AS Unit 2: The Price System and the Microeconomy Flashcards
The price mechanism and markets
The price mechanism is essential to the allocation of resources. It sends a signal from consumers to producers. It does not require any government involvement. The market is the process through which similar products are bought and sold
Demand
The quantity of a product that buyers are willing and able to buy at different prices per period of time, ceteris paribus
“able” = effective demand
“willing to buy” = notional demand
The demand curve
Based on the overall market demand
Changes in price cause a change in quantity demanded shown hy movements up and down the demand curve
Features of a demand curve
Linear relationship
Continuous relationship
Time-based relationship
Ceteris paribus
Factors affecting demand
Income
Related products
Fashion, tastes and attitudes
Supply
The quantity of a product that suppliers are willing and able to sell at different prices over a period of time, ceteris paribus
The supply curve
A positive relationship means that:
- When price rises, QS rises
- When price decreases, QS decreases
Changes in price cause movement up and down the supply curve
Features of a supply curve
Casual relationship
Linear relationship
Continuous relationship
Time-based relationship
Factors affecting supply
Costs of production
Size of industry
Price of other products (substitutes and complements)
Government policies
Weather, natural disasters, war, supply chain issues etc
Causes of a shift to the right of the demand curve
Increase in income
Increase in price of substitutes
Decrease in price of complements
Favourable change in fashion, tastes or attitudes
Causes of a shift to the left of the demand curve
Decrease in income
Decrease in price of substitutes
Increase in price of complements
Unfavourable change in fashion, tastes or attitudes
Causes of a shift to the right of the supply curve
Decrease in costs of production
Growth of industry
Decrease in price of competitors
Decrease in indirect tax
Increase in subsidies
Causes of a shift to the left of the supply curve
Increase in costs of production
Decline in size of industry
Increase in price of competitors
Increase in indirect tax
Fall in subsidy
Price elasticity of demand
Measures the responsiveness of the quantity demanded for a product following a change in the price of the product, ceteris paribus
If demand is elastic, a small change in price will result in a larger change in QD
If demand is price inelastic a large change in price will result in a smaller change in QD
PED formula
Percentage change in quantity demanded/ percentage change in price
Perfectly inelastic demand
Occurs if regardless of price, consumers are willing and able to buy the same amount. PED = 0
Unit elastic demand
Occurs if the increase in price is exactly the same as the change in quantity demanded. PED = 1
Perfectly elastic demand
Occurs if the relative change in quantity demanded is infinite. PED = infinity
Factors affecting PED
Availability and attractiveness of substitutes (information, necessities, luxuries, addictive products, brand image)
Relative expense
Time
Income elasticity of demand definition
Measures the responsiveness of the quantity demanded following a change in income
Income elasticity of income formula
Percentage change in quantity demanded/Percentage change in income
Classification of goods relating to income
A normal goods demand increases as income increases (YED = 0-1)
An inferior goods demand decreases as income increases (YED is negative)
A necessities demand is unlikely to change as income changes (YED = near 0)
A luxury good has a YED>1 and is normal
Cross elasticity of demand
Measures the responsiveness of the quantity demanded for one product following a change in the price of another, ceteris paribus
Is elastic when quantity demanded for one responds more than proportionately to a change in the price of another
XED formula
XED = Percentage change in quantity demanded for product A/Percentage change in the price of product B
XED values
When positive, goods are substitutes
When negative, goods are complements
When 0, there is no particular relationship
Relationship between PED and price variance
The difference between peak and off-peak times
Businesses use price variations to increase revenue because they know changes in PED
Relationship between PED and total expenditure
When demand is inelastic, businesses can increase prices to increase revenue
When demand is elastic, businesses can decrease prices to increase quantity demanded so revenue increases
They can use persuasive advertising to persuade consumers to buy
Create brand image to make products look superior
Merge with a competitor to increase market share and market control
Create monopolies
PED can be used to explain:
Price variations in a market
The impact of changing prices on consumer expenditure and sales revenue
The effects of changes in indirect taxes on government income
YED can be used to:
Forecast future demand for a range of goods and services
Allow government spending to allocate resources to places with higher demand
Show sustained economic growth
Allow firms to expect sales of inferior goods to decrease in economics growth but increase during a recession
XED:
Substitutes are positive
A high XED will cause a great decrease in quantity demanded
It identifies complementary products and produces a pricing structure for more revenue from it
Calculating these values is hard as data for 2 point in time is required and needs to separate all other influences. Also occurs estimating YED. Data is more unreliable as time span increases
Price elasticity of supply definition
Measures the responsiveness of the quantity supplied of a product following a change in price of the product, ceteris paribus
PES formula
Percentage change in quantity supplied/Percentage change in price
If PEs>1:
Supply is elastic
Is PES<1:
Supply is inelastic
If PES=0
Supply is perfectly inelastic
If PES=infinity
Supply is perfectly elastic
Factors affecting PES
Availability of stocks
Time period
Productive capacity
How business react to market conditions with PES
PES helps businesses respond to market conditions. They can hold stock for variations in demand and increase the scale of the business if demand persists.
