price determination in a competitive market Flashcards
what is elasticity theory?
looks at sensitivity of one variable in relationship to another
what is elasticity coefficient?
the measure of the response of one variable to changes in another variables
what do different signs in elasticity theory suggest?
- sign= positive relationship (i.e. as income increase demand decreases)
- sign= negative relationship (i.e. as price increases demand decreases)
how do you work out percentage change?
change in value/original value x 100%
what does price elasticity of demand (PED) mean?
- measures responsiveness of demand to a change in price
how do you calculate PED?
% change in quantity demanded/% change in price
(dinner/plate)
*answer always positive
PERFECTLY INELASTIC- PED coefficient + explanation
PED coefficient - 0
explanation- demand doesn’t change as price changes (completely unresponsive)
could increase price as much as wanted and demand stays the same
PRICE INELASTIC- PED coefficient + explanation
PED coefficient- 0 –> 1
explanation- % change in quantity demanded is less than % change in price i.e. large change in price will lead to a smaller change in demand (demand is relatively unresponsive)
- firm should increase price in this situation as although demand will decrease a bit total revenue will increase
UNITARY ELASTIC- PED coefficient + explanation
PED coefficient- 1
explanation- % change in quantity demanded is exactly equal to % change in price (change in demand=change in price)
- increasing/decreasing price has no impact on on total revenue a
RELATIVELY ELASTIC- PED coefficient + explanation
PED coefficient - 1->infinity
explanation- % change in quantity demanded is more than % change in price (change in price= demand change by a greater amount)
- firm will want to decrease price to increase sales revenue
PERFECTLY ELASTIC- PED coefficient + explanation
PED coefficient- infinity
explanation- any change in price will cause demand to fall to zero
- firm couldn’t increase price as they would be no demand at all
PED elastic vs inelastic
PED= elastic (so coefficient is greater than 1), rise in price will cause total expenditure to fall (vice versa)
PED= inelastic (so coefficient is less than 1), a rise in price will cause total expenditure to rise (vice versa)
therefore total expenditure depends on the PED of the good/service
how do you calculate total revenue
TR= price x quantity
determinants of PED?
substitutes
time
addictiveness/habitual consumption
necessity or luxury
percentage of income
peak + off-peak
determinants of PED- substitutes + time
substitutes:
- no close/lack of substitutes= products likely to be inelastic (vice versa)
- several close substitutes= more price elastic
time:
- short-run= more inelastic as consumers find it difficult to change shopping habits
- long- run= more elastic consumers adjust to changing market conditions
determinants of PED- addictiveness/habitual consumption + necessity/luxury
addictiveness/habitual consumption:
- e.g. cigarettes= inelastic as they’re addictive so consumers demand them no matter what
necessity/luxury
- necessities demand= price inelastic
- luxuries demand= price elastic
determinants of PED- percentage of income + peak/off-peak
percentage of income:
- smaller % of income= more likely to be price inelastic as change in price is less noticed
peak/off-peak
- e.g. peak train times= tickets more price inelastic
cross elasticity of demand (XED) what is it?
- measures responsiveness of a change in demand for one good (X), to change in price of another good (Y)
XED how to calculate?
% change in quantity demanded of good x/ % change in price of good y
determinants of XED?
substitutes
complements
unrelated goods (no relationship)
determinants of XED explained
SUBSTITUTES
- have a + XED (XED is greater than 0)
- as price of good y increases, demand of good x increases
- close substitutes= higher XED as consumer demand for good x will be more sensitive to change in price of good y
COMPLEMENTS
- have a - XED (XED is less than 0)
- as price of good y increases, demand of good x decreases
- close complements= higher XED as consumer demand for good x will be more sensitive to change in price of good y
UNRELATED GOODS
- XED will be 0
- change in price of good y will have no impact on demand of good x
cross price elastic vs inelastic
cross price inelastic
- coefficient= 0 -1
- as demand for good x change at less proportion than change in price of good y
cross price elastic
- coefficient= greater than 1
- as demand for good x changes at a greater proportion than the change in price of good y
XED relevance to business
- substitutes- firms will try to differentiate from their competition (quality etc)
–> through advertising, branding etc consumers are more likely to stick with their product - complements- firms create range of complements to accompany core products e.g. apple ecosystem
more complements= more likely to increase total revenue
income elasticity of demand (YED) what is it?
