Price determination in Competitive Markets: How Markets Work
Demand
Quantity of a good/service consumers are willing and able to buy at a given time period
Effective Demand: Willing/able to pay
Latent Demand: Willingness to buy, but lack purchasing power
Derived Demand: Demand for good X connected to demand for good Y
e.g. demand for steel linked to demand for new vehicles and other manufactured products
Steel is a cyclical industry – market demand for steel affected by changes in economic cycle
and fluctuations in exchange rate. In recession, demand for steel falls
Composite demand: Good demanded for multiple uses e.g. oil to make plastic or petrol
Joint Demand: Demand for two interdependent goods e.g. printer and printer ink
Giffen Good: price rise leads to increase in demand – poor can’t afford luxury alternatives
Ostentatious good: price rise increases demand as quality has increased
Demand Curve
Relationship between price and quantity demanded over period
Increasing the price increases opportunity cost
If rational, only consume more if it increases welfare
If demand rises – extension of demand
If demand falls – contraction of demand
Income Effect:
Fall in price increases real purchasing power of consumers
Allows higher consumption – smaller % of income
For normal goods, increase in demand caused by increase in real income
Substitution Effect:
Fall in price of good X makes it relatively cheaper compared to substitutes
Some consumers switch to good X, increasing demand
Depends on how close of a substitute
Movement along demand curve:
A change in price causes movement along demand curve
Elastic demand: price increase cause significant fall in demand e.g. Tesco tea bags
Inelastic Demand: Price increase will cause small fall in demand e.g. petrol
Firms reduce price to increase demand
Consumers effective demand increases when:
1. Increase real purchasing power
2. Relatively cheaper compared to substitutes
3. Opportunity cost falls
Factors that shift demand curve
, 1. Incomes
Disposable income rises (afford more goods) - consumption rises – demand increases
Inferior goods: Incomes rise – afford better alternatives – consumption/demand falls
2. Advertising/Publicity
More aware of product - increase brand loyalty - demand increases
e.g. Higher spending on advertising by Coca Cola increased global sales
Bad publicity – reduce demand
3. Price of Substitute goods
If price of substitute good falls, demand falls (cheaper alternative)
If price of substitute good increases, demand increases (cheaper alternative)
e.g. If price of Samsung phones increase, demand for Apple iPhones increase
4. Price of complementary goods
If price of complementary good falls, demand increases
If price of complementary good increases, demand falls
e.g. If price of game consoles fall, demand for video games increases
5.Fashion
6.Changes in quality
Increase in quality e.g. better-quality phone cameras, encourages consumption –
reduces demand of substitute goods
7.Change in interest rates
If interest rates fall, cheaper to borrow, increase consumer spending, demand increases
If interest rates increase, more expensive to borrow, incentive to save, demand falls
8.Weather
In cold weather, increased demand for fuel and warm clothes
9.Expectations over future prices
A commodity e.g. gold, may be bought due to speculation it will increase in price
Supply
Demand
Quantity of a good/service consumers are willing and able to buy at a given time period
Effective Demand: Willing/able to pay
Latent Demand: Willingness to buy, but lack purchasing power
Derived Demand: Demand for good X connected to demand for good Y
e.g. demand for steel linked to demand for new vehicles and other manufactured products
Steel is a cyclical industry – market demand for steel affected by changes in economic cycle
and fluctuations in exchange rate. In recession, demand for steel falls
Composite demand: Good demanded for multiple uses e.g. oil to make plastic or petrol
Joint Demand: Demand for two interdependent goods e.g. printer and printer ink
Giffen Good: price rise leads to increase in demand – poor can’t afford luxury alternatives
Ostentatious good: price rise increases demand as quality has increased
Demand Curve
Relationship between price and quantity demanded over period
Increasing the price increases opportunity cost
If rational, only consume more if it increases welfare
If demand rises – extension of demand
If demand falls – contraction of demand
Income Effect:
Fall in price increases real purchasing power of consumers
Allows higher consumption – smaller % of income
For normal goods, increase in demand caused by increase in real income
Substitution Effect:
Fall in price of good X makes it relatively cheaper compared to substitutes
Some consumers switch to good X, increasing demand
Depends on how close of a substitute
Movement along demand curve:
A change in price causes movement along demand curve
Elastic demand: price increase cause significant fall in demand e.g. Tesco tea bags
Inelastic Demand: Price increase will cause small fall in demand e.g. petrol
Firms reduce price to increase demand
Consumers effective demand increases when:
1. Increase real purchasing power
2. Relatively cheaper compared to substitutes
3. Opportunity cost falls
Factors that shift demand curve
, 1. Incomes
Disposable income rises (afford more goods) - consumption rises – demand increases
Inferior goods: Incomes rise – afford better alternatives – consumption/demand falls
2. Advertising/Publicity
More aware of product - increase brand loyalty - demand increases
e.g. Higher spending on advertising by Coca Cola increased global sales
Bad publicity – reduce demand
3. Price of Substitute goods
If price of substitute good falls, demand falls (cheaper alternative)
If price of substitute good increases, demand increases (cheaper alternative)
e.g. If price of Samsung phones increase, demand for Apple iPhones increase
4. Price of complementary goods
If price of complementary good falls, demand increases
If price of complementary good increases, demand falls
e.g. If price of game consoles fall, demand for video games increases
5.Fashion
6.Changes in quality
Increase in quality e.g. better-quality phone cameras, encourages consumption –
reduces demand of substitute goods
7.Change in interest rates
If interest rates fall, cheaper to borrow, increase consumer spending, demand increases
If interest rates increase, more expensive to borrow, incentive to save, demand falls
8.Weather
In cold weather, increased demand for fuel and warm clothes
9.Expectations over future prices
A commodity e.g. gold, may be bought due to speculation it will increase in price
Supply
