1.3 Price determination in a competitive market

Question 1

Law of demand

Answer 1

As price increases, quantity demanded decreases. As price decreases, quantity demanded increases.

Question 2

Market

Answer 2

anywhere where buyers and sellers come together, a price is agreed and a transaction takes place

Question 3

Price

Answer 3

amount of money that must be paid to acquire a good or service

Question 4

Demand

Answer 4

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

Question 5

Consumer expenditure

Answer 5

the amount of money consumers spend on a given quantity of goods in a given period of time

Question 6

Rationing function of prices

Answer 6

The rationing function of price is the way in which rising prices reduce demand or limit access to a good or service, ensuring that only those who are willing and able to pay can obtain it.

When a good becomes scarce (e.g. due to a supply shock), its price increases. This discourages some consumers from buying it, thus reducing excess demand. The higher price “rations” the limited supply to those who value it the most (those who are willing to pay more).

Question 7

Consumer surplus

Answer 7

Consumer surplus is the extra utility consumers receive when they pay a price lower than what they were willing to pay.

Question 8

Utility

Answer 8

the economic welfare an individual gains from consuming a good

Question 9

Law of diminishing marginal utility

Answer 9

for one consumer, the marginal utility from a good decreases for each additional unit consumed

Question 10

Normal good

Answer 10

when the demand for a good increases as incomes rises and demand decreases as income fall

Question 11

Inferior good

Answer 11

when the demand for a good decreases as income rises and demand increases as income falls

Question 12

Complementary good

Answer 12

a good which is in joint demand, or which is demanded at the same time as the other good (gloves and scarfs)

Question 13

Substitute good

Answer 13

a good in competing demand, or which can be used in place of the other good

Question 14

Direct tax

Answer 14

a direct tax is a tax that is paid directly to the government by individuals or organizations based on their income or wealth

Question 15

Causes of changes in demand (7)

Answer 15

• change in price or related goods
• changes in incomes
• Fashions, Tastes and preferences
• Advertising and branding
• Demographic change
• External shocks (pandemics, natural disaster)
• Seasonal factors

Question 16

extension in demand

Answer 16

the increase in quantity demanded due to a fall in price

Question 17

contraction in demand

Answer 17

the fall in the quantity demanded due to a rise in price

Question 18

Total revenue

Answer 18

the total amount of money a firm receives by selling goods or services

Question 19

Total revenue formula

Answer 19

Price x Quantity

Question 20

Marginal revenue

Answer 20

change in total revenue from an additional unit of output

Question 21

Marginal revenue formula

Answer 21

change in total revenue / change in quantity

Question 22

Price elasticity of demand (PED)

Answer 22

measures the extent to which the demand for a good changes in response to a change in the price of that good

Question 23

PED formula

Answer 23

% change in quantity demanded / % change in price( new-old/old)

Question 24

Perfectly price inelastic

Answer 24

The quantity demanded does not change in response to price changes; PED = 0

Question 25

Perfectly price elastic

Answer 25

consumers will only buy at one specific price, and any change in price causes demand to fall to zero (or become infinite if the price drops). PED = ∞

Question 26

inelastic PED

Answer 26

PED < 1

Question 27

elastic PED

Answer 27

PED > 1

Question 28

Factors affecting PED (5)

Answer 28

- how close substitutes are to product - availability of substitutes - change of price of luxuries - addiction - whether purchase can be postponed

Question 29

Income

Answer 29

the flow of money a person or household receives in a particular time period

Question 30

Income elasticity of demand (YED)

Answer 30

measures the extent to which the demand for a good changes in response to a change in the income of consumers.

Question 31

YED

Answer 31

% change in quantity demanded / % change in income

Question 32

What is the YED for normal goods?

Answer 32

positive

Question 33

What is the YED for inferior goods?

Answer 33

Negative

Question 34

Cross elasticity of demand (XED)

Answer 34

measures the extent to which the demand for a good changes in response to a change in the price of another good.

Question 35

XED formula

Answer 35

% change in quantity demanded of good X / % change in price of good Y

Question 36

What is the XED for complementary goods?

Answer 36

Negative

Question 37

What is the XED for substitutes?

Answer 37

Positive

Question 38

Total cost

Answer 38

the whole cost of producing a particular level of output

Question 39

Producer revenue

Answer 39

the amount of money received by producers from selling a given quantity of goods in a given period of time

Question 40

Incentive function

Answer 40

when prices for a good/service rise, it incentivises producers to reallocate resources from a less profitable market to this market in order to maximise their profits

Question 41

Producer surplus

Answer 41

a measure of the economic welfare enjoyed by firms or producers: the difference between the price a firm succeeds in charging and the minimum price it would be prepared to accept

Question 42

Indirect tax

Answer 42

a tax which can be shifted by the person legally liable to pay the tax onto someone else, for example through raising the price of a good being sold by the taxpayer. They are normally levied on spending

Question 43

Ad valorem tax

Answer 43

a tax added on as a percentage, such as VAT

Question 44

Tax per unit

Answer 44

a set tax levied per good sold, regardless of the good's price, such as passenger duty on airfares; causes a leftward shift in supply curve

Question 45

Subsidy

Answer 45

a payment made by government or other authority, usually to producers, for each unit of the relevant good they produce; causes a rightward shift of the supply curve

Question 46

Law of supply

Answer 46

producers offer more of a good as its price increases and less as its price falls

Question 47

Describe an extension of supply

Answer 47

a movement along the supply curve to the right (higher price & higher quantity supplied).

