Microeconomics: Price determination in a competitive market Flashcards
What is demand?
The quantity of a good or service that consumers are able and willing to buy at a given price during a period of time.
This varies with price as the lower the price, the more affordable the good so consumer demand increases.
What does the demand curve show?
Price and Quantity demanded
Expansion in demand shows that if prices go down, demand increases because more people are willing and able to buy the good.
Contraction in demand shows that if prices go up, demand decreases because less people are willing and able to buy the good.
What are factors that shift the demand curve?
Population
Advertising
Substitutes- if the price of the substitute falls, the quantity demanded for the original good will fall because consumers will switch to the cheaper option.
Interest rates- If the price of borrowing money increases, demand for high priced items will fall.
Fashion trends- demand for clothing items depends on the fashions at the time.
Income- for normal goods, demand rises as income rises. For inferior goods, demand rises as income falls. e.g. bus travel.
Complementary goods- goods where the demand is linked e.g. if the price of iPhone falls , the demand for air pods will rise.
What 4 factors cause the demand curve to slope downwards?
Substitution effect
Income effect
Diminishing marginal utility
Seasonal factors
What is the substitution effect?
As the price of a product decreases, it becomes more desirable compared to similar products so consumers are more likely to switch to the cheaper option, leading to an increase in quantity demanded.
What is the income effect?
When the price of a product falls, consumers effectively have more real purchasing power allowing them to buy more of the product, leading to an increase in quantity demanded.
What is diminishing marginal utility?
As people consume more of a particular product, the additional satisfaction/utility they derive from each additional unit starts to diminish meaning they are willing to pay less for each successive unit.
e.g. after buying so many pairs of shoes, consumer satisfaction starts to fall.
What is effective demand?
Demand for a good/service from consumers that is backed up with an ability to pay.
What is potential (latent) demand?
Demand is not yet expressed in the market-place because consumers do not have the ability to pay.
What is derived demand?
Demand for a factor of production that is used to produce another good/service. The demand depends on the demand for the good/service they are used to produce.
e.g. the demand for economic teachers depends on the demand for students studying economics.
What is joint demand?
Demand for one product is directly and positively related to market demand for a related good/service.
e.g. pasta and sauces
2 complements= joint demand
cross-price elasticity of demand= negative
What is composite demand?
Goods that have more than one use.
An increase in market demand for one product can lead to a fall in market supply of the other as resources are switched.
e.g. milk is used for cheese, yoghurt, cream
What does the right shift in demand show?
More is demanded at every price level
What does the left shift in demand show?
Less is demanded at every price level
What is supply?
Quantity of a good or service a producer is willing and able to provide at a given price.
What is the law of supply?
For most products, quantity supplied varies directly with its price
Why are supply curves upward-sloping?
If price increases, it is more profitable for firms to supply the good so supply increases
Higher prices encourage new firms to enter the market - seems profitable so supply increases.
Larger outputs mean that the firm’s cost increases so they can charge a higher price to cover the costs.
What is extension in supply?
As price increases, quantity supplied increases.
What is contraction in supply?
As price decreases, quantity supplied decreases.
What is indirect tax?
A tax on spending e.g. VAT (on all non-essential goods), excise (taxes on petrol, cigarettes etc)
What is direct tax?
A tax on income e.g. income tax, corporation tax etc
What are the factors that shift the supply curve?
Productivity - if productivity increases, the quantity of supply increases e.g. better technology, education, and training
Indirect taxes - if Governments increase tax on a product, suppliers would supply less.
number of firms- If firms increase, supply increases
subides- cause an outward shift in supply
weather- favourable conditions will increase supply
Cost of production - If production costs increase, firms will reduce the amount they produce.
Government regulations- If Governments implement health and safety requirements, consumer protection increases but this increases the cost of firms.
What is equilibrium price and quantity?
Supply meets demand
What is market clearing price?
Firms are willing and able to supply at the price and consumers are willing and able to buy it.
What is a shortage?
Demand is greater than supply as a result of lower prices
What is surplus?
There is too much supply and not enough demand as the price is too high.
What is price elasticity of demand (PED)?
The responsiveness of quantity demanded to a change in the price of a product.
How is PED calculated?
Percentage change in quantity demanded / percentage change in price
What are the key factors affecting PED?
Number of close substitutes
Addictiveness/habitual consumption
Degree of necessity
Proportion of income spent on the good
Cost of switching between products
Time period allocated for consumers to respond following a price change
Peak and off-peak demand (peak=inelastic, off-peak=elastic)
Breadth of definition of a good/service (narrow=inelastic, wider=elastic)
Method of payment (cash=elastic, card=inelastic)
What does elastic demand show?
A change in price leads to a proportionally greater change in quantity demanded.
greater than (>) 1
What does inelastic demand show?
A change in price leads to a proportionally lesser change in quantity demanded.
less than (<) 1
What does unitary elastic show?
The quantity demanded changes at exactly the same rates as price.
1
What does perfectly inelastic show?
The quantity demanded remains the same as the price changes i.e. demand is completely unresponsive to changes in price.
0
What does perfectly elastic show?
Any quantity is demanded at a given price.
INFINITY
What should a firm do if demand for a firm’s good is inelastic?
Increase prices to maximise revenue as this will lead to a proportionally smaller decrease in demand which increases revenue.
What should a firm do if demand for a firm’s good is elastic?
Decrease prices to maximise revenue which will lead to a proportionally greater increase in demand which increases revenue.
How is revenue calculated?
Price x quantity
What is income elasticity of demand?
The responsiveness of quantity demanded to a change in income.
How is income elasticity of demand calculated?
Percentage change in quantity demanded / percentage change in income
What YED do normal goods have?
Positive which means YED>0. When incomes are falling, demand decreases.
What YED do inferior goods have?
Negative YED>0, fall in demand as income increases e.g. “value” options at supermarkets.
What YED do normal necessary products have?
Income inelastic, YED>0<1. Low but positive income elasticity.
What should firms do if demand for a firm’s good is inelastic?
Increase prices to maximise revenue. This will lead to a proportionally smaller decrease in demand which increases revenue.
What should firms do if demand for a firm’s good is elastic?
Decrease prices to maximise revenue. This will lead to a proportionally greater decrease in demand which increases revenue.
What is cross price elasticity of demand (XED)?
Measures the responsiveness of the quantity demanded of one good to a change in the price of another related good.
How is XED calculated?
% change in QD of A/ % change in price of B
What XED do substitutes have?
Positive as an increase in the price of one product will lead to a rise in demand for its substitutes.
What are strong substitute relationships?
Very responsive to each other- consumers quick to switch e.g. coke and Pepsi.
What are weak substitute relationships?
A big price rise doesn’t have that much impact on demand- goods aren’t related e.g. Coke and Lemonade.
What happens if XED is negative?
Two goods are complements e.g. fish and chips
