chapter 3: price determination in a competitive market Flashcards
what is a market
a market is a voluntary meeting of buyers and sellers in which exchange takes place
when do competitive markets occur and what are their characteristics
they occur when there are a large number of buyers and sellers who all accept the ruling market price.
they lack entry and exit barriers so it is easy to enter or leave the market
they also have a high degree of transparency so everyone in the market knows what everyone else is doing
what is the relationship between price level and quantity demanded on the demand curve
a demand curve shows how as price decreases, quantity increases, because people are less likely to demand a good if the price is very high, and they are likely to demand the good more if the price is low
what is the difference between market demand and individual demand
market demand is the quantity of goods or service that all the consumers in the market are willing to buy (sum of all the consumers in the market)
individual demand is the quantity that a particular individual would like to buy
when is there a contraction of demand
when a rise in price leads to less being demanded
what are substitute goods and what type of demand do they cause
alternative goods used for the same purpose, and they have competing demand because they aren’t bought at the same time (e.g. apples and pears)
describe the conditions of demand
an increase in the price of a substitute good causes a rightward shift in the demand curve
a fall in the price of a complementary good causes a rightward shift
what are complementary goods and what type of demand do they cause
goods that are bought together and experience joint demand (e.g. paper and printer ink)
what are the conditions of demand for normal goods
demand increases as income rises and demand falls as income falls
what are the conditions of demand for inferior goods
demand decreases as income rises and demand increases as income falls
what is elasticity
the responsiveness of a second variable to an initial cange in the first variable
what is the formula for price elasticity of demand
%change in quantity demanded / %change in price
what is the formula for income elasticity of demand
%change in quantity demanded / %change in income
what is the formula for cross elasticity of demand
%change in QD of good A / %change in price of good B
draw the graph for perfectly elastic demand and write what PED is equal to
answer: graph 1
what does the price elasticity of demand measure
measures consumers’ responsiveness to a change in a good’s price
draw the graph for perfectly inelastic demand and write what PED is equal to
graph 2
draw the graph for elastic demand and write what PED is equal to
graph 3
what are the four factors determining price elasticity of demand
-substitutability
-percentage of income
-necessities or luxuries
-time
draw the graph for unit elastic demand and write what PED is equal to
graph 5
draw the graph for inelastic demand and write what PED is equal to
graph 4
how does substitutability affect price elasticity of demand
when a substitute exists for a product, consumers respond to a price increase by switching to a substitute good for which price hasn’t risen
- when substitutes are available, demand for the product is inelastic, and vice versa
how does percentage of income affect price elasticity of demand
when households spend a lot of their income and they spend a small fraction of it on a good, they dont notice a change in price as much so won’t respond
- however if a household spends a large proportion of their income on a good they will notice and be more elastic
how does whether the good is a necessity or a luxury affect price elasticity of demand
demand for necessities is usually price inelastic because everyone has to buy them, but sometimes this isn’t true if there are substitutes. e.g brown bread and white bread
the same is said for luxuries being price elastic, but might not be if there are substitutes
how does time affect price elasticity of demand
demand is more elastic in the long run than in the short run, because it takes time to respond to a price change
-however demand can be elastic in the short run if people respond quickly, e.g. a sudden rise in the price of petrol
how does total consumer expenditure affect PED
-if total consumer expenditure increases in response to a price fall, demand is elastic
-if total consumer expenditure decreases in response to a price fall, demand is inelastic
- if total consumer expenditure stays thesame in response to a price fall, demand is neither elastic or inelastic as it is unity
what does income elasticity of demand measure
measures how demand responds to a change in income
what does the nature of income elasticity of demand depend on
whether the good is a normal or inferior good
describe the difference in YED for inferior and normal goods
- YED is always negative for an inferior good and positive for a normal good
what are normal goods divided into and what are their YEDs
superior goods (luxuries) (YED > 1)
necessities (YED between 0 and 1)
describe the difference in demand for luxuries and necessities with response to income
demand of a luxury rises more with an income increase than for necessities
what does cross elasticity of demand measure
measures how the demand for one good responds to changes to price of another good
what two types of demand relationship are there which affects the XED and which types of goods match with these
complementary goods with joint demand
substitute goods with competing demand
example of complementary goods that are in joint demand
cars and petrol
draw the supply curve and explain why there is a positive relationship
graph 7
-firms are willing to raise their supply if is profitable, (profit is the difference between total revenue and the costs of production)
-it is unprofitable to produce and sell extra units unless price increases
example of substitute goods that are in competing demand
car travel and bustravel, as an increase in the price of running a car will cause some people to switch to public transport
what is the formula for the price elasticity of supply
PES = %change in quantity supplied / %change in price
draw the graph showing perfectly elastic supply and what PES is equal to
graph 8
