Price Determination in a Competitive Market Flashcards
Demand
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.
The factors that shift the demand curve can be remembered using the mnemonic PIRATES:
o 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.
Formula for PED
PED = % change in Quantity Demanded/ % change in Price
PED is >1.
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.
PED is <1.
A price inelastic good has a demand that is relatively unresponsive to a change in price. PED is <1.
PED = 1.
A unitary elastic good has a change in demand which is equal to the change in price. PED = 1.
PED = 0.
A perfectly inelastic good has a demand which does not change when price changes. PED = 0.
PED = infinity.
A perfectly elastic good has a demand which falls to zero when price changes. PED = infinity.
The law of diminishing marginal utility
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.
This can be explained using the example of chocolate. The first chocolate bar will benefit the consumer more, because it satisfies more of their needs, and so the consumer is willing to pay more for it. The second bar will satisfy the consumer less, because they have less need for it, and the consumer will be willing to pay less for it. Eventually the utility derived will become zero.
Factors influencing PED
Necessity, Substitutes, Addictiveness or habitual consumption, Proportion of income spent on the good, Durability of the good, and Peakand off-peak demand
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.
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.
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.
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.
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.
Peakand off-peak demand
During peak times, such as 9am and 5pm for trains, the demand for tickets is more price inelastic
The burden of an indirect tax
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.
