Section 2 - Price Determination

Question 1

Market - definition

Answer 1

>A market is anywhere buyers and sellers can exchange goods and services.

Question 2

Sub-markets - deifintion

Answer 2

>Sub-markets are smaller markets that make up a market.
>For example, the labour market is made up of lots of sub-markets, e.g. the market for teachers, engineers and doctors.

Question 3

Supply and demand

Answer 3

>The price charged for and quantity sold of each good or service are determined by the levels of demand and supply in a market.
>The levels of demand and supply are shown using diagrams.
>These diagrams demonstrate the price level and quantity demanded/supplied of goods and services.

Question 4

Demand - definition

Answer 4

>Demand is the quantity of a good/service that consumers are willing and able to buy at a given price, at a particular time.

Question 5

What does a demand curve show?

Answer 5

>A demand curve shows the relationship between price and quantity demanded.
>At any given point along the curve it shows the quantity of the good or service that would be bought at a particular price.
>Demand curves can be curved but are more often drawn as straight lines. They’re usually labelled with a ‘D’.

Question 6

Demand Curves

Answer 6

>Demand curves usually slope downwards.
>This means that the higher the price charged for a good, the lower quantity demanded.
>At price ‘P’, the quantity ‘Q’ is demanded.
>A decrease in price from ‘P’ to ‘P1’ causes an extension in demand - it rises from ‘Q’ to ‘Q1’.
>An increase in price from ‘P’ to ‘P2’ causes a contraction in demand - it falls from ‘Q’ to ‘Q2’.
>So, movement along the demand curve is caused by changes in prices.

Question 7

Relationship between price and quantity demanded.

Answer 7

>In general, consumers aim to pay the lowest price possible for goods and services.
>As prices decrease more consumers are willing and able to purchase a good or service - so lower price means higher demand.
>The relationship between price and quantity demanded can also be explained using the law of diminishing marginal utility, and the income and substitution effects.

Question 8

Income effect

Answer 8

>Assuming a fixed level of income, the income effect means that as a price falls the amount that consumers can buy with their income increases, and so demand increases.

Question 9

Substitution effect

Answer 9

>A fall in the price of a good makes it relatively cheaper than other goods, so consumers will increase demand for the cheaper good and reduce demand for the more expensive good.

Question 10

Changes in demand and demand curves

Answer 10

>Changes in demand cause a shift in the demand curve.
>A demand curve moves to the left when there is a decrease in the amount demanded at every price.
>A demand curve shifts to the right when there is an increase in the amount demanded at every price.

Question 11

Factors causing a shift in the demand curve.

Answer 11

>Changes in tastes and fashion can cause demand curves to shift to the right is something is popular and to the left when it is out of fashion.
>Changes to people’s real income, the amount of goods/services that a consumer can afford to purchase with their income, can affect the demand for different types of goods differently: normal goods, inferior goods, luxury goods.
>Changes in demand in one market can affect demand in other markets.

Question 12

Normal goods

Answer 12

>Normal goods (e.g. DVDs) are those which people will demand more of if their real income increases.
>This means that a rise in real income causes the demand curve to shift to the right - people want to buy more of the good at each price level.

Question 13

Inferior goods

Answer 13

>Inferior goods (e.g. cheap clothing) are those which people demand less of if their real income increases.
>This means that a rise in real income causes the demand curve to shift to the left - people demand less at each price level since they’ll often switch to more expensive goods instead.

Question 14

Luxury goods

Answer 14

>A more equal distribution of income (i.e. a reduction in the difference between the incomes of rich and poor people) may cause the demand curve for luxury goods (e.g. sports cars) to shift to the left - and the demand curve for other items to shift to the right.
>This is because there’ll be fewer really rich people who can afford luxury items, and more people who can afford everyday items.

Question 15

Changes in demand in one market

Answer 15

>Some markets are interrelated, which means that changes in one market affect a related market.
>Substitute goods.
>Complementary goods.
>New products.
>Derived demand.
>Multi-use products.

Question 16

Interrelated markets - shifts in demand curve - substitute goods

Answer 16

>Substitute goods are those which are alternatives to each other - e.g. beef and lamb.
>An increase in the price of one good will decrease the demand for it and increase that demand for its substitutes.
>This is also known as ‘competitive demand’.