- measures responsiveness of a change in demand to a change in income
how to calculate YED?
%change in quantity demanded/% change in income
what type of goods are relevant in YED?
normal goods + inferior goods
normal goods YED?
- have a positive (+) income elasticity of demand
- as income increases, demand for product increases
YED- normal necessity
co-efficient= 0 –> 1
- income inelastic–> demand changes at lower proportion than increase in income (relatively unresponsive to change in income)
YED- normal luxury
co-efficient= greater than 1
- income elastic –> demand changes at higher proportion than the increase in income (more responsive to change in income)
YED- standards of living
- wealthier countries= more likely to have consumers with higher disposable incomes= greater spending power + more likely to spend on luxuries= firms produce products to suit these needs
- global standards of living are rising= we expect to see more ppl move away from inferior goods + towards luxury
YED- the economic cycle
- economies in a decline= lower disposable incomes + consumers move from luxuries to necessities + inferior (vice versa) –> firms identify economic state e.g. recession etc + produce goods/services to meet demand of consumers
YED- inferior goods
- always have a negative (-) income elasticity of demand
- because demand for products decreases as income increases
- YED coefficient= less than 0
YED- KEY POINTS
- higher standard of living= ppl demand for luxuries tends to increase as they already have necessities
- poorer consumers tend to spend more on necessities
- normal goods that are necessities have a lower positive YED coefficients than luxuries
price elasticity of supply (PES) what is it?
measures responsiveness of a change in supply to a change in price
PES how to calculate it?
% change in quantity supplied/% change in price
PES price inelastic vs elastic
price inelastic
- coefficient= less than 1
- increase in price= increase in S but to less of a proportion to the change in price
price elastic
- coefficient greater than 1
- an increase in price= increase in demand to a greater proportion to the change in price (vice versa)
PERFECTLY ELASTIC- coefficient + explanation
coefficient - 1
explanation- quantity supplied is completely unresponsive to the change in price
- firms would supply same amount at any given price
PRICE INELASTIC- coefficient + explanation
coefficient- 0 –>1
explanation- % change in quantity supplied is less than % change in price
- may be due to incentive for firm to increase supply isn’t enough
PRICE ELASTIC- coefficient + explanation
coefficient- 1 –> infinity
explanation- % change in quantity supplied is greater than the change in price
- may be because firm may find it easy to increase supply as the incentive is greater etc
PERFECTLY ELASTIC- coefficient + explanation
coefficient- infinity
explanation- if price changed quantity supplied would fall to zero
PES- KEY POINT
- firms try to increase their PES
- more elastic PES coefficient= firms more flexible in changing supply of its products= making it more competitive
- this contrasts PED where firms want more inelastic coefficient
determinants of PES
PRICE
HOW SUBSTITUTABLE FACTORS ARE
SPARE CAPACITY
STOCKS
TIME FRAME ALLOWED
ARTIFICIAL LIMITS
determinants of PES- price + how substitutable factors are
PRICE
- increase in price= incentive for firms to increase supply due to more profit
HOW SUBSTITUTABLE FACTORS ARE
- when it’s possible + can be achieved at low cost then supplies will be elastic
determinants of PES- spare capacity + stocks
SPARE CAPACITY
- spare capacity= firms can expand outward easily to meet rising demand without upward pressure on costs e.g. having spare resources etc
STOCKS
- low level of stocks= supply inelastic (vice versa)
- e.g. spare warehouse + storage space
determinants of PES- time frame allowed + artificial limits
TIME FRAME ALLOWED
- momentary= fixed supply
- short run= inelastic supply
- long run= elastic supply
(gets more elastic over time)
ARTIFICIAL LIMITS
- e.g. impact of patents that limit which firms can supply a product
e.g. paracetamol (lots of firms) vs neurofen (1 firm)
price mechanisms what are they?
