Price Determination in a Competitive Market

Question 1

What is demand?

Answer 1

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

Question 2

What is the difference between effective and latent demand?

Answer 2

Effective demand is demand for customers, which is backed up with an willingness and ability to pay, Whereas potential (Latent) demand is demand which customers cannot back up on the market (eg wanting yachts)

Question 3

What assumption do we make about consumer demand?

Answer 3

It is assumed that customers are rational, and therefore aim to maximise their overall utility, using the resources they have.

Question 4

Explain the three reasons why the demand curve is downwards sloping.

Answer 4

Income Effect: When the price of a product or products falls, consumers spend less of their income on such goods and therefore end up with more disposable income. As a result, they feel more wealthy, and will therefore want to increase their consumption (as per the wealth effect). Equally, when prices rise people will be spending more of their income, leaving them will less disposable income, thus feeling poorer. They will therefore reduce their consumption to reflect this.

Substitution Effect: When the price of a product increases, alternative products now become cheaper. People may now substitute over to alternative simular products as they are cheaper

Law of Diminishing Marginal Returns: The more units of a given good consumed, the smaller the marginal utility received from consuming the good becomes. Given rational consumers aim to maximise their utility, they will only pay as much as the additional utility they will receive for a product. The amount they are willing to pay therefore decreases as quantity increases. The demand therefore is downwards sloping.

Question 5

What is the Law Of Demand?

Answer 5

The law of demand is that as price declines, the quantity demanded expands, and that as price rises, the quantity demanded contracts. (We see a movement along a demand curve)

Question 6

What causes a contraction/extension in demand vs what causes shifts in the demand curve?

Question 7

What factors cause a shift in the demand curve?

Answer 7

• Change in price of a substitute good - if the price of an alternative/substitute good rises, people will buy less of the substitute good, and will instead switch to this good, shifting the curve to the right.
• Change in the price of a complementary good - If a complementary good falls in price, then people might buy more of both goods, causing a shift to the right. (eg: If bike prices fall, then people will buy more bikes, leading to an increased sale of helmets)
• Change in the income of consumers - when consumers have more income, their purchasing power increases, shifting the curve. This works in both ways however.
• Changes in distribution of income - when income is distributed more equally, total demand may increase, as people on lower incomes typically spend a higher proportion of their income/wealth. Also, more people can afford to purchase goods
• Seasonal factors for goods and services - eg Christmas goods
• Effective Advertisement - more people know about a product, the market increases, and so does demand.

Question 8

What is the difference between a contraction/extension in demand and a shift in demand? What causes an contraction/extension in demand vs a shift in demand?

Answer 8

A change in price of a good causes a contraction/extension in demand

Changes in income, prices of compliments/substitutes, seasonal factors/advertisement shift the demand curve for a given good.

Question 9

Define Consumer and Producer Surplus and draw them on a supply vs demand diagram.

Answer 9

Consumer surplus - the difference between how much buyers are prepared to pay for a good and what they actually pay

Producer Surplus - the difference between the price producers would have been willing to sell at and the price that they actually sell a given unit of a good at.

Question 10

Consumer Surplus

Answer 10

just to read not to test

Question 11

What is the difference between the market demand curve and the individual demand curve? What is the difference in their shapes

Answer 11

Individual demand curve - Demand curve showing demand vs price for individuals
Market demand curve - the sum of all individual demand curves.

Different individuals may have different demand curves due to having different incomes or preferences

The market demand curve aggregates all of this, and so will not look the same as every single individual curve which makes it up. It will also be much further out from the origin to reflect greater total demand

Question 12

What is price elasticity of demand?

Answer 12

Price elasticity of demand is the ratio of percentage change in quantity demanded in response to the percentage change in price.

PED = % Change Demand / % Change Price

Question 13

PED’s are ALWAYS ________.
This is because….

Answer 13

PED’s are ALWAYS NEGATIVE
This because price and quantity demand have an inverse relationship, so will one will always be negative

Question 14

What is the Law Of Diminishing Marginal Returns

Answer 14

In economics, diminishing returns are the decrease in marginal output of a production process as the amount of a single factor of production is incrementally increased, holding all other factors of production equal.

Question 15

What does it mean for a good to be: Perfectly Elastic, Relatively Elastic, Unitary Elastic, Relatively Inelastic, Perfectly Inelastic
What elasticities do goods in each of these categories have?

