Ways of Determining Price in a Competitive Market

One of the hottest topics in microeconomics is answering the question of determining price on the market. The dynamics of supply and demand influence the market price of an item or service. The market price is the price at which quantity provided equals quantity requested. Consumer and economic surplus are calculated using market prices.

Ways of Determining Price in a Competitive Market

The Relationship Between Price and Quantity Demanded 

Households and firms operate simultaneously in two sets of markets. The first of these contains the goods markets, in which members of households demand and buy consumer goods and services produced and supplied by firms. But for household demand in the goods market to be an effective demand — that is, demand backed up by an ability to pay — households must first sell their labor, or possibly the services of any capital or land they own, in the markets for factors of production. Households’ roles are therefore reversed in goods markets and factor markets. In this chapter, we ignore factor markets and focus solely on the determinants of demand for consumer goods and services. 


Market Demand and Individual Demand

Normally when economists refer to demand, they mean market demand. This is the quantity of a good or service that all the consumers in the market wish to, and are able to, buy at different prices. By contrast, individual demand is the quantity that a particular individual, such as yourself, would like to buy. The relationship between market and individual demand is simple. Market demand is just the sum of the demand of all the consumers in the market.


Ceteris Paribus Assumption

A woman with an income of £15,000 a yr desires of owning a modern Bugatti vehicle priced at over £1 million. Explain why this isn't always an instance of powerful demand. When we draw a market demand curve to expose how plenty of the coolest or service families plan to demand at various feasible charges, we expect that each one the other variables that can additionally influence calls for are held unchanged or steady. This is the ceteris paribus assumption, because of these other things being identical. Among the variables whose values are held constant or unchanged whilst we draw a call for curve are disposable earnings and tastes or fashion. Collectively, the variables whose values determine planned demand are regularly called the situations of demand. An exchange in a condition of demand shifts the call for the curve to a new position.


Normal Goods and Inferior Goods

When disposable income increases, a demand curve shifts rightward, but only if the good is a normal good, for which demand increases as income increases. However, some goods are examples of an inferior good, for which demand decreases as income increases, and an increase in income shifts the demand curve leftward. To take an example, private car transport and bus travel are not just substitutes for each other. As people’s incomes rise, demand for cars generally increases, while, at the same time, demand for bus travel usually falls. If people respond in this way to changes in income then private transport is a normal good, but certain forms of public transport are inferior goods. For an individual, whether a good is normal or inferior depends on personal income, tastes, and, possibly, age. For young children, junk food such as sweets is usually a normal good, but later in life, tastes change and sweets may become an inferior good. Providing a good is a normal good, an increase in income shifts the good’s demand curve to the right. However, if the good is inferior for most people, its demand curve shifts to the left when income increases.


The Meaning and types of Elasticity of Demand


There are three types of elasticities of demand:

● price elasticity of demand

● income elasticity of demand

● cross-elasticity of demand


Whenever a change in one variable (such as a good’s price) causes a change to occur in a second variable (such as the quantity of the good that households are prepared to demand), elasticity can be calculated. The elasticity measures the proportionate responsiveness of the second variable to the change in the first variable. For example, if a 5% increase in price were to cause households to reduce their demand by more than 5%, demand would be elastic. In this example, a change in price induces a more than proportionate response by consumers. But if the response were less than a reduction of 5%, demand would be inelastic. And if the change in price were to induce exactly the same proportionate change in demand, demand would be neither elastic nor inelastic — this is called unit elasticity of demand. Elasticity is a useful descriptive statistic of the relationship between two variables because it is independent of the units, such as price and quantity units, in which the variables are measured.


Factors Determining Price

Substitutability

Substitutability is the most important determinant of price elasticity of demand. When a substitute exists for a product, consumers respond to a price rise by switching expenditure away from the good and buying a substitute whose price has not risen. When very close substitutes are available, demand for the product is highly elastic. Conversely, demand is likely to be inelastic when no substitutes or only poor substitutes are available.