- means by which decisions of consumers + businesses interact to determine the allocation of resources
–> interaction of demand + supply in a market economy that allocates scarce resources amongst competing needs + wants - Adam Smith referred to it as ‘invisible hand of the market’ –> resources allocated through price mechanisms in a free market economy
- 3 functions of price mechanisms if any function breaks down= market failure can occur
price mechanisms- what are the 3 functions
- rationing
- incentive
- signalling
price mechanisms- rationing function
- prices ration scarce resources when demand exceeds supply
- when there’s a shortage= prices rise= only those with willingness + ability to pay to buy
price mechanisms- incentive functioning
- incentive function encourages producers to increase or decrease profits
- when prices of good/service rise= incentivises producers to reallocate resources from a less profitable market to maximise profits
- falling prices incentivises reallocation of resources to a new market
price mechanisms- signalling function
- price acts as a signal to consumers + new firms entering the market
- change in price= signal about where resources are wanted (markets with increasing prices) + where they’re not (markets with decreasing prices)
–> allows consumers + producers to make informed decisions - high price= signals producer to produce more of that good/service + signal to other producers to enter the market
- falling price= signals to consumers to purchase more of a product –> all causes shifts in demand + supply curves
demand curve- what does it show
- shows relationship between price and quantity demanded
- y axis= price
- x axis= quantity demanded
demand curve for a normal good
- always negatively sloped
- as price falls, quantity demanded increases (vice versa)
demand curve- movements along the curve
- change in price causes a movement along the curve
- rise in price= contraction along demand curve as quantity demanded decreases
- decrease in price= expansion along demand curve as quantity demanded increases
demand curve- rational choice theory
ppl make logical decisions that’ll maximise their personal benefits
demand curve- demand meaning
quantity of a good/service that consumers are willing + able to buy at any given price
ceteris paribus
‘all other factors stay the same’
e.g. if raise a price of a good you assume other factors (consumer income etc) don’t change
–> allows us to identify impact of changes in one factor
determinants of the demand for goods + services
- price of good
- consumer income
- prices of other goods + services
- consumer tastes or fashion
determinants of the demand- price + consumer income
- price of good
if price of normal good/service increase demand will decrease (vice versa)
BUT for veblen goods the ‘snob effect’ means ppl may pay more as price increases due to increased status etc –> would have a + slope on demand curve - consumer income
income increases= demand for normal goods increases (shown by outward shift) - inferior good- demand decreases as income increases
certain inferior goods where demand rose as income rose (giffen goods)
e.g. price of bread up= poor family has no income to spend on meat etc so has to spend even more money on bread
determinants of the demand- prices of other goods + services, consumers tastes or fashion
prices of other goods + services
- SUBSTITUTE product- (alternative) e.g. coke price increase so demand for pepsi increase
- COMPLEMENTARY product- bought alongside a good/service e.g. price of fish increases so demand for chips decreases
consumer tastes or fashion
- more fashionable, advertised products etc= increased demand
other factors:
- population changes (size + age)
- advertising
- level of comp in market
- future expectations of price
- seasons
- marginal utility i.e. the benefit of consuming a good, falls –> consumers less willing to buy e.g. eating 1 chocolate bar= satisfies more so won’t/will be less willing to pay for another at higher price
shifts in demand curve
- increase in demand= outward shift (to the right)
- decrease in demand= inward shift (to the left)
- determinants cause this shift
supply curve- what is it?
shows relationship between price + quantity supplied
often positively sloped as higher prices imply higher profits= incentive to expand production
–> price of product rise= supply rises (vice versa) –> higher prices= firms more likely to cover the costs= they’ll make a profit –> higher prices is a incentive for firms to expand production
what is supply?