Question 17

Interrelated markets - shifts in demand curve - complementary goods

Answer 17

>Complementary goods are goods that are often used together, so they’re in joint demand - e.g. strawberries and cream.
>If the price of strawberries increases, demand for them will decrease along with the demand for cream.

Question 18

Interrelated markets - shifts in demand curve - new products

Answer 18

>The introduction of a new product may cause the demand curve to shift to the left for goods that are substitutes for the new product and to the right for goods that are complementary to it.

Question 19

Interrelated markets - shifts in demand curve - derived demands

Answer 19

>Derived demand is the demand for a good or a factor of production used in making another good or service.
>For example, an increase in the demand for fencing will lead to an increased derived demand for wood.

Question 20

Interrelated markets - shifts in demand curve - multi-use products

Answer 20

>Some goods have more than one use, e.g. oil can be used to make plastics or for fuel - this is composite demand.
>This means changes in the demand curve for fuel could lead to changes in the demand curve for plastics.

Question 21

Price Elasticity of Demand (PED) - definition

Answer 21

>PED is a measure of how the quantity demanded of a good responds to a change in its price.
>Usually negative because demand falls as price increases for most goods.

Question 22

PED formula

Answer 22

% change in Qd/ % change in price.

Question 23

What types of PED are there?

Answer 23

1. Elastic demand. PED > 1.
2. Inelastic demand. 0 < PED < 1.
3. Unit elasticity of demand. PED = -/+ 1.

Question 24

Elastic (relatively elastic) demand

Answer 24

>The value of PED is greater than 1 as a % change in price will cause a larger % change in quantity demanded.
>The higher the PED, the more elastic demand for the good is.
>Perfectly elastic demand has a PED of +/- infinity and any increase in price means that demand will fall to zero. Consumers are willing to buy all they can obtain at a particular price, but none at a higher price.

Question 25

Inelastic (relatively inelastic) demand

Answer 25

>PED is between 0 and 1. This means a % change in price will cause a smaller % change in quantity demanded. The smaller the value of PED, the more inelastic demand for the good is.
>Perfectly inelastic demand has a PED of 0 and any change in price will have no effect on the Qd. At any price, the Qd will be the same.

Question 26

Unit Elasticity of Demand

Answer 26

>PED = +/- 1.
>The size of the % change in price is equal to the % change in Qd.

Question 27

Income Elasticity of Demand

Answer 27

>Income elasticity of demand (YED) measures how much the demand for a good changes with a change in real income.

Question 28

Types of YED

Answer 28

>Income elastic. YED > 1.
>Income inelastic. YED < 1.
>Perfectly inelastic. YED = 0.

Question 29

Cross Elasticity of Demand

Answer 29

>Cross elasticity of demand (XED) is a measure of how the quantity demanded of one good responds to a change in the price of another good.
>If two goods are substitutes their XED will be positive and if they’re complements their XED will be negative.

Question 30

XED formula

Answer 30

> % change in Qd of good A/ % change in price of good B.

Question 31

What factors influence the PED?

Answer 31

1. Substitutes. (biggest influence).
2. Type of good (or service).
3. Percentage of income spent on the good.
4. Time.

Question 32

PED influencers - substitutes

Answer 32

>The more substitutes a good has, the more price elastic demand is - if there are many substitutes available then consumers can easily switch to something else if the price rises.
>The number of substitutes a good has depends on how closely it’s defined, e.g. peas have a number of substitutes (like carrots and sweetcorn), but vegetables as a group have fewer.

Question 33

PED influencers - type of good (or service)

Answer 33

>Demand for essential items is price inelastic but demand for non-essential items tends to be price elastic.
>Demand for goods that are habit-forming (e.g. alcohol, tabacco) tends to be price inelastic.
>Demand for purchases that cannot be postponed (e.g. emergency plumbing services) tends to be price inelastic.
>Demand for products with several different uses (e.g. water) tends to be price inelastic.

Question 34

PED influencers - percentage of income spent on good

Answer 34

>Demand for products that need a large proportion of the consumer’s income is more price elastic than demand for products that only need a small proportion of income. Consumers are more likely to shop around for the best price for an expensive good.