Answer 15

Question 16

What type of elasticity is this?

Answer 16

Perfectly Price Elastic

Question 17

What factors impact the PED of a given good?

Answer 17

1. Luxury vs necessity
   Consumers have less choice then to consume goods which are necessities, such as food or gas, and so they are less elastic, but goods which are a luxury, such as bottled water, will be much more elastic as consumers do not require to buy them
2. Addiction / Habit
   Goods which are addictive or habit will be much less elastic, as consumers require them out of addiction, and therefore will respond less to changes in price
3. Proportion of Income Spent on Good
   Goods which take up a large proportion of one’s income will be much more elastic, as a %change in the price of an expensive good, will be a much greater change than a good which costs very little
4. The Availability of Substitutes
   If substitutes are readily available and easy to switch to, then a good will be more price elastic, as people can easily switch to a cheaper alternative if the price changes of a good.
5. Brand Loyalty

Question 18

What type of elasticity is this?

Answer 18

Relatively Elastic
A small change in price has a large impact of quantity demanded.

Question 19

What type of elasticity is this?

Answer 19

Unitary Elastic

Question 20

What type of elasticity is this?

Answer 20

Relatively Inelastic

Question 21

What type of elasticity is this?

Answer 21

Perfectly Inelastic
A change in price has no impact on quantity demanded.

Question 22

What are “necessity” normal goods. Give an example.
What type of income elasticity are normal goods?

Answer 22

Normal goods are relatively income inelastic
Example: Milk, Rice
They have a positive YED but smaller than 1

Question 23

What are inferior goods. Give an example.
What type of income elasticity are inferior goods?

Answer 23

Inferior goods are income inelastic goods
Examples: Tesco own range baked beans
YED Range: YED<0
For Inferior Goods, QD reduces as Income rises. This is because people only buy them when they cannot afford better alternatives. As soon as they can afford them, they will switch to these substitutes.

Question 24

What are luxury goods. Give an example.
What type of income elasticity are luxury goods?

Why are luxury goods like this?

Answer 24

Luxury goods are income elastic
Example: Holidays, Watches
They have YED value between 1 - infinity

This shows that for a given increase in incomes, such goods will have an even larger increase in QD

For luxury goods, such as holidays, they are very price elastic, as when people have increased incomes, these are the types of goods which they will spend their new excess of income on, as they are goods which people want but don’t need, and so they respond to changes in real income

Question 25

How can firms use elasticity data to inform their prices and revenue predictions?

Answer 25

When a firm is attempting to optimise profits by changing the amount of units they sell, and therefore also the price, they can use elasticity data to work out how the change will affect revenue

In general, we can use the acronym ISED to work out the change when increasing revenue
Inelastic - Same (higher price = higher revenue)
Elastic - Decrease (higher price = lower revenue)

Question 26

Why would a firm want to increase the price of an inelastic good?

Answer 26

Because the good is inelastic, increasing its price will lead to smaller percentage decrease in demand
Therefore a higher price will fetch a greater total revenue

Question 27

Why would a firm want to decrease the price of an elastic good?

Answer 27

Decreasing the price will lead to a greater percentage increase in quality demanded
Therefore by lowering the price, TR will increase.

Question 28

Explain how this demonstrates the ISED acronym?

Question 29

Explain how this demonstrates the ISED acronym?

Question 30

What is price elasticity of income?

Answer 30

Price Elasticity of Income (YED), is how much Quantity Demanded changes in response to a change in real income.
Also represented as: (%Change QD) / (%Change Y)

Question 31

What is cross elasticity of demand?

Answer 31

XED measured the response of the quantity demanded of one good in response to a change in Price of another.
The formula is: (%Change QD (Good A)) / (%Change Price (Good B))

Question 32

What factors influence XED?

Answer 32

Substitutes - A rise in the price of a substitute will lead to an increase in Quantity Demanded of that good, due to the substitution effect. Substitutes have a positive XED
Compliments - A rise in the price of a complementary good will lead to a decrease in QD of that good, as people will demand less of the complementary good, and therefore QD for the good decreases, as it is linked to the QD of the complementary good. Complementary goods have a negative XED
Unrelated Goods - For two goods that are unrelated, such as cement and rice, a rise in price of good A will have no impact on good B, and therefore XED is 0.

