Price determination in a competitive market 3.1.2

• What is the relationship between price and demand?

  Price and Demand are inversaly proportional

  
  

  ——> as price increases demand decreases

  ——> as price decreases demand increases
• What is Demand?


  The quantity of a product that purchasers are willing and able to buy at a given price in each time period.
• When is demand effective?

  Only if its backed up by willingness and ability to pay the market price

  
  

  (lower prices make products more affordable for consumers on limited budgets)
• Substitution Effect


  As price decreases it attracts other customers from similar products, because of this they're now more likely to switch to the cheaper product.
• Income Effect


  When price decreases consumers have more purchasing power (become more willing and able to purchase)
• Marginal


  From one additional unit
• Diminishing Marginal Utility


  As people consume more of a product the utility/satisfaction they derive from each additional unit diminishes, this means that they're willing and able to pay for less for each successive unit

  
  

  —contributes to a downwards sloap
• What causes a movement along the demand curve?

  ONLY changes in price
• How does the demand curve move when there's a higher price

  Higher price = contraction in demand
• How does the demand curve move when there's a lower price

  Lower price = extension demand
• Factors that cause a shift in demand

  Population — larger population increases demand.

  
  

  Income — more income more likely to afford good.

  
  

  Related goods — availability of substitutes and complements.

  
  

  Advertisement — increases demand and brand loyalty.

  
  

  Tastes — trends in the product.

  
  

  Expectation — if customers expect price or product supply of a good to change then they'll buy more (e.g in Covid when ppl where buying more toilet paper).

  
  

  Seasons — demand changes according to the season (e.g ice cream).
• Disposal Income


  Income left over from salary after tax
• Discretionary Income


  Income left over from salary after tax and other essentials (e.g bills,rent, etc).
• Elasticity


  Measure of how responsive demand is to a change in a specific factor.
• What is price elasticity of demand?

  The responsiveness of demand to a change in price

  
  

  — Helps us understand how sensitive consumers demand is to changes in price
• PED Calculation


  % change in quantity demanded / % change in price
• Relatively elastic demand


  PED is lower than -1

  
  

  —-> change in price leads to bigger percentage change
• Relatively inelastic demand


  PED is between 0 and -1

  
  

  —-> change in price leads to smaller percentage change.
• Perfectly elastic


  PED = infinity

  
  

  ——> any change in price results in demand falling to 0
• Unitary elasticity


  PED = -1

  
  

  —-> change in price leads to a proportional change in demand.
• Factors that affect PED

  1. Number of close substitutes - more substitutes, more elastic

  
  

  2. Proportion of income allocated to spend on good - larger income, more elastic.

  
  

  3. Degree of whether its a necessity or luxury - necessities (inelastic) luxuries (elastic)

  
  

  4. Time - the longer it takes to produce the longer it takes to respond (more elastic)

  
  

  5. Habit Forming - more addicted, more inelastic

  
  

  6. Cost of switching between products.

  
  

  7. Degree of brand loyalty.

  
  

  8. Breadth of definition of a good or service (if there's substitutes)
• What does income elasticity of demand (YED) measure?

  The responsiveness of quantity demanded to a change in income

  
  

  (how sensitive consumer demand is to a change in income)
• YED formula


  % change in quantity demanded / % change in income
• What do you distinguish between for YED?

  —Normal goods

  —Luxury goods

  —Necessities

  —Inferior goods
• What is a normal good?

  goods that consumers demand more of when their incomes rise
• What is a luxury good?

  An item we don't need to survive
• What is necessity?


  An item we need to survive
• What is an inferior good?

  goods that consumers demand less of when their incomes rise
• YED of Normal goods

  They have a positive income elasticity, therefore it is >0
• YED of Luxury goods

  YED is greater than one, therefore it is >+1
• YED of Necessities


  YED is between 0 and 1, therefore it is >0 and <+1
• YED of Inferior goods

  They have a negative income elasticity therefore it is < 0
• YED of Normal Necessary Products

  They have a low but positive income elasticity , therefore their YED is >0 and <1
• YED of Normal Luxuries

  They have a high and positive income elasticity, therefore their YED is >1
• What is considered a luxury and necessity

  There is no set answer, this is purely contextual this is because it depends on economic circumstances of the consumers involved.
• Demand for inferior goods

  When income increases, the demand for inferior goods decrease.

  (This causes an inward shift of the demand curve).

  
  

  —-> when incomes fall, the market for inferior goods will rise
• Why is income elasticity important for firms?

  — Helps firms predict the effect of changes in the macro economic cycle o their sales.

  
  

  — luxury products with high YED see greater sales volatily over a business cycle than necessities.

  
  

  — important for businesses to have a diversified product range.

  
  

  — higher value-added products increase profit margins, this is because they have a high YED and low PED.
• What does Cross Elasticity of Demand measure

  Measures the percentage change in the quantity demanded of Good A after a change in price of Good B.

  
  

  —measures the responsiveness of quantity demanded of one good to a change in the price of another related good (complements and substitutes)
• Formula of cross elasticity of demand (XED)

  % change in quantity demanded in good A/ % change in price of good B
• XED of substitutes


  Substitutes have a positive XED

  
  

  — This is because an increase in the price of one product will lead to a rise in demand for its substitute

  
  

  — A rise for Good B will result in a rise in demand for Good A and visa versa