Price Determination In A Competitive Market Flashcards
How does a demand curve shows the relationship between price and quantity demand?
What is a demand curve?
A demand curve shows the relationship between the price of a good or service and the quantity demanded by consumers, assuming all other factors remain constant (ceteris paribus). It typically slopes downward from left to right, reflecting the law of demand:
“As the price of a good falls, the quantity demanded increases, and vice versa.”
This inverse relationship occurs due to:
- The income effect – As prices fall, consumers’ purchasing power increases, allowing them to buy more.
- The substitution effect – If a good’s price falls, it becomes relatively cheaper compared to substitutes, leading to higher demand.
What factors can cause a shift in the demand curve?
A shift in the demand curve occurs when non-price factors (determinants of demand) change, causing demand to increase (rightward shift) or decrease (leftward shift) at every price level.
Factors That Shift the Demand Curve:
1. Changes in Income
2. Changes in Tastes and Preferences
3. Changes in the Price of Related Goods
4. Changes in Population and Demographics
5. Expectations of Future Prices
6. Government Policies and Regulations
7. Seasonal Changes
What can cause a movement along the demand curve?
Any factors that causes a change in price.
Where a shift in the demand curve occurs due to changes in non-price determinants.
What is the income elasticity of demand?
What is the relationship between YED and normal and inferior goods?
Income elasticity of demand (YED) measures how responsive of the quantity demanded of a good change in consumer income.
Types of Goods Based on YED:
Normal Goods (YED > 0): Demand increases as income rises.
Luxury goods (YED > 1): Demand rises more than proportionally with income (e.g., designer clothing, international holidays).
Necessities (0 < YED < 1): Demand rises less than proportionally with income (e.g., bread, electricity).
Inferior Goods (YED < 0): Demand decreases as income rises (e.g., instant noodles, second-hand cars).
Example: During economic growth, demand for luxury cars increases, while demand for fast food may fall as consumers switch to healthier, higher-quality options.
What is the cross elasticity of demand?
What is the relationship between XED and substitute & complementary goods?
Cross elasticity of demand (XED) measures how the quantity demanded of one good changes in response to a change in the price of another good.
Types of Goods Based on XED:
- Substitute Goods (XED > 0): A rise in the price of one good increases the demand for the substitute.
Example: If the price of Pepsi rises, demand for Coca-Cola increases.
- Complementary Goods (XED < 0): A rise in the price of one good decreases the demand for the complement.
Example: If the price of printers increases, demand for printer ink falls.
- Unrelated Goods (XED = 0): No relationship between the goods (e.g., cars and bananas).
Example: The rise of streaming services (e.g., Netflix) led to a decline in demand for DVDs, showing a strong positive XED between streaming and DVDs.
What is the price elasticity of demand?
What is the relationship between PED and the total revenue?
Price elasticity of demand (PED) measures how quantity demanded responds to a change in price.
Relationship Between PED and Total Revenue (TR):
- Elastic Demand (PED > 1): A price decrease increases TR, while a price increase reduces TR.
Example: Luxury goods like designer bags.
- Inelastic Demand (PED < 1): A price increase increases TR, while a price decrease reduces TR.
Example: Essential goods like petrol or medicine.
- Unitary Elastic Demand (PED = 1): A price change does not affect TR.
Example: Cigarettes have inelastic demand, meaning price hikes (e.g., via taxation) increase total revenue without significantly reducing sales.
What factors that influence elasticities of demand?
YED
Income levels, necessity vs. luxury
Designer clothes (high YED), rice (low YED)
XED
Strength of substitution or complementarity
Pepsi & Coca-Cola (high XED), Phones & Apps (strong complements)
PED
Availability of substitutes, necessity, time period, proportion of income spent
Petrol (low PED), Soft drinks (high PED)
What is a supply curve?
A supply curve shows the relationship between the price of a good or service and the quantity supplied by producers, assuming all other factors remain constant (ceteris paribus).
It typically slopes upward from left to right, reflecting the law of supply:
“As the price of a good rises, the quantity supplied increases, and vice versa.”