Question 35

PED influencers - time

Answer 35

>In the long run demand becomes more price elastic as it becomes easier to change to alternatives because consumers have had the time to shop around.
>Also, in the long run, habits and loyalties can change.

Question 36

Firms use of PED

Answer 36

>Firms need to understand the relationship between total revenue (price per unit x quantity sold) and a product’s PED.
>Elasticity changes along a straight-line demand curve.

Question 37

Straight-line demand curve and PED

Answer 37

>PED changes along the demand curve from minus infinity at high price/zero demand, through an elasticity of minus 1 at the midpoint, to an elasticity of zero at zero price/high quantity demanded.
>The total revenue changes as move along the demand curve.
>Total revenue is maximised when PED = -1. The nearer a firm sets a product’s price to the mid-point of the demand curve, the higher its total revenue will be.

Question 38

Demand curve and elastic demand

Answer 38

>A reduction in price will increase the firm’s total revenue.
>An increase in price will reduce the firm’s total revenue.

Question 39

Demand curve and inelastic demand

Answer 39

>A reduction in price will reduce the firm’s total revenue.
>An increase in price will increase the firm’s total revenue.

Question 40

Normal goods and YED

Answer 40

>These goods has a positive YED (0 < YED < 1).
>As income rises, demand increases.
>The size of the demand increase is dependent on the product’s elasticity.
>If the YED of a product is elastic (YED > 1) then it’s a luxury (or superior) good.

Question 41

Inferior goods and YED

Answer 41

>These goods have negative YED (YED < 0).
>As incomes rise, demand falls.
>A rise in income will lead to the inferior good being replaced with one considered to be of higher quality.

Question 42

XED and substitute goods

Answer 42

>Substitutes have positive XEDs. A fall in the price of one substitute will reduce the demand for the other.
>The closer the substitutes, the higher the positive XED.

Question 43

XED and complementary goods

Answer 43

>Goods that are complements have negative XEDs.
>An increase in the price of a good will lead to a reduction in demand for its complements.

Question 44

A zero XED

Answer 44

>Goods which have a XED of zero are independent (or unrelated) goods and don’t directly affect the demand of each other.

Question 45

Supply - definition

Answer 45

>Supply is the quantity of a good or service that producers supply to the market at a given price, at a particular time.

Question 46

Extension along the supply curve

Answer 46

>An increase in price causes an extension in supply.

Question 47

Contraction along the supply curve

Answer 47

>A decrease in price causes a contraction in supply.

Question 48

Supply Curve

Answer 48

>Slope upwards - higher price = higher quantity supplied.
>Producers and sellers aim to maximise their profits. Ceteris paribus, the higher the price for a good or service the higher the profit.
>Higher profit provides incentive to expand production and increase supply, which explains why the quantity supplied of a good/service increases as price increases.
>However increasing supply increases costs. Firms will only produce more if the price increases by more than the cost.
>Increased prices mean that it will become profitable for marginal firms (these are firms that are just breaking even) to supply the market - increasing market supply levels.
>In perfect competition, the supply curve is the marginal cost curve.

Question 49

Factors which cause a shift in the supply curve - list

Answer 49

1. Changes to the costs of production
2. Improvements in technology
3. Changes to the productivity of factors of production
4. Indirect taxes and subsidies.
5. Changes to the price of other goods.
6. Number of suppliers.

Question 50

Factors which cause a shift in the supply curve - changes to the costs of production

Answer 50

>An increase in one or more of the costs of production will decrease producer’s profits and cause the supply curve to shift left.
>It a cost of production decreased, the supply curve would shift right.

Question 51

Factors which cause a shift in the supply curve - improvements in technology

Answer 51

>Technological improvements can increase supply as they reduce the costs of production.
>E.g. improvements in energy efficiency of commercial freezers could reduce the energy costs of a food company.

Question 52

Factors which cause a shift in the supply curve - changes to the productivity of factors of production

Answer 52

>Increased productivity of a factor of production means that a company will get more output from a unit of the input.
>Reduces costs.
>Supply curve shifts right.

Question 53

Factors which cause a shift in the supply curve - indirect taxes and subsidies

Answer 53

>An indirect tax on a good effectively increases costs for a producer - this means that the supply is reduced and the supply curve shifts left.
>A subsidy on a good encourages its production as it acts to reduce costs for producers - this shifts curve right.

