/necessity, luxuries will have more price elastic demand, as when the price of luxuries increase, individuals will decrease their consumption markedly realising consumption is not necessary.

Necessities will have more price inelastic demand as when the price of necessities increase, individuals will not decrease their consumption markedly realising consumption is necessary.

4) Addictive/habit forming, if the good in question is addictive or habit forming, demand for it will be price inelastic. This is because even when the price of these goods increase, an individual may not be able to stop themselves from consuming it due to its addictive or habit forming nature.

5) Time period, in the long run demand for goods and services tends to become more price elastic because more substitutes enter the market over time allowing consumers to switch their consumption more easily if prices are rising for other goods or services.

Question 21

What is income elasticity of demand (YED) a measure of?

Answer 21

the responsiveness of quantity demanded for a good given a change in consumers real income

Question 22

YED formula

Answer 22

% change in quantity demanded / % change in income

Question 23

What is cross elasticity of demand (XED) a measure of?

Answer 23

the responsiveness of quantity demanded of a good A given a change in price of good B

Question 24

XED formula

Answer 24

% change in quantity demanded of good A / % change in price of good B

Question 25

Define supply

Answer 25

the quantity of a good or service producers are willing and able to produce at a given price in a given time period

Question 26

Outline the law of supply

Answer 26

there is a direct relationship between price and quantity supplied.
as price increases, Qs increases and vice versa, assuming CETERIS PARIBUS

Question 27

Why is there a direct relationship between price and quantity supplied?

Answer 27

PROFIT MOTIVE that private producers have
higher prices imply higher profits which provides an incentive to expand production

Question 28

Outline non price factors that shift the supply curve (PINTSWC)

Answer 28

Productivity
Indirect tax
Number of firms
Technology
Subsidies
Weather
Costs of production

Question 29

How can productivity shift the supply curve? (PINTSWC)

Answer 29

(where labour productivity is the output per worker per hour).
if labour productivity increases, more output is being produced per worker in an hour with no increase in cost for the firm. therefore reduces the cost of production for firms increasing their willingness and ability to supply, shifting the supply curve to the right from S1 to S2.

Question 30

How can indirect taxes shift the supply curve? (PINTSWC)

Answer 30

an indirect tax is an expenditure tax that increases a firm’s costs of production but can be transferred.
if indirect taxes are imposed or increased, the costs of production for a firm will increase, reducing the willingness and ability to supply shifting the supply curve to the left from S1 to S3.

Question 31

How can the number of firms in the market shift the supply curve? (PINTSWC)

Answer 31

if there is an increase in the number of firms in the market perhaps due to high profits being made in the sector and low barriers to entry, the total supply in the market increases with the supply curve shifting to the right from S1 to S2.

Question 32

How can technology shift the supply curve? (PINTSWC)

Answer 32

an improvement in technology for a firm, for example new software, new or upgraded capital machinery or new IT equipment will improve the productive efficiency of business operation and reduce costs of production increasing the willingness and ability for a business to supply, shifting the supply curve to the right from S1 to S2

Question 33

How can subsidies shift the supply curve? (PINTSWC)

Answer 33

a subsidy is a money grant given to producers to reduce their costs of production and to encourage an increase in output.
if subsidies are imposed or increased, costs of production decrease for a firm increasing their willingness and ability to supply, shifting the supply curve to the right from S1 to S2.

Question 34

What is price elasticity of supply (PES) a measure of?

Answer 34

the responsiveness of quantity supplied of a good or service given a change in price

Question 35

PES formula

Answer 35

% change in quantity supplied / % change in price

Question 36

What are the determinants of PES? (PSSST)

Answer 36

1) Production lag

2) Stocks, if stocks are high for a producer it is much easier for them to respond to changes in demand and price. Supply for products where stocks are high is therefore price elastic.

3) Spare Capacity, for businesses with lots of spare capacity, it is much easier for them to respond to changes in demand and price. To increase production, a business simply needs to utilise its unemployed factors of production. Supply for products where businesses have large spare capacity is therefore price elastic.

4) Sustainability of FOPs, the more substitutable FOP are for a firm, the easier it is for them to respond to changes in demand and price for different goods/services they are producing.

5) Time, in the SR supply is price inelastic whereas in the LR supply is price elastic because it is easier for businesses to adapt their production processes to increase or decreases.

Question 37

What are the special functions to return market back to equilibrium? (SARI but in order of SIRA)

Answer 37

1. signal excess demand/supply and need to inc/dec resources
2. incentivise producers to inc/dec output to increase profit
3. ration scarce resources by encouraging/discouraging consumption
4. allocate scarce resources efficiently at equilibrium

Question 38

Excess demand diagram analysis

Answer 38

in a free market, a price below equilibrium at P1 would not last.
this is because at P1, there is excess demand with producers facing long waiting lists, queues, low stocks and competition between buyers.
to clear this, producers raise prices to P; the higher price signalling the excess demand and more resources needed in the market.
the higher price incentivises producers to increase output to make more profit (an extension of supply).
higher prices also ration demand by discouraging consumption (a contraction of demand). equilibrium is formed at PQ*, without excess demand - an efficient allocation of resources.

Question 39

Excess supply diagram analysis

Answer 39

in a free market, a price above equilibrium at P1 would not last.
this is because at P1, there is excess supply (a surplus) with producers facing excess stocks, full warehouses/stores, empty tables in restaurants etc.
to clear this, producers reduce prices to P; the lower price signalling the excess supply and less resources needed in the market.
the lower price incentivises producers to reduce output and liquidate stocks instead to make more profit (a contraction of supply).
lower prices also encourage greater consumption (an extension of demand) via the rationing function.
equilibrium is formed at PQ*, without excess supply - an efficient allocation of resources.

Question 40

Joint demand (complements) +e.g

Answer 40

demand for goods which tend to be consumed together
e.g. printers and ink, coffee machines and capsules

Question 41

Competitive demand (substitutes) +e.g.

Answer 41

demand for goods which fulfil similar wants and needs, such that one can be consumed in the place of the other and provide similar utility (substitute goods)
e.g. coke and pepsi, big mac and whopper

Question 42

Derived demand (input demand) +e.g.

Answer 42

demand for a good which is used to meet another demand, so when demand for one good or service increases, derived demand will increase for the goods which are used to produce it
e.g. cars and aluminium, goods/services and labour, holidays and airline travel

Question 43

Composite demand + e.g.

Answer 43

demand for a good which has multiple different uses, such that, as people demand the good more for one use, less is available for other uses
e.g. bread and livestock (wheat), cheese and butter (milk)

Question 44

Joint supply + e.g.

Answer 44

the idea that the increase in the production of one good will increase the supply of another good
e.g. honey and beeswax, crude oil and petroleum/paraffin