This positive relationship occurs because:
- Higher prices increase potential profits, incentivizing firms to expand production.
- New firms may enter the market, attracted by higher prices.
- Existing firms may allocate more resources to the production of that good.
Example: If oil prices rise, oil producers will extract and supply more oil to the market.
What factors may cause supply curve shifts?
A movement along the supply curve occurs only due to a change in price.
A shift in the supply curve occurs when non-price factors change:
- Changes in Production Costs
- Technological Improvements
- Government Taxes and Subsidies
- Changes in the Number of Producers
- Natural Factors and Shocks
- Expectations of Future Prices
- Regulations and Trade Policies
What is the price elasticity of supply?
Price elasticity of supply (PES) measures how much the quantity supplied of a good changes in response to a change in price.
Interpretation of PES values:
- PES > 1 (Elastic Supply): Supply responds significantly to price changes.
- PES < 1 (Inelastic Supply): Supply responds weakly to price changes.
- PES = 1 (Unitary Elasticity): Supply changes proportionally with price.
- PES = 0 (Perfectly Inelastic): Supply remains unchanged regardless of price.
- PES = ∞ (Perfectly Elastic): Any price decrease causes supply to drop to zero.
What factors can influence PES?
Spare Capacity
More spare capacity = more elastic supply.
If a factory has idle machines, it can increase output quickly.
Production Time
Shorter production time = more elastic supply.
Bread supply adjusts faster than oil production.
Stock Levels
High stock levels = more elastic supply.
Supermarkets can quickly supply more bottled water after a price rise.
Factor Mobility
More mobile resources = more elastic supply.
Workers who can quickly switch industries increase supply elasticity.
Time Period
PES is more elastic in the long run than in the short run.
Farmers need time to increase wheat production.
How the interaction of demand and supply determines equilibrium prices in a market economy?
Market equilibrium occurs when quantity demanded = quantity supplied, meaning there is no excess demand or excess supply.
- Equilibrium Price (Market-Clearing Price): The price at which demand and supply are equal.
- Equilibrium Quantity: The quantity exchanged at the equilibrium price.
How disequilibrium like excess demand and excess supply lead to a price change?
Excess Demand (Shortage)
Occurs when demand exceeds supply at a given price.
Cause: Price is too low.
Effect: Prices rise as consumers compete for limited goods.
Example: Housing shortages in London push prices up.
Excess demand → price rises → firms supply more → equilibrium restored.
Excess Supply (Surplus)
Occurs when supply exceeds demand at a given price.
Cause: Price is too high.
Effect: Firms lower prices to sell surplus stock.
Example: Overproduction of electric cars may lead to price reductions.
Excess supply → price falls → consumers demand more → equilibrium restored.
What types of demand relationship?
Joint demand (complementary goods)
- When two goods are consumed together, an increase in demand for one leads to an increase in demand for the other.
- Implication: Price or supply changes in one market directly impact another.
- Real-World Example: A rise in fuel prices reduces demand for cars that run on petrol/diesel.
competitive demand (substitute goods)
- When two goods are alternatives, an increase in demand for one reduces demand for the other.
- Implication: Firms must be aware of competitors’ pricing and product changes.
- Real-World Example: As more people switch to plant-based milk, demand for dairy milk declines.
composite demand
- When a good is demanded for multiple uses, changes in one market affect others.
- Implication: A rise in demand for one use can create shortages or price increases in others.
- Real-World Example: The rise of electric vehicle batteries increases demand for lithium, raising prices in the smartphone industry.
derived demand
- When demand for one good depends on demand for another.
- Implication: A downturn in one industry affects supply chains.
- Real-World Example: A decline in house construction reduces, demand for bricks, cement, and construction workers.
What types of supply relationship?
Joint Supply
- Definition: When producing one good automatically produces another.
- Example: Beef and leather – when cows are slaughtered for meat, leather is produced as a by-product.
- Implication: A change in the supply of one product affects the supply and price of its by-product.
- Real-World Example: If crude oil production falls, both petrol and diesel prices rise.
