4.1.3 – Price Determination in a Competitive Market

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    4.1.3.1- Determinants of the Supply of G & S

    quantity of a good/service that a consumer is able to buy at a
    given price. A demand curve shows the relationship between
    price and quantity demanded.
    o A movement from A to C is a contraction in demand.

    o A movement from A to B is an extension in demand.
    The relationship between price and quantity demanded is explained using:
    • Law of diminishing marginal utility
    • Income effect – at a fixed income, as price decreases the amount a consumer
    can buy with their income increases leading to an increase in demand.
    • Substitution effect – when a good becomes cheaper demand will increase due
    to other similar goods being more expensive.

    Factors that can lead to a change in demand:
    o Change in fashion
    o Changes in real income

     

     

    Types of goods:
    o Normal goods – (e.g. DVD’s) goods that people demand more if their real income increases. This
    will lead to a rightwards shift for the demand curve.
    o Inferior goods – (e.g. cheap clothing) goods that people demand less when their real income
    increases. This causes a leftwards shift for the demand curve.
    Changes in Demand in One Market Affect Demand in Other Markets:
    o Substitute goods – (e.g. coca cola & Pepsi) goods which are the alternative of one another. An
    increase in demand for one leads to a decrease in the demand for another.
    o Complementary goods – (chairs & tables) goods that are often used together. An increase in
    demand for one leads to an increase in demand for the other.
    o Derived demand – demand for a good or a factor of production used to make another good or
    service. For example, an increase in demand for fences will lead to a higher demand for wood.

    4.1.2.3 – Price, Income and Cross Elasticities of Demand

    Price elasticity of demand (PED):
    • PED is a measure of how quantity demanded responds to change in
    price

    Cross elasticity of demand (XED):
    • XED is a measure of how the quality of demand of one good responds to a change in price of another good.
    • XED = percentage change in quantity demanded of good A Percentage change in price of good B
    o If they are substitutes the XED will be positive. As a fall in price of one product reduces demand for another
    o If they are complements the XED will be negative. As a rise in price of one good reduces demand for another
    o If they are unrelated the XED will be zero

    Uses of Elasticities of Demand
    Factors that influence PED:
    • Substitutes – the more substitutes, the higher the PED.
    • Type of good or service – essential items are normally price inelastic.
    • Percentage of income spent on good – large proportion of income spent on it e.g. fridge so is price elastic.
    • Time – over time people are able to find alternatives so demand becomes price elastic

    Total Revenue and PED

    • If a good has elastic demand then:
    o A decrease in price will increase the firm’s total revenue.
    o An increase in price will decrease the firm’s total revenue.
    • If a good has inelastic demand then:
    o A decrease in price will decrease the firm’s total revenue.
    o An increase in price will increase the firm’s total revenue.
    For normal goods the YED is positive because as incomes rise, demand increases for the luxury good
    For inferior goods the YED is negative because as incomes rise, demand decreases so cheap good

    4.1.3.3 – Determinants of the Supply of G & S

    Supply is the quantity of the good or service that

    producers supply at a given price at a certain time.
    • A supply curve shows the relationship between price and quantity supplied.
    • The higher the price of a good the more supplied to maximise profits and there’s a
    larger incentive to expand production
    o A movement from A to C is an extension in supply.
    o A movement from A to B is a contraction in supply.
    Factors that cause a shift in supply:

    o Changes to the cost of production – higher wages (labour)
    o Improvements in technology – more efficient output
    o Changes in productivity of the factors of production – more efficient workers
    o Number of suppliers – increased supply to a market
    o Indirect taxes and subsidies
    o Changes to price of other goods – if a good increases un price then they
    increase production of it

    Joint supply – production of one good/service involves production of another e.g. crude oil refined makes petrol

    4.1.3.4 – Price Elasticity of Supply:

    Price elasticity of supply is a measure of how the quantity supplied of a
    good respond to a change in price

    A high PES is important for firms
    o Firms respond quickly to changes in price and demand
    o So supply is as elastic as possible
    o To improve supply they have flexible working patterns and use new technology
    • short run Supply is price inelastic as capacity and at least one factor of production is fixed (normally capital)
    • long run supply is elastic as firms have enough time to increase capacity and react to changes in price & demand
    Factors that affect PES:
    o Unemployment – easy to attract new workers so is price elastic
    o Perishable goods – can’t be stored for long so have inelastic supply
    o Industries with mobile factors of production – easy to expand labour force so more elastic supply

    4.1.3.5 – Market Equilibrium

    • A market is in equilibrium when demand equals supply.
    • Shifts in demand and supply change market equilibrium.
    • So, when supply and demand aren’t equal it causes
    disequilibrium
    o If there’s more supply than demand then there’s a
    surplus of supply
    o If there’s more demand than supply there’s a shortage of supply
    • This model has several assumptions
    o uses ceteris paribus
    o supply and demand are independent factors
    o all markets are perfectly competitive

    Demand and Supply – Agriculture
    • agricultural products display short run Price Instability
    • agricultural products are commodities – a good that could be
    swapped with any other good of the same type
    o this supply can be affected by a natural disaster and weather
    • agricultural products have an inelastic PED and PES
    • buffer stocks affect the price of Agricultural Products
    o buffer stocks involve a government setting a minimum and maximum price for a product e.g. wheat
    o the aim of buffer stocks is to stabilise market prices and prevent shortages
    Demand and Supply – Oil
    • demand for oil is price inelastic – as a change in price has small change in quantity demanded
    • supply for oil is price inelastic – as its very difficult to exploit more oil in the short term
    • lots of factors affect demand for oil
    o demand increases during boom and decreases during world recession
    o value of US dollar
    o if demand for one product rises then the derived demand for oil will also increases
    o attractiveness of buying oil substitutes
    o weather conditions
    o standards of living

    Demand and Supply – Housing
    • Short run PED and PES for housing are inelastic
    o as no substitutes for it so a rise in price causes small reduction in demand
    o takes time to build houses due to rules and regulations so supply is restricted in the short
    run
    Demand and Supply – Transport
    Transport is usually derived demand – results from demand for other goods or services
    • people want to get to places for work, leisure activity
    • firms want to being factors of production together, and bring goods to consumers
    • demand for transport is income and price inelastic
    o transport has positive YED – as real income increases demand increases
    • car and air travel have positive YED and public transport has negative YED
    • theres some cross elasticity between transport modes
    • demand for car travel depends on several things:
    o cost of journey – PED for travelling by car is LOW
    o income – higher incomed people use cars more
    o substitutes – travelling by bus or train
    o complements – e.g. insurance and car parking

     

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