3. Price Determination in a Competitive Market

• Demand is the quantity of a good or service that consumers are willing and able to buy at a given price
• the law of demand states that as price falls, quantity demanded increases
• the law of demand shows an inverse relationship between price and demand
• the demand curve slopes downwards because of the law of demand
• the determinants of demand:

  • income
  • price of substitutes
  • tastes and preferences
  • expectations of future prices
  • population changes
  • advertising
• supply is the quantity producers are willing and able to produce at a given price
• the law of supply states that as price rises, quantity supplied increases
• determinants of supply:

  • costs of production
  • technology
  • expectations
  • number of firms in the market
  • taxes and subsidies
  • external shocks
• PED measures the responsiveness of quantity demanded following a change in price
• % change in Quantity Demanded

  PED = ————————————————————

  % change in Price
• PED is always negative
• PED is greater than 1 means demand is elastic - demand changes more than price
• PED less than 1 means demand is inelastic - demand changes less than price
• PED is 0 demand is perfectly inelastic - demand doesn’t change
• infinity demand is perfectly elastic
• PED is 1 then it is unit price elastic
• YED measures the responsiveness of quantity demanded following a change in income
• % change in Quantity Demanded

  YED = ————————————————————

  % change in income
• YED greater than 0 are normal goods - demand increases as income increases
• YED greater than 1 are luxury goods - demand increases more than with income
• YED 0-1 are necessities - demand increases with n come but less than proportionally
• YED less than 1 are inferior goods - demand decreases when income increases
• XED measure the responsiveness of quantity demanded of one good following a change in price of another good
• % change in Quantity Demanded of good A

  XED = ——————————————————————————-

  % change in Price of good B
• XED greater than 0 are substitutes - demand for A rises after price of B rises
• XED less than 0 are complements - price of good B rises, demand for good A falls
• Markets are interconnected
• substitute goods - a change in one effects the other
• complementary goods - a change in one effects the demand for another
• derived demand - demand depends upon the demand for final good (labour)
• joint supply - production of one good produces another
• composite demand - goods are demanded for multiple uses
• equilibrium - demand = supply
• if price is above equilibrium there is excess supply
• if price is below equilibrium there is excess demand
• consumer surplus is the difference between the price consumers are willing and able to pay and the price they actually pay
• producer surplus is the difference between the price the producers are willing and able to accept and the price they actually accept
• rationing is limiting who gets the product when scarce
• signalling is when prices send signals to consumers
• incentives are when higher prices encourage supply and lower prices encourage demand