what are the conditions of supply that affect whether the curve will shift (CTTS)
-costs of production
-technical progress
-taxes on firms
-subsidies granted by government to firms
what does the price elasticity of supply measure
measures the extent to which the supply of a good changes in response to a change in the price of it
draw the graph showing elastic supply and what PES is equal to
graph 9
what are 3 rules when it comes to price elasticity of supply curves
- intersect price axis means curve is elastic at all points
- intersect quantity axis means curve is inelastic at all points
- intersect origin means elasticity is unity (+1) at all points
draw the graph showing unit elastic supply and what PES is equal to
graph 10
draw the graph showing inelastic supply and what PES is equal to
graph 11
draw the graph showing perfectly inelastic supply and what PES is equal to
graph 12
what are the factors determining the PES
-length of production period
-availability of spare production
-ease of accumulating stocks
-ease of switching between production methods
-no. of firms in the market and the ease of entering the market
-time
how does the length of the production period affect the PES
if firms can convert raw materials into finished goods quickly then supply is more elastic than when it takes longer
how does the ease of switching between production methods affect the PES
when firms can quickly alter the way they produce goods (e.g. from capital to labour), supply is more elastic than when it is difficult
how does the ability of spare capacity affect the PES
if a firm posesses spare capacity and if raw materials and labour are available, production can be increased in the short run
how does the ease of accumulating stocks affect the PES
when stocks of unsold finished goods are stored at a low cost, firms can respond quickly to a sudden increase in demand
- firms can also respond to a price fall by diverting current production away from sales and into stock
how does the number of firms in the market and the ease of entering the market affect the PES
the more firms are in the market, the easier it is for firms to leave or enter and the greater the PES
draw the graph which shows PED getting more elastic, showing market period supply, short run supply and long run supply from an outward shift in demand + EXPLAIN
- the market period supply curve is shown by S1, showing when there is a sudden rise in demand, supply is completely inelastic as firms can’t immediately increase output
- so the price rises from p1 to p2 to remove the excess demand that came from the shift right
- in short run, higher price means higher profits, creating incentives for firms to increase outputs by FOP^
- the SR supply curve is shown by S2, more elastic because splly increases to Q2 and price falls from P2 to P3
- in the long run firms may believe the increase in demand is long lasting so may increase FOPs more such as capital which is variable in the long run. so output rises to Q3 and price falls to P4
draw the graph showing market equilibrium and explain what it is and how/when it occurs
market equilibrium occurs when the demand curve and supply curve cross
- at P1, households plan to demand exactly the same quantity that firms plan to supply
- P1 is the equilibrium price
- Q1 is the equilibrium quantity
when does market disequilibrium occur
when planned demand < planned supply (and price falls)
or when planned demand > planned supply (and price rises)
draw the diagram showing how excess demand and excess supply lead to changes in price + describe using short side and long side, and when there is excess demand and excess supply
graph 15
- When price is P1, firms want to supply Q2 but households are only willing to buy Q1 (producers are on the long side and households are on the short side)
- whoever is on the short side can always fulfill their wants, in this case households will only buy what they want to
- excess supply is the difference between firms wanting to sell Q2 but households only buying Q1
- excess demand is when households want to buy Q2 but firms only sell Q1 and the short side and the long side swap over
draw a graph showing how a shift in supply would affect market equilibrium and why + what external event may hit the market
graph 16
-For example, a bumper harvest causes supply curve to shift from S1 to S2.
-Before the shift, P 1was equilibrium price, and once the curve shifts, P1 is the disequilibrium price (too many goods are supplied)
-To get rid of the unsold stock, producers need to reduce the price, so price falls from P1 to P2 eliminating the excess supply
-In the new equilibrium planned supply is equal to planned demand but at the lower equilibrium price of P2
draw a graph showing how a shift in demand would affect market equilibrium and why
graph 17
-An increase in consumers’ incomes leads to an increase in demand
-Before the increase, equilibrium price was P1, but increased incomes shift demand curve from D1 to D2
- the disequilibrium replaces equilibrium
- right ward shift of demand is shown by Q2-Q1 (excess demand)
- price increased to P2 to eliminate the excess demand and quantity is bought changing to Q3
what event in the economy may cause the supply curve to shift for a company
a change in price of a good in joint supply
what event in the economy may cause the demand curve to shift for a company
by a change in price of a good in complementary demand or a substitute good
- or by a change in price of a good in composite demand
what is joint supply and when does it occur + example
occurs when production of one good leads to supply od a by-product
- e.g. if demand for beef increases, slaughter of cows to meet demand leads to more cow hides so more supply of leather
compare the effect of an increase in price of a complementary good in joint demand and a substitute good in competitive demand
an increase in the price of a good in joint demand has the opposite effect to that of a good in competitive demand
what is composite demand and describe what happens when there is a change in demand
demand for a good which has more than one use
- an increase in demand for one use of the good reduces the supply of the good for an alternative use
what is derived demand
occurs when a good is necessary for the production of other goods
- e.g the demand for c
