Topic 3 - Price Determination in a Competitive Market

• Demand


  The quantity of a good or service that consumers are able and willing to buy at a given price during a given period of time
• Demand varies with price

  The lower the price, the more affordable the good and so consumer demand increases
• Movements along the demand curve


  1. At price P1, a quantity of Q1 is demanded

  2. At the lower price of P2, a larger quantity of Q2 is demanded (expansion of demand)

  3. At the higher price of P3, a lower quantity of Q3 is demanded (contraction of demand)
• Only changes in price will cause movements along the demand curve
• Shifting the demand curve


  1. Price changes do not shift the demand curve

  2. A shift from D1 to D2 is an inward shift in demand, so a lower quantity of goods is demanded at the market price of P1

  3. A shift from D1 to D3 is an outward shift in demand, more goods are demanded at the market price of P1
• Factors that shift the demand curve (PIRATES)


  • Population
  • Income
  • Related goods
  • Advertising
  • Tastes and fashions
  • Expectations
  • Seasons
• Diminishing marginal utility


  As an extra unit of the good is consumed, the marginal utility, i.e. the benefit derived from consuming the good, falls. Therefore, consumers are willing to pay less for the good.
• Price elasticity of demand (PED)

  The responsiveness of a change in demand to a change in price
• Types of price elasticity of demand

  • Price elastic good (PED > 1)
  • Price inelastic good (PED < 1)
  • Unitary elastic good (PED = 1)
  • Perfectly inelastic good (PED = 0)
  • Perfectly elastic good (PED = infinity)
• Factors influencing PED


  • Necessity
  • Substitutes
  • Addictiveness or habitual consumption
  • Proportion of income spent on the good
  • Durability of the good
  • Peak and off-peak demand
• Elasticity of demand and tax revenue

  • If a firm sells a good with an inelastic demand, they are likely to put most of the tax burden on the consumer
  • If a firm sells a good with an elastic demand, they are likely to take most of the tax burden upon themselves
• Elasticity of demand and subsidies

  A subsidy increases supply, the benefit can go to the producer or the consumer
• PED and total revenue


  • If a good has an inelastic demand, the firm can raise its price and quantity sold will not fall significantly, increasing total revenue
  • If a good has an elastic demand and the firm raises its price, quantity sold will fall, reducing total revenue
• Income elasticity of demand (YED)

  The responsiveness of a change in demand to a change in income
• Types of goods based on YED


  • Inferior goods (YED < 0)
  • Normal goods (YED > 0)
  • Luxury goods (YED > 1)
• Cross elasticity of demand (XED)


  The responsiveness of a change in demand of one good, X, to a change in price of another good, Y
• Types of goods based on XED

  • Complements (XED < 0)
  • Substitutes (XED > 0)
  • Unrelated goods (XED = 0)
• Inferior goods


  Goods for which demand decreases as income increases (YED < 0)
• Normal goods


  Goods for which demand increases as income increases (YED > 0)
• Luxury goods


  Goods for which an increase in income causes an even bigger increase in demand (YED > 1)
• Luxury goods


  • Holidays
• Luxury goods are also normal goods, and they have an elastic income
• During periods of prosperity, such as economic growth when real incomes are rising


  Firms might switch to producing more luxury goods and fewer inferior goods, because demand for luxury goods will be increasing
• Complements


  • Have a negative XED, if one good becomes more expensive, the quantity demanded for both goods will fall
  • Close complements: a small fall in the price of good X leads to a large increase in QD of Y
  • Weak complements: a large fall in the price of good X leads to only a small increase in QD of Y
• Substitutes


  • Can replace another good, so the XED is positive and the demand curve is upward sloping
  • Close substitutes: a small increase in the price of good X leads to a large increase in QD of Y
  • Weak substitutes: a large increase in the price of good X leads to a smaller increase in QD of Y
• Unrelated goods


  • Have a XED equal to zero, the price of one good has no effect on the demand for the other
• Firms are interested in XED because it allows them to see how many competitors they have. Therefore, they are less likely to be affected by price changes by other firms, if they are selling complementary goods or substitutes
• Supply


  The quantity of a good or service that a producer is able and willing to supply at a given price during a given period of time
• Supply curves


  • Upward sloping because: if price increases, it is more profitable for firms to supply the good, so supply increases
  • High prices encourage new firms to enter the market, because it seems profitable, so supply increases
  • With larger outputs, firm's costs increase, so they need to charge a higher price to cover the costs
• Movements along the supply curve


  At price P1, a quantity of Q1 is supplied. At the lower price of P2, Q2 is supplied. This is a contraction of supply. If price increases from P2 to P1, QS increases from Q2 to Q1. This is an expansion of supply. Only changes in price will cause these movements along the supply curve.
• Firms are driven by the desire to make large profits
• Shifting the supply curve


  • Price changes do not shift the supply curve. A shift from S1 to S2 is an outward shift in supply, so a larger quantity of goods is supplied at the market price of P1. A shift from S3 to S1 is an inward shift in supply. More goods are supplied at the market price of P1.
• Factors that shift the supply curve (PINTSWC)


  • Productivity
  • Indirect taxes
  • Number of firms
  • Technology
  • Subsidies
  • Weather
  • Costs of production
• Price elasticity of supply (PES)


  The responsiveness of a change in supply to a change in price
• Elastic supply


  • Firms can increase supply quickly at little cost, PES > 1
• Inelastic supply


  • An increase in supply will be expensive for firms and take a long time, PES < 1
• Perfectly inelastic supply


  • Supply is fixed, so if there is a change in demand, it cannot be met easily, PES = 0
• Perfectly elastic supply


  • Any quantity demanded can be met without changing price, PES = infinity
• Factors influencing PES


  • Timescale
  • Spare capacity
  • Level of stocks
  • How substitutable factors are
  • Barriers to entry to the market
• Equilibrium price and quantity

  When supply meets demand, price has no tendency to change, and it is known as the market clearing price