Working of Competitive Markets Flashcards
What can the firm influence in the internal environment?
Factors
○ Quality of goods- affects quantity, price
○ Climate- affects products and supply chains
○ Management structure- how is it organised
○ Geography- where they’re actually located
○ Employees- productivity
○ Government policy
-State of the economy; financial crisis, economic growth; tax policy
○ Competitors (partly external as well)
○ Central bank interest rate
○ Production cycle- time between creating to getting it to the market
○ Technological developments (& external)
What does the firm have little control over in the external environment?
Factors:
○ Prices of raw materials
How do changes in the economy affect businesses?
- Logistical operations (how to ship things)
- Trading blocks- e.g. US and EU; US and China; UK and Brexit
- Financial crisis-
- Bitcoin- online currency; volatile and risky- globalised currency?
- Political changes- e.g. Trump; Brexit - exchange rates, location
- Shift in Power- emergence of newer countries, global power
What is the central economic problem?
Scarcity
• Finite resources
- lack of resources/inputs
e. g. land, labour, raw materials, enterprise
• Infinite wants
-wants are endless
infinite wants, finite resources
What is economics
the science of choice
-how to allocate money, choices, how many people to employ etc.
What are the two sides of the market?
Demand- infinite want (what consumers want to purchase)
Supply- finite resources ( how businesses create)
Define the Price mechanism
balance between supply and demand
What is the Demand Curve?
it demonstrates the relationship between two variables
Constructed in ceteris paribus:
• Holding everything else constant (all factors that influence the model are constant) then asking the question
Define Substitution effect
idea that as the price of a good goes down, other products become relatively more expensive and customers will buy the cheaper product, so demand increases
define income effect
when the price of a good goes down, the real income will go up.
Though actual income doesn’t change, real income does change
define ‘real’
taking into account the price level
E.g. wages- how much money you earn
real wages- given the amount of money I earn, how much can I buy given the prices you see.
What will cause the demand curve to shift?
• Change in price- movement along the D curve (moves up and down)
• Change in any other determinant of demand- shift in D curve (not including price)
○ Increase in demand - rightward shift (outward)
○ Decrease in demand - leftward shift (inward)
Causes of rise in demand
- Tastes shift towards this product
- Rise in price of substitute goods
- Fall in price of complementary goods
- Rise in income
- Expectations of a rise in price.
Why does the demand slope downwards
- Income Effect
- Substitution effect
- law of diminishing marginal Utility theory
note: will slope down for normal and inferior goods, but up for Giffen goods, as the income effect outweighs the substitution effect
Define law of diminishing marginal Utility Theory
○ How much welfare/ satisfaction you receive from one more of a particular good
○ How much you are willing to pay to one more
e.g. 1 more pizza slice
○ The greater amount of utility you receive, the more the consumer will be willing to pay for it
○ Downwards sloping marginal utility curve
-Diminishing marginal utility
○ Marginal utility = 0
-No additional satisfaction from consuming one more of a product
Do firms have demand curves?
- All firms construct them, however curves usually based on past data or forecast data
- All firms know is how much they are selling at a given price- only one point on the curve
Firm demand curve vs. market demand curve
- Market change, less of a change in the demand curve- as this is multiple firms
- Market is more flatter than the firms
What is the key problem with using estimated demand functions?
- Doesn’t accurately represent how people behave
* Assumed that every other variable that affected the demand was constant
Are more variables in a demand function good?
not necessarily,
• More variables you add, the more complicated the demand curve becomes
• Variables become related, causes statistical errors
What does it mean when the demand curve is sloping downwards?
• Product is either inferior or normal -NOT a Giffen good
define a Giffen Good
a staple good
A good where a higher price causes an increase in demand (reversing the usual law of demand).
The increase in demand is due to the income effect of the higher price outweighing the substitution effect.
Define Price Elasticity of demand
numerical measure of the responsiveness of demand to a change in price
PED= Percentage change in market demand for a product / Percentage change in market price for a product
What sign should we expect PED to have
○ Expect a -ve sign- as there is an inverse relationship between price and demand
Why do we use proportions or percentage changes for PED?
- To compare different units of measurement, we convert them to percent so they are the same unit
- To compare different products
i. To see if a change in price is big or small e.g. doubled
What value will the PED figure have (greater or less than one)?
○ Depends on how responsive it is
○ Size is affected by different factors, main factor is the number/ closeness of substitutes
What is the Spectrum of Price elasticity of Demand?
