Working of Competitive Markets

Question 1

What can the firm influence in the internal environment?

Answer 1

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)

Question 2

What does the firm have little control over in the external environment?

Answer 2

Factors:

○ Prices of raw materials

Question 3

How do changes in the economy affect businesses?

Answer 3

• 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

Question 4

What is the central economic problem?

Answer 4

Scarcity

• Finite resources

• lack of resources/inputs
  e. g. land, labour, raw materials, enterprise

• Infinite wants
-wants are endless
infinite wants, finite resources

Question 5

What is economics

Answer 5

the science of choice

-how to allocate money, choices, how many people to employ etc.

Question 6

What are the two sides of the market?

Answer 6

Demand- infinite want (what consumers want to purchase)

Supply- finite resources ( how businesses create)

Question 7

Define the Price mechanism

Answer 7

balance between supply and demand

Question 8

What is the Demand Curve?

Answer 8

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

Question 9

Define Substitution effect

Answer 9

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

Question 10

define income effect

Answer 10

when the price of a good goes down, the real income will go up.
Though actual income doesn’t change, real income does change

Question 11

define ‘real’

Answer 11

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.

Question 12

What will cause the demand curve to shift?

Answer 12

• 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)

Question 13

Causes of rise in demand

Answer 13

• 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.

Question 14

Why does the demand slope downwards

Answer 14

• 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

Question 15

Define law of diminishing marginal Utility Theory

Answer 15

○ 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

Question 16

Do firms have demand curves?

Answer 16

• 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

Question 17

Firm demand curve vs. market demand curve

Answer 17

• Market change, less of a change in the demand curve- as this is multiple firms
• Market is more flatter than the firms

Question 18

What is the key problem with using estimated demand functions?

Answer 18

• Doesn’t accurately represent how people behave

* Assumed that every other variable that affected the demand was constant

Question 19

Are more variables in a demand function good?

Answer 19

not necessarily,
• More variables you add, the more complicated the demand curve becomes
• Variables become related, causes statistical errors

Question 20

What does it mean when the demand curve is sloping downwards?

Answer 20

• Product is either inferior or normal -NOT a Giffen good

Question 21

define a Giffen Good

Answer 21

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.

Question 22

Define Price Elasticity of demand

Answer 22

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

Question 23

What sign should we expect PED to have

Answer 23

○ Expect a -ve sign- as there is an inverse relationship between price and demand

Question 24

Why do we use proportions or percentage changes for PED?

Answer 24

1. To compare different units of measurement, we convert them to percent so they are the same unit
2. To compare different products
   i. To see if a change in price is big or small e.g. doubled

Question 25

What value will the PED figure have (greater or less than one)?

Answer 25

○ Depends on how responsive it is | ○ Size is affected by different factors, main factor is the number/ closeness of substitutes

Question 26

What is the Spectrum of Price elasticity of Demand?

Answer 26

``` Perfectly elastic demand Elastic demand Unit elastic demand Inelastic Demand Perfect Inelastic demand ```

Question 27

What is Perfectly elastic demand?

Answer 27

if there is a change in price, there will be an infinite change in demand • A horizontal demand curve • PED = - infinity

Question 28

What is Elastic Demand?

Answer 28

percentage change in demand > percentage change in price • -Infinity < PED < - 1 • Flat demand at any price

Question 29

What is Unit Elastic Demand?

Answer 29

percentage change in demand = percentage change in price • PED = -1 • Demand curve = exponential line If price changes, Total revenue/ expenditure will not change

Question 30

What is Inelastic Demand?

Answer 30

percentage change in demand < percentage change in price • -1 < PED < 0 • Steep demand at any price

Question 31

What is Perfect inelastic demand?

Answer 31

If the price changes, demand will remain the same, demand in unresponsive • A vertical demand curve • PED = 0

Question 32

What is the point elasticity of demand formula used for?

Answer 32

* 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

Question 33

What is the formula for the price elasticity of demand?

Answer 33

Price elasticity of demand = dQ/dP × P/Q ○ dQ/dP - rate of change of quantity over price ○ P/Q- price: quantity ratio

Question 34

When is elasticity constant?

Answer 34

* Price elasticity the same in perfect elastic demand * Unit elastic demand * Perfect inelastic demand

Question 35

Why do firms need to know about price elasticity of demand?

Answer 35

• 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)

Question 36

What is Price elastic demand?

Answer 36

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

Question 37

What is Price inelastic demand?

Answer 37

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

Question 38

What is income elasticity of demand?

Answer 38

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

Question 39

What is the measurement, determinants and application to business for Income elasticity of demand?

Answer 39

• 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

Question 40

What is Cross-price elasticity of demand?

Answer 40

How responsive is a firms demand to a change in price in a competitor

Question 41

What is the measurement, determinants and application to business for Cross-price elasticity of demand?

Answer 41

• 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

Question 42

What is the Supply Curve?

Answer 42

* 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

Question 43

Define Law of diminishing returns

Answer 43

as supply goes up, marginal costs will increase | ○as P goes up, Q goes up

Question 44

What causes movements in the supply curve

Answer 44

• 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

Question 45

Causes of a rise in supply

Answer 45

* 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

Question 46

Define Price Elasticity of Supply

Answer 46

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

Question 47

Factors that affect PES

Answer 47

* Time period- supply more elastic in long-run | * Capacity of the firm to produce/ availability of raw materials

Question 48

What is the Price and Output determination?

Answer 48

``` • 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

Question 49

why does the supply curve slope upwards?

Answer 49

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

Question 50

how does the law of diminishing marginal utility explain why the demand curve slopes downwards?

Answer 50

- 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.