Question 54

Factors which cause a shift in the supply curve - changes to the price of other goods

Answer 54

>If the price of one product (A) made by a firm increases, then a firm may switch production from a less profitable one (B) to increase production of A and make the most of the higher price that they can get for it.
>This decreases the supply of product B.

Question 55

Factors which cause a shift in the supply curve - number of suppliers

Answer 55

>An increase in the number of suppliers in a market (including new firms) will increase supply to the market, shifting curve right.

Question 56

Joint supply - definition

Answer 56

>Joint supply is where the production of one good or service involves the production another (or several others) - it’s another example of when markets are interrelated.
>E.g. if crude oil is refined to make petrol this will also increase the supply of butane.

Question 57

Joint supply info

Answer 57

>If the price of a product increases, then supply of it and any joint products will also increase.
>E.g. if petrol prices increase, the level of drilling for oil will rise and the supply of petrol and its joint products will increase.

Question 58

Price Elasticity of Supply - definition

Answer 58

>PES is a measure of how the quantity supplied of a good responds to a change in its price.

Question 59

PES - formula

Answer 59

>%change in Qs divided by %change in price.
>PES is generally positive since the higher the price the greater the supply.

Question 60

PES - types brief

Answer 60

1. Inelastic = 0 < PES < 1.
2. Elastic = PES > 1.
3. Unit elasticity of supply: PES = 1.
4. Perfectly inelastic: PES = +/- infinity.
5. Perfectly inelastic: PES = 0

Question 61

Elastic PES

Answer 61

> PES > 1.
>This means a percentage change in price will cause a larger percentage change in quantity supplied.
>Perfectly elastic supply has a PES of +/- infinity and any fall in price means that the quantity supplied will be reduced to zero.

Question 62

Inelastic PES

Answer 62

> 0This means a percentage change in price will cause a smaller percentage change in quantity supplied.
>Perfectly inelastic supply means that any change in price will have no effect on the quantity supplied.

Question 63

What is important for firms in terms of PES?

Answer 63

>A high PES is important to firms.
>Firms aim to respond quickly to changes in price and demand.
>To do so they need to make their supply as elastic (i.e. responsive to a price change) as possible.
>Measures undertaken to improve the elasticity of supply include flexible working patterns, using the latest technology and having spare production capacity.
>E.g. if a firm has spare production capacity it can quickly increase supply of a good without an increase in costs (e.g. the cost of building a new factory).

Question 64

PES - short run

Answer 64

>Over short periods of time firms can find it difficult to switch production from one good to another.
>This means that supply is likely to be more price inelastic in the short run compared to the long run.
>The short run is the time period when a firm’s capacity is fixed, and at least one factor of production is fixed.
>Capital is often the FoP that’s fixed in the SR - a firm can recruit more workers and buy more materials, but it takes time to build additional production facilities. This means that it can be difficult to increase production in the SR, so supply in the SR is inelastic.

Question 65

PES - long run

Answer 65

>In the long run all the FoP are variable - so in the LR a firm is able to increase its capacity.
>This means that supply is more elastic in the LR because firms have longer to react to changes in price and demand.

Question 66

Industries - LR and SR

Answer 66

>The distinction between long run and short run varies with different industries because production times and levels of capital equipment vary between industries.
>For example, the long run for a firm that makes sandwiches will be a shorter time than that of a firm that builds ships - to change production levels in ship building requires more capital equipment, more planning etc. Because ships take longer to produce than sandwiches, the supply of ships is more inelastic.

Question 67

Factors that affect PES

Answer 67

1. Long run and short run
2. During periods of unemployment supply tends to be more elastic - it’s easy to attract new workers if a firm wishes to expand.
3. Perishable goods have an inelastic supply as they can’t be stored for very long.
4. Firms with high stock levels often have elastic supply - they’re able to increase supply quickly if they want to.
5. Industries with more mobile factors of production tend to have more elastic supply. E.g. those that find it easy to expand their labour force and don’t have production and machinery/facilities that are difficult to relocate. For example, industries that employ lots of unskilled workers may find it easy to increase their labour force.