Percentage of Income

The demand curves for goods or services on which households spend a large proportion of their income tend to be more elastic than those of small items that account for only a small fraction of income. This is because, for items on which only a very small fraction of income is spent, particularly for those which are rarely purchased, people hardly notice the effect of a change in price on their income. The same is not true for ‘big-ticket’ items such as a new car or a foreign holiday.


Necessities or Luxuries

It is every now and then stated that the call for requirements is rate inelastic, whereas the demand for luxuries is elastic. This assertion ought to be treated with warning. When no obvious replacement exists, demand for a luxurious suitable may be inelastic, even as at the opposite intense, call for for specific varieties of simple nutrition is probable to be elastic if different staple meals are available as substitutes. It is the existence of substitutes that sincerely determines charge elasticity of call for, now not the issue of whether or not the good is a luxury or a necessity.


The ‘Width’ of the Marketplace Definition

The wider the definition of the marketplace below consideration, the lower the price elasticity of demand. Thus the call for the bread produced by using a specific bakery is possibly to be extra elastic than the call for bread produced through all bakeries. This is due to the fact the bread baked in different bakeries presents a range of near substitutes for the bread produced in only one bakery. And if we widen the feasible market still similarly, the elasticity of call for bread produced through all the bakeries may be greater than that for meals as a whole.


Time

The time period in question will also affect the price elasticity of demand. For many goods and services, demand is more elastic in the long run than in the short run because it takes time to respond to a price change. For example, if the price of an electric-powered car falls relative to the price of a petrol-engine car, it will take time for motorists to respond because they will be ‘locked in’ to their existing investment in petrol-engine cars. In other circumstances, the response might be greater in the short run than in the long run. A sudden rise in the price of petrol might cause motorists to economize in its use for a few weeks before getting used to the price and drifting back to their old motoring habits.


The Supply of Goods and Services

Normally when economists refer to supply, they mean market supply. The market supply is the quantity of a good or service that all the firms or producers in the market plan to sell at different prices. By contrast, supply by a single firm is the quantity that a particular firm would like to sell within the market. As with demand, the relationship between the two is simple. The market supply is just the sum of the supply of all the firms or producers in the market at different market prices. If we assume that a firm always aims to make the biggest possible profit, it follows that a firm will only want to supply more of a good if it is profitable so to do. For a firm, profit is the difference between the total revenue the firm receives when selling the goods or services it produces and the costs of producing the goods. Assuming firms do not change their size or scale, the cost of producing extra units of a good generally increases as firms produce more of the good. As a result, it is unprofitable to produce and sell extra units of a good unless the price rises to compensate for the extra cost of production. Rising prices will also encourage new firms to enter the market. The result is the upward-sloping market supply curve we have illustrated. As with demand, the supply of a good varies according to the time period being considered.


The Length of the Production Period Determines a Price Elasticity of Supply

If firms can convert raw materials into finished goods very quickly (for example, in just a few hours or days), supply will tend to be more elastic than when several months are involved in the production, as with many agricultural goods. When a firm possesses the spare capacity, and if labor and raw materials are readily available, production can generally be increased quickly in the short run. The ease of accumulating stocks When stocks of unsold finished goods are stored at low cost, firms can respond quickly to a sudden increase in demand. Alternatively, firms can respond to a price fall by diverting current production away from sales and into stock accumulation. The ease with which stocks of raw materials or components can be bought from outside suppliers and then stored has a similar effect. The ease of switching between alternative methods of production When firms can quickly alter the way they produce goods — for example, by switching between the use of capital and labor — supply tends to be more elastic than when there is little or no choice. In a similar way, if firms produce a range of products and can switch raw materials, labor, or machines from one type of production to another, the supply of any one product tends to be elastic. The number of firms in the market and the ease of entering the market generally, the more firms there are in the market, and the greater the ease with which a firm can enter or leave, the greater the elasticity of supply. We have already noted that demand is more elastic in the long run than in the short run because it takes time to respond to a price change. The same is true for supply.


References

WEB: Economics For A-level Year 1 and AS - Ray Powell, James Powell, 2, 3, 4, 5, 9, 19 ... https://www.hoddereducation.co.uk/media/Documents/Economics/AQA_A-Level_Economics_Sample.pdf

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