Question 33

Substitute goods always have ______XEDs. This is because:

Answer 33

Substitute Goods Have Positive XED
This is because if the price of good A rises, the QD of good B will also rise. Equally, if price of good A falls, the QD of good B will also fall

Question 34

Complementary goods always have ______XEDs. This is because:

Answer 34

Complementary Goods Have Negative XED’s
This is because when two goods are complements, if good A has an increase in price, the other will have a fall in QD, as less people are buying good A (due to higher price), and therefore the demand for B also decreases, as they are complementary goods. Equally if the price of Good A falls, the QD of Good B will rise.

Question 35

non-related goods always have ______XEDs. This is because:

Answer 35

Non Related Goods Have Low XED’s
If two goods have a XED of 0, or near to 0, they are unrelated. Eg: QD for Taxis, and Price of Bananas

Question 36

What is Price Elasticity of Supply?

Answer 36

This measures the responsiveness of changes in quantity supplied in response to price. As a generalisation, as price increases, so does supply (as vice-versa), as producers are more willing to supply more at higher prices, as profits are larger.
PES = %Change Supply / %Change Price

Question 37

What are the 5 determinants of Price Elasticity of Supply.

Answer 37

Determinants of PES
1. Excess Capacity
When firms are not operating at full capacity, and have excess capacity to increase supply, they will be much more supply elastic, as if prices increase, they can easy respond by increasing supply, by using up their spare capacity (eg unused machinery). If firms do not have excess capacity, they may not be able to increase supply, and are therefore more supply inelastic

2. Availability of Factors of Production
   When factors of production are readily and easily available, then supply will be more elastic, as firms are able to obtain more input factors when they want to increase production. However, for some products, such as diamond necklaces, factors of production are not very readily available, as diamonds and precious metals are very rare and do not have a regular stream of availability. Therefore for these products, supply will be more inelastic.
3. State of the Economy
   When the economy is in poor condition, with high levels of unemployment, supply is actually more elastic. This is because as there is more unemployment, it is easy to increase the workforce by hiring people, and therefore supply. Moreover, buildings or factories to buy/rent are much more readily available, as there are less firms operating, so expanding supply is much easier. Contrary, if the economy is booming, there will be less unemployed people, and it will be harder and more expensive to expand.
4. Stockpiles and Perishability
   Perishable goods are goods which go off, and therefore cannot be stockpiled (storing large amount of stock for extended periods of time) for long periods of time (eg Cheese). Goods which are non perishable (like pencils), can be stockpiled and are therefore much more elastic than goods which can’t. This is because if price increases, supply can also easily increase to meet it by simply using up reserves of stockpiled goods. If these reserves do not exists, then more of the good will have to be produced, which will take time to arrange.
5. Time Period
   In the Short Run, it is assumed that factors of production are fixed, and so supply is more inelastic. This is because suppliers will be limited by their fixed factors of production, and so even if price increases, they cannot increase supply because they don’t have enough space or machinery. In the Long Run however, it is assumed that factors of production can be changed, and therefore supply can be increased by simply increasing factors of production, such as workforce of factories

There is a positive relationship between quantity supplied and price, and therefore PES will always be positive

Question 38

A firm with lots of spare capacity will be more supply ______, whereas a firm with little space capacity will be supply _______

Answer 38

A firm with lots of spare capacity will be more supply ELASTIC, whereas a firm with little space capacity will be supply INELASTIC

EXPLAINATION: When firms are not operating at full capacity, and have excess capacity to increase supply, they will be much more supply elastic, as if prices increase, they can easy respond by increasing supply, by using up their spare capacity (eg unused machinery). If firms do not have excess capacity, they may not be able to increase supply, and are therefore more supply inelastic

Question 39

Explain why Excess capacity, Time Period, Availability of good specific factors of production, state of the economy and stockpiles + perishability impact PES?

Question 40

Draw inelastic supply curve. Label it with values for Price Elasticity of Supply (PES)

Answer 40

PES < 1

Question 41

Draw an elastic supply curve. Label it with a value for PES

Answer 41

PES > 1

Question 42

How can barriers to entry in the market influence PES?

Answer 42

If there a high barriers to entry to the market, supply will be more inelastic as it is harder for more firms to join the market and increase supply to the market

Question 43

What do supply and demand curves fundamentally show?