Perfectly elastic demand Elastic demand Unit elastic demand Inelastic Demand Perfect Inelastic demand
What is Perfectly elastic demand?
if there is a change in price, there will be an infinite change in demand
• A horizontal demand curve
• PED = - infinity
What is Elastic Demand?
percentage change in demand > percentage change in price
• -Infinity < PED < - 1
• Flat demand at any price
What is Unit Elastic Demand?
percentage change in demand = percentage change in price
• PED = -1
• Demand curve = exponential line
If price changes, Total revenue/ expenditure will not change
What is Inelastic Demand?
percentage change in demand < percentage change in price
• -1 < PED < 0
• Steep demand at any price
What is Perfect inelastic demand?
If the price changes, demand will remain the same, demand in unresponsive
• A vertical demand curve
• PED = 0
What is the point elasticity of demand formula used for?
- Firms wants to know what the elasticity of demand is on one point of the curve
- Ranges from - ∞ to 0
- At higher prices, demand is more price elastic
- Low prices, inelastic demand
What is the formula for the price elasticity of demand?
Price elasticity of demand = dQ/dP × P/Q
○ dQ/dP - rate of change of quantity over price
○ P/Q- price: quantity ratio
When is elasticity constant?
- Price elasticity the same in perfect elastic demand
- Unit elastic demand
- Perfect inelastic demand
Why do firms need to know about price elasticity of demand?
• Affects its total revenue
○ Tells them how to change pricing strategy e.g. raise or lower
Price elasticity of demand affects a firm’s sales revenue and consumer expenditure (TE = TR = P x Q)
What is Price elastic demand?
a) price rises, quantity falls proportionately more; therefore total expenditure (P x Q) falls
b) price falls, quantity rises proportionately more; therefore total expenditure (P x Q) rises
If the increase in price = fall in demand nothing changes
A) P increase, q decreases by a lot more so total expenditure must go down = total revenue
B) Upward affect on Q bigger than P, so total expenditure goes up
What is Price inelastic demand?
a) price rises, quantity falls proportionately less; therefore total expenditure (P x Q) rises.
b) price falls, quantity rises proportionately less; therefore total expenditure (P x Q) falls
What is income elasticity of demand?
How responsive is demand to a change in income
• Can use demand function to work out elasticity
○ Multiply variable by P/Q or Y/Q
What is the measurement, determinants and application to business for Income elasticity of demand?
• measurement
○ normal goods (positive elasticity)
§ Income goes up, demand goes down
○ inferior goods (negative elasticity)
• determinants
○ degree of ‘necessity’ of the good
• applications to business
○ importance of perceptions of the product
○ repositioning a product
What is Cross-price elasticity of demand?
How responsive is a firms demand to a change in price in a competitor
What is the measurement, determinants and application to business for Cross-price elasticity of demand?
• measurement
○ substitute goods (positive elasticity)
○ complementary goods (negative elasticity)
• determinants
○ closeness of complements or substitutes
○ time period
• applications to business
○ effects of changes in competitors’ pricing strategy
○ strategies to make a product less cross elastic
What is the Supply Curve?
- As prices go up, it becomes more profitable to produce
* More firms come into the market as they can make a profit from supplying a product
Define Law of diminishing returns
as supply goes up, marginal costs will increase
○as P goes up, Q goes up
What causes movements in the supply curve
• change in price
⇒ movement along S curve
• change in any other determinant of supply ⇒ shift in S curve
– increase in supply ⇒ rightward shift
– decrease in supply ⇒ leftward shift
Causes of a rise in supply
- Fall in costs of production
- Reduced profitability of alternative products that could be supplied
- Increased profitability of goods in joint supply
- Benign shocks
- Expectations of a fall in price
Define Price Elasticity of Supply
The responsiveness of supply to a change in price
• Positive relationship- PES always positive
PES = Percentage change in market supply of a product / Percentage change in market price for a product
Factors that affect PES
- Time period- supply more elastic in long-run
* Capacity of the firm to produce/ availability of raw materials
What is the Price and Output determination?
• Equilibrium price and output ○ response to shortages and surpluses § shortage (D > S) ⇒ price rises § surplus (S > D) ⇒ price falls
○ significance of ‘equilibrium’ (market clearing price)
§ Demand and supply are equal, no surplus or shortage
§ Nothing changes; Market will continue to adjust until equilibrium in established
why does the supply curve slope upwards?
Supply slopes upwards because
- higher prices mean more profits,
- so firms are encouraged to supply more.
- because as production rises, marginal costs rise due to diminishing marginal returns,
- firms must be able to charge a higher price to justify increased production
how does the law of diminishing marginal utility explain why the demand curve slopes downwards?
- as more of a good is consumed, diminishing marginal utility sets is, so each additional unit is valued at less and less.
- consumers are willing to pay less for it and so we have a demand curve that slopes downwards.
- This is backed up by the substitution and income effects.
