Price determination in a competitive market (micro)

Question 1

Determinants of Demand

Answer 1

There is an inverse relationship between P and Qd. Demand is the quantity of a good/service consumers are willing and able to buy at a given price in a given time period.
Downward sloping due to substitution and income effects.
Determinants:
P - population
A - advertising
S - substitute’s price
I - income
F - fashion taste
C - complements price

Question 2

Determinants of Supply

Answer 2

• costs of production
• price of complement
• price of substitute
• technology
• expected future price.

Question 3

Normal good

Answer 3

A normal good is a good that experiences an increase in demand due to an increase in a consumer’s income. Normal goods have a positive correlation between income and demand. Examples of normal goods include food, clothing, and household appliances.

Question 4

Inferior good

Answer 4

An inferior good is an economic term that describes a good whose demand drops when people’s incomes rise. These goods fall out of favour as incomes and the economy improve as consumers begin buying more costly substitutes instead.

Question 5

Income effect

Answer 5

The income effect is the resultant change in demand for a good or service caused by an increase or decrease in a consumer’s purchasing power or real income. As one’s income grows, the income effect predicts that people will begin to demand more (and vice-versa).

Question 6

Substitution effect

Answer 6

The substitution effect is the decrease in sales for a product that can be attributed to consumers switching to cheaper alternatives when its price rises. When the price of a product or service increases but the buyer’s income stays the same, the substitution effect generally kicks in.

Question 7

PED

Answer 7

Elastic - a change in price causes consumer expenditure to fall. PED > 1
Inelastic - A price rise causes total consumer expenditure to rise. PED < 1
Unit elastic = 1
Perfectly elastic = Infinity
Perfectly inelastic = 0
Calculation: PED = (% change Qd)/(% change price)
Always negative

Question 8

Determinants of PED

Answer 8

S - substitutes
P - percentage of income
L - luxury
T - time

Question 9

YED

Answer 9

Measures the responsiveness of demand to a change in income.
YED = (% change demand)/(% change income).
Income elastic demand– when demand is highly & positively responsive to a change in income
Income inelastic demand– when demand only responds a little to a change in income
Inferior good- a product with a negative income elasticity of demand
Normal good– any product with a positive income elasticity of demand
Luxury good– a product with a highly positive income elasticity of demand (YED > +1)

Question 10

XED

Answer 10

measures the responsiveness of the quantity demanded of one good to a change in the price of another good. It tells us how much the demand for one good is affected by a change in the price of another good.
XED = (% change Qd A)/(% change P B).
positive = substitutes
negative = complements
close to zero = unrelated
zero = independent goods

Question 11

PES

Answer 11

Measures the responsiveness of supply to a change in price.
PES = (% change Quantity supplied)/(% change in price).
Determinants:
- Time taken to make goods.
- Extent of spare capacity in the production process.
- Level of stock held.
- How easy it is to switch production.

Question 12

Spare capacity

Answer 12

Spare capacity occurs when a business is not making full use of its available capacity – there are spare factors of production including land, labour and capital. When an economy has plenty of spare capacity, short run aggregate supply (SRAS) is elastic, and the output gap is negative.

Question 13

Total Revenue

Answer 13

Total revenue (TR) = price per unit multiplied by quantity sold. Total revenue is the total amount of money that a company brings in from the sale of its products or services. It’s calculated by multiplying the price of a product or service by the number of units sold.
If demand is elastic, cutting price = more total revenue
If demand in inelastic, raising price = more total revenue
if demand is unitary then any moderate price change won’t lead to any change in revenue.

Question 14

Market equilibrium

Answer 14

A market is said to be in equilibrium when where is a balance between demand and supply. If something happens to disrupt that equilibrium (e.g. an increase in demand or a decrease in supply) then the forces of demand and supply respond (and price changes) until a new equilibrium is established.

Question 15

Price mechanism

Answer 15

The price mechanism is the way in which prices are determined in a market economy. It is a central feature of the market system, which relies on the forces of supply and demand to allocate resources and distribute goods and services.

Question 16

Consumer surplus

Answer 16

A measure of the welfare that people gain from consuming goods and services, or a measure of the benefits they derive from the exchange of goods. Consumer surplus is the difference between the total amount that consumers are willing and able to pay for a good or service (indicated by the demand curve) and the total they pay (the market price).

Question 17

Producer surplus

Answer 17

Producer surplus is a measure of producer welfare. It is measured as the difference between what producers are willing and able to supply a good for and the price they actually receive

Question 18

Joint demand

Answer 18

Joint demand is when the demand for one product is directly and positively related to market demand for a related good or service. Two complements are said to be in joint demand and the cross price elasticity of demand is negative. Examples of joint demand include: fish and chips, iron ore and steel and apps for smartphones.

Question 19

Competitive demand

Answer 19

Markets where number of substitutes exist and one good can be purchased instead of another good.

Question 20

Composite demand

Answer 20

Composite demand is where goods have more than one use. An increase in the demand for one product leads to a fall in supply of the other. An example is milk which can be used for cheese, yoghurts, cream, butter and other products including fertilizer.

Question 21

Derived demand

Answer 21

Derived demand is demand that comes from (is derived) from the demand for something else. Thus, the demand for machinery is derived from the demand for consumer goods that the machinery can make. If there is low demand for consumer goods, there is low demand for the machinery that can make them. Demand for bricks is derived from spending on new construction projects.

Question 22

Joint supply

Answer 22

Joint supply is where an increase or decrease in the supply of one good leads to an increase or decrease in supply of a by-product.

Question 23

Substitute goods

Answer 23

Substitutes are goods or services in competitive demand. Substitutes have a positive cross price elasticity of demand. (I.e. XED > 0) which means that an increase in the price of one product will lead to a rise in demand for a substitute.

Question 24

Complements

Answer 24

Complements are goods or services in joint demand. Cross price elasticity of demand (XED) for two complements will be negative. An increase in the price of Good T will lead to a contraction in demand for T and a fall in demand for a complement, good S.

Question 25

Functions of PM

Answer 25

1) Signalling function
Prices perform a signalling function – i.e. they adjust to demonstrate where resources are required.
Prices rise and fall to reflect scarcities and surpluses.
If prices are rising because of high demand from consumers, this is a signal to suppliers to expand production to meet the higher demand.
If there is excess supply in a market, the price mechanism will help to eliminate a surplus of a good by allowing the market price to fall.
2) Incentive function
Through choices consumers send information to producers about their changing nature of needs and wants.
One important feature of a free-market system is that decision-making is decentralised, i.e. there is no single body responsible for deciding what to produce and in what quantities.
This is in contrast to a planned (state-controlled) economic system where there is significant intervention in market prices and state-ownership of key industries.
3) Rationing function
Prices ration scarce resources when demand outstrips supply.
When there is a shortage, price is bid up – leaving only those with willingness and ability to pay to buy.

Question 26

Factors affecting supply

Answer 26

Anything that changes costs of production.
- law of supply = positive relationship between price and quantity supplied
- technology advancements
- tax and productivity
- profit incentivises more production

Question 27

Equilibrium price

Answer 27

The price where the amount the consumers want to buy is equal to the amount producers want to sell. Market-clearing price. Supply and demand forces dictate the equilibrium price and quantity in a free market.
Shift in demand curve: increase in demand will cause an increase in price. Supply will extend and form a new equilibrium. Opposite for inward shift.
Supply shift: increase in supply causes an decrease in price. Demand will extend and form a new equilibrium.