Answer 43

A supply curve shows the relationship between price and
quantity supplied.

A demand curve shows the relationship between price and quantity demanded

Question 44

What is supply (microeconomics)?

Answer 44

Supply is the quantity of a good or service that a producer is able and willing to supply at a given price during a given period of time.

Question 45

Why is the supply curve upwards sloping?

Answer 45

o If price increases, it is more profitable for firms to supply the good, so supply increases.
o High prices encourage new firms to enter the market, because it seems profitable, so supply increases.
o With larger outputs, firm’s costs increase, so they need to charge a higher price to cover the costs due to diminishing marginal returns making the marginal cost increase at greater output in the short run

Question 46

Explain what is meant by the profit motive?

Answer 46

The profit motive is the idea that firms are motivated by the single goal to mark large profits and maximise their profits

Question 47

What is the Law of Supply?

Answer 47

There is a direct relationship between price and quantity supplied. As price increases, quality demanded decreases.

Question 48

What is the market clearing price?

Answer 48

This is the price at which supply meets demand, and there is no excess supply or demand

It is the equilibrium price

Question 49

Through what mechanisms do the markets remain in equilibrium?

Answer 49

FREE MARKET FORCES

S - Signalling:

Question 50

If price is too high: Demand is lower than the supply at that given price, so there is a surplus of goods onto the market

Question 51

At the market clearing price, the market is in ___________, at any other price, the market is in ____________

Answer 51

equilibrium
disequilibrium

Question 52

What is market interrelationships?

Answer 52

This is the idea that changes in one market are likely to affect other markets, changing the supply or demand in other markets and therefore altering the price

Question 53

What types of market interrelationships are there? (5)

Define and explain each one, giving an example.

Answer 53

• Derived Demand: This is when the demand for a factor of production or intermediary good is linked to the demand for another good, because it is used to produce that good

Eg: The demand for bricks is derived from the demand for the building of houses

• Joint Demand: This is when the demand for one good is tied to the demand for another because they are bought together. Eg: A bike and chain oil
• Competing Demand: This is when two goods are substitutes are therefore an increase in the demand for one good will reduce the demand for another
• Joint Supply: This is when increasing the supply of one good causes an increase in the supply of another good. Eg: Lamb and the supply of wool
• Composite demand - Composite demand happens when goods or services have more than one use so that an increase in the demand for one product leads to a fall in supply of the other
  eg: A good example is the use of Milk for cheese, yoghurts, cream

Question 54

Substitute goods are in _________ demand. This is because:

Answer 54

Competing demand:
This is because when people switch away from one good they move towards purchasing more of the substitute good

This means they always have positive XEDs

Question 55

What impact do non price factors have on the supply curve? What are these non price factors?

Answer 55

Non-price factors shift the supply curve. Note: This is the MARKET supply curve.
Costs of production - if costs of production
These non price factors are:
Productivty
Taxes and subsidies
Number of firms in the market

Question 56

How does the Law of Diminishing marginal return inform the shape of the demand curve?

Question 57

How does the availability of subs impact the price elasticity of demand for a given good?

Answer 57

If substitutes are readily available and easy to switch to, then a good will be more price elastic, as people can easily switch to a cheaper alternative if the price changes of a good.

Question 58

What are the types of market interrelationships that are needed to be known? Just state them not explain.

Answer 58

Joint Demand
Joint Supply
Competing Demand
Composite Demand
Derived Demand

Question 59

What type of market interrelationship do complementary goods display? Give an example.

Answer 59

Joint demand occurs when two goods are demanded together, also known as complementary goods. Bricks and bricklayers are demanded together - when a builder demands (hires) a bricklayer, they also demand bricks for them to use.

Question 60

Draw a graph showing the interrelationship between

Question 61

State and explain what type of XED complimentary goods have

Answer 61

Complementary goods are goods which are bought and used together. They have a negative XED as an increase in the price of one will decrease the demand for the other.

Question 62

Complimentary goods are in _________ demand

Answer 62

joint demand - if you demand more PS3’s you will also have a rise in demand for PS3 Games

Question 63

A good is in composite demand when it is demand for ___ or more __________ uses

Answer 63

A good is in composite demand when it is demand for TWO or more SEPERATE uses