Question 48

Describe a contraction of supply

Answer 48

movement along the supply curve to the left (lower price & lower quantity supplied).

Question 49

Producer revenue =

Answer 49

producer surplus + the cost to producers of supplying

Question 50

Factors affecting supply (8)

Answer 50

- Changes in costs of production - Introduction of new technology - Indirect taxes - Government subsidies - External Shocks - changes in productivity - changes in prices of other goods - new firms entering the market

Question 51

Price elasticity of supply (PES)

Answer 51

measures how much the supply of a good changes in response to a change in the price of that good

Question 52

PES formula

Answer 52

% change in quantity supplied / % change in price

Question 53

Factors determining PES (6)

Answer 53

- The length of production period - The availability of spare capacity - The ease of accumulating stocks - The ease of switching between alternative production methods - The number of firms in the market - The ease of entering the market

Question 54

Shortage

Answer 54

Excess demand If there is excess demand, market forces will result in an extension in supply and a contraction in demand, causing a rise in price to its market clearing level. This is because firms will spot this excess demand and recognise that they will have to increase prices in order to ration demand. Furthermore, as firms increase their prices, supplies will be willing to supply greater the good in greater quantities due to the profit motive. Both the contraction in demand an extension of supply will result in the market reaching equilibrium.

Question 55

Surplus

Answer 55

Excess supply If there is excess supply, market forces will result in a contraction in supply and an extension in demand, causing a fall in price to its market clearing level. This shortage in demand will result in a decrease in the price of the good as firms will realise that they have to lower their prices if they are to sell all their goods. This is also combined with the fact that when firms start to lower their price, demand will also increase. The combination of a contraction in supply (fewer firms will be willing to supply at the same quantity given a decrease in price) and increase in demand will cause the market to reach equilibrium.

Question 56

Equilibrium price

Answer 56

price where quantity supplied equals quantity demanded.at this price there is no shortage or surplus, and there is no tendency for the market price to change

Question 57

Free market forces

Answer 57

forces in free markets which act to reduce prices when there is excess supply and raise prices when there is excess demand

Question 58

Deadweight loss

Answer 58

the loss of welfare when the maximum attainable level of total welfare is not achieved

Question 59

Joint supply

Answer 59

when one good is produced, another good is also produced from the same raw materials (e.g. beef and leather)

Question 60

Joint demand

Answer 60

a good which is demanded at the same time as another good (e.g. printers and ink cartridges)

Question 61

Competing demand

Answer 61

a good which can be used in place of the other good

Question 62

Composite demand

Answer 62

demand for a good which has more than one use (e.g. oil for plastics and oil for petrol)

Question 63

Derived demand

Answer 63

Quantity demand for a good which is an input into the production of another (e.g. houses and bricks)

Question 64

consequence of tax

Answer 64

The tax burden on the taxpayer

Question 65

consequence of subsidy

Answer 65

the subsidy burden on the subsidy recipient

Question 66

Impact of changing price on revenue when demand is price elastic

Answer 66

If price decreases, total revenue increases (because the increase in quantity demanded is large enough to offset the lower price). If price increases, total revenue decreases (because the decrease in quantity demanded is large enough to outweigh the higher price).

Question 67

Impact of changing price on revenue when demand is price inelastic

Answer 67

If price increases: Total revenue increases because the percentage decrease in quantity demanded is smaller than the percentage increase in price. If price decreases: Total revenue decreases because the percentage increase in quantity demanded is smaller than the percentage decrease in price.

Question 68

Impact of changing price on revenue when demand is unitary price elastic

Answer 68

total revenue will remain unchanged as price changes

Question 69

unitary price elastic

Answer 69

the percentage change in quantity demanded is exactly equal to the percentage change in price.

Question 70

increase and decrease in demand

Answer 70

A decrease in the demand for a good/service will result in a decrease in quantity (Q to Q1) as well as a reduction in price (P to P1). If the firm was to keep the good/service at the same price then there would be an excess of supply. Therefore by reducing the price it encourages firms to produce less quantity of the good/service thus allowing the market to reach equilibrium. An increase in the demand for a good/service will result in an increase in the price (P to P2) as well as an increase in quantity (Q to Q2). This is due to the fact that if the price of the good stayed the same then there would be an excess of demand. Therefore by increasing the price it helps to ration the demand for the good/service as well as incentivising suppliers to increase the quantity that they supply.

Question 71

increase and decrease in supply

Answer 71

An increase in the supply of a good/service will result in a higher quantity supplied (Q to Q1) and a lower price (P to P1). If the price were to remain the same, there would be an excess of supply, leading to unsold goods. By allowing the price to fall, consumers are encouraged to buy more, while producers may reduce future output, helping the market return to equilibrium. The lower price also makes the good/service more accessible, balancing the increased availability with higher demand. A decrease in the supply of a good/service will lead to a lower quantity supplied (Q to Q1) and a higher price (P to P1). If the price stayed unchanged, demand would exceed supply, creating shortages. The rising price helps ration the limited supply to those willing to pay more, while also incentivizing producers to increase output if possible. This adjustment ensures that the market clears, balancing the reduced supply with the available demand.