the quantity of a good/service that producers are willing + able to sell at any given price
determinants of supply in market
impact of changing costs of production
technological progress
prices of other goods + services
govt policies e.g. taxes, subsidies
determinants of supply in a market- impact of changing costs of production + technology
impact of changing costs of production
- costs of production are created by the price of factor inputs i.e. factors of production
- if cost increases= more expensive to supply product= can decrease output (vice versa)
- tech improvements can help reduce costs of production
technological progress
- better tech= more efficient production + cost effective= profitable to supply more
determinants of supply in a market- prices of other goods + services
govt policies e.g. taxes, subsidies
prices of other goods + services
- if price of good A increases, may be more profitable to stop producing good B + only producing good A
- if prices are rising firms will enter market due to greater incentive to make profits
govt policies e.g. taxes, subsidies
- indirect taxes= more expensive tp create a product= supply decreases
- subsidies (finance provided to producers)= cheaper to produce a product= supply increases
other factors:
- expectations for the future
- weather events etc
shifts in supply curve
- increase in supply= outward shift (to the right)
- decrease in supply= shift to the left= inward shift
- to show a bigger change in supply show a bigger shift (leave a bigger gap)
key point
- shifts happen because of determinants + movements along the curves due to price
what is market equilibrium?
- in market- interaction of demand + supply determines equilibrium price
- market equilibrium- point at which demand=supply
–> known as market clearing price as all products will be sold at this price –> buyers get exact amount they want to buy + sellers sell exactly the amount they want to sell at this price. nothing is left over (markets cleared) - any change in demand/supply= new equilibrium price
market equilibrium- excess supply
- price is above market equilibrium
- quantity demanded is lower than supply as firms wish to supply more at a higher price
- too much supply= firms need to decrease price to get rid of excess products
- amount of excess supply= difference between supply + demand
market equilibrium- excess demand
- price is below market equilibrium
- quantity demanded exceeds supply –> firms have less incentive to supply at lower price so there’s too much demand (firms would need to increase price to reduce this excess demand)
market equilibrium- market forces
market forces= always pushing prices towards market equilibrium
- too much supply= reduce price
- too much demand= increase price
- change in price will lead to movement along the supply/demand curve BUT change in any other factor (determinants of supply/demand)= shift in demand/supply curve
market equilibrium- shifts in demand curve
- increase demand= outward= price will rise + quantity demanded = new market equilibrium
- shift in demand= movement along supply curve
- decrease in demand shown by inward shift= price fall + quantity demanded= new market equilibrium
- shift in demand= movement along supply curve
market equilibrium- shifts in supply curve
- increase in supply= outward shift= price falls + quantity supplied increase= new market equilibrium= movement along demand curve
- decrease in supply= inward shift= price rises + quantity supplied decreases= new market equilibrium= shifts in supply= movement along demand curve
interrelationship between markets
changes in one market will affect other markets
- competitive market operates through interaction of demand + supply
- as demand of goods + services changes in a market= impacts other markets
- firms move away from markets with low demand + towards high demand/increasing demand markets –> this leads to an increase in supply as firms move to new markets
- introduction of new product/supplier= further impacts goods + services in competitive market –> depends upon relationship between these products
interrelationship between markets- joint demand
- goods that are complements= in joint demand
- complements = negative XED (as price good A increases demand of good B decreases)
- increase in demand for one good= increase in demand of another good, vice versa
- demand for substitutes= depends on variety of factors
–> rise in price of beef= rise in demand for lamb (vice versa) - positive XED (price of good A increases, demand of good B decreases)
- close substitutes= higher XED as consumer choice will be more sensitive
interrelationship between markets- composite demand
- occurs when there’s competing uses of a good/service
- increase in demand for one good/service= restricts its availability for another use –> therefore there’s competing uses for the same product
e.g. land can be used to grow barley OR wheat –> increase production of wheat due to high demand= less land available for barley= price of barley rises
interrelationship between markets- derived demand
- occurs when a particular good/factor of production is necessary for the provision of another good/service
- demand for one good is related to demand of a related good e.g. tinned tomatoes demand increases= demand for metal used to make tin increases in demand
- increase in demand for a product will create a derived demand for a related good/service
interrelationship between markets- joint supply
- occurs when the production of one good creates a by-product that also can be supplied (production of another good)
- increase in supply of one product will lead to an increase in the supply of another product e.g. sheep for meat will increase supply of wool, or wheat + shreddies
–> this will cause supply curve to shift outwards for both products and price to decrease
