Price Determination

• Demand is the willingness and ability to consume at a given price and time
• The law of demand states there is an inverse relationship between price and quantity demanded
• The demand curve slopes downwards because of the income and substitution effect
• Income effect: purchasing power decreases and price increases
• Substitution effect: as price increases, other products become more price competitive and therefore more appealing
• Factors shifting demand curve:

  • population
  • Advertising
  • Substitute prices
  • Income
  • Trends
  • Interest rates
  • Compliments prices
• Market equilibrium is the opposing forces of supply and demand coming together to form a market clearing price where demand = supply
• Outward shift of demand goes right
• Inward shift of demand goes left
• Supply is a quantity of a good that producers are willing and able to produce at a given price and time
• The law of supply states that there is a direct relationship between price and quantity supplied
• The supply curve shifts upwards because of the profit motive - as price increases, there is more profit to be made
• Factors shifting supply curve:

  • productivity
  • indirect taxes
  • number of firms
  • technology
  • subsidy
  • weather
  • costs of production
• PED measures the responsiveness in demand following a change in price
• PED = % ^ in quantity / % ^ in price
• When PED is below 1, demand is inelastic
• When PED is 1 it is unit elastic
• When PED is above 1 it is elastic
• factors affecting PED:

  • substitutes
  • type of product
  • percentage of income spent on good
  • time
  • habit
• YED mesaures the responsiveness in demand following change in real income
• YED = % ^ in quantity demanded / % ^ in real income
• If YED is greater than 1, the good is income elastic
• If YED is smaller than 1, the good is income inelastic.
• For normal goods, YED is positive because an increase in income will lead to an increase in quantity demanded.
• For inferior goods, YED is negative because an increase in income will lead to a fall in demand. 
• Necessity Goods, such as staple foods like rice, have an inelastic YED
• Luxury Goods, such as watches, have an elastic YED
• Addictive Goods, such as cigarettes, tend to be income inelastic because consumers continue to buy  the despite fall in incomes
• XED measures the responsiveness in demand for good X after a change in the price of good Y
• XED = % ^ in quantity demanded of X / % ^ in price of Y
• If XED is positive: the two goods are substitutes
• If XED is negative: the two goods are complementary
• If XED is 0: there is no relationship between the two goods
• PES measures the responsiveness of supply following a change in price
• PES = % ^ in supply / % ^ in price
• When PES is above 1 it is elastic
• When PES is below 1 it is inelastic
• Factors affecting PES:

  • spare capacity
  • time
  • length of production period
  • stockpiling