Agricultural supply is more inelastic that most. It is also unstable due to external forces such as the climate
The stability of global markets is affected by changes in demand for manufactured goods and agricultural products. When PES in inelastic, any change in demand has a big impact on global agricultural prices and therefore farmers incomes
When is a market in equilibrium?
When quantity supplied is equal to quantity demanded, ceteris paribus. This exists because the plans of consumers represented by the market demand curve match the plans of suppliers represented by the market supply curve
Disequilibrium
Where market supply and demand are not equal. The market mechanism adjusts supply or demand to reach equilibrium. When there is excess supply, the clearing price is too high so suppliers should reduce prices. If there is excess demand, prices should increase so fewer customers are willing to buy so the market clears
Market adjustment
This does not happen instantly. There may be time lags if firms can’t react quickly to increase or decrease production. This is further influenced by how long it takes consumers and producers to make known the price they are willing to pay for or sell a product at when the market is in disequilibrium
When does equilibrium price and quantity change?
When there are changes in demand and supply occuring due to non-price factors.
Causes of a shift in supply in relation to equilibrium
Costs: No business can last for long if they continue to make a loss. Factors that could influence costs of supply are: wage rates, worker productivity, raw material and component prices, equipment maintenance costs, distribution costs and changes in technology
Other products: SUpply of products onto the market can be determined by the actions of competitors. A competitor may lower prices to increase sales reducing the supply of a substitute
Industry: Firms outside the industry may react if there are great profits to be made. Current firms in the industry may be able to invest to grow and take advantage of this. New local competitors may emerge. Supply rises
Government: Legislation to protect consumers or workers may impose more costs on companies. Exise duties are tax on outputs. Ad valorem tax is on specific goods and services. This increases costs because forms want to put some of the tax burden on consumers
What will happen to equilibrium is supply and demand change simultaneously?
It will not be affected
Alternative demand
A substitute good. A rise in the price of one product will lead to an increase in demand and price of the substitute
Joint demand
A complement is in joint demand
Derived demand
Where something is required because it is needed for the production of other goods and services
Joint supply
Occurs when two goods are produced together but for different purposes
Rationing
The price system can limit products in the market. Rationing is automatic. Exclusive products have a high price so rationing will take place. Demand is limited and ensures it is in line with quantity supplied
Signalling
Prices act as a signal to producers and consumers. A rise in quantity demanded results in a rice in price signalling to producers to put out more products or the other way around. The price mechanism works so the outcome is a new equilibrium position
Transmission of preferences
The price mechanism allows the wants of consumers to be make known to producers. This is automatic. If consumers don’t buy a particular product, producers should improve the product, reduce its price or both if they want to stay in the business
Provision of incentive
Price is an incentive to buyers and sellers. Low price and special offers encourage consumers to buy. They get more satisfaction from consuming a product if they think it is a good deal. Higher prices can stop consumer purchasing but encourage suppliers to produce more while low price can discourage willingness to supply. If low prices persist, suppliers may exit the market
The significance of consumer surplus
Those who receive the most satisfaction will be willing to pay a higher price than those receiving little satisfaction. For most products, price is given and cannot respond to consumer satisfaction. When price falls, more will be demanded because it appeals more to consumers. When price rises, quantity demanded will fall since price increase is greater than satisfaction.
What is consumer surplus?
The difference between the price a consumer is willing to pay and its market price (some may want the product at almost any price)
The impact of a price change on consumer surplus depends on…
The extent of price change. The larger the change in price, the larger the change in consumer surplus
PED. When inelastic, a rise in price will see less of a fall in consumer surplus than if it was elastic
The significance of producer surplus
Producers have different price they are willing to supply products at. They are keen to supply consumers who are willing to pay a price above which they would normally be prepared to accept. The additional revenue is producer surplus
The impact of a price change on producer surplus depends on…
The extent of the price change. The greater the price change, the greater the change in producer surplus
PES. When elastic, an increase in price will see a greater increase in producer surplus than if it was inelastic
What does consumer and producer surplus together equal?
The net benefit to society
