Resource Allocation in Competitive Markets
Determinant of CED
the relationship between 2 goods and closeness of substitute or complement.
Price Controls
the setting of minimum or maximum prices by the government so that prices are unable to adjust to their equilibrium level determined by market demand and supply. Results in market disequilibrium and therefore, shortages and surpluses. Price floors and Price ceilings.
dead-weight loss
welfare benefits that are lost to society because resources are not allocated efficiently.
Welfare Effects
welfare change on society caused by free market decisions of firms, households and government. measured in terms of gains and losses in consumers' and producers' surplus.
Surplus
when quantity supplied exceeds the quantity demanded, causing a downward pressure on the price.
Effective Demand
willingness to pay and ability to pay; support with purchasing power
Problems with Applications of elasticity concepts
1) Computation Issues 2) Ceteris paribus assumption 3) Government Intervention and impacts on market outcomes
Non-price determinants of Supply
1) Cost of Production 2) State of Technology 3) Natural Factors 4) Number of Firms 5) Government Policies (indirect tax/subsidy) 6) Joint Supply 7) Competitive Supply 8) Expectation of future price change
Governmental Intervention on market outcomes
1) Indirect taxes 2) Indirect subsidies 2) Price controls
Applications of YED
1) Producers (e.g. responding to changes in income) 2) Government (e.g. infrastructural planning)
Determinants of PED
1) Substitutes Availability 2) Habitual Consumption 3) Income Proportion spent on good 4) Time Period
Effect of price Floors
1) Surpluses 2) Firm inefficiency 3) overallocation of resources to the production of the good and allocative inefficiency 4) negative welfare impacts.
Determinants of PES
1) Time Period 2) Factor Mobility 3) No. of Firms 4) Stocks and Spare Capacity 5) Length of production period
Non-price Determinants of Demand
1)Taste and Preferences -Seasonal Changes 2) Expectation of future prices 2) Income (Normal vs inferior good) 3) Interrelated Goods 4) Government Policies 5) Interest Rates 6) Exchange Rates
Freedom of choice and enterprise
All decisions are made by households and firms, consumers have consumer sovereignty, workers are free to choose place and extent of work, Firms are free to choose choice of product and choice of production methods.
Ceteris Paribus
All other things held constant
Determinants of YED
Degree on necessity of good, and nature of good is dependent on the level of income of consumer. (Good can be luxury good at low income levels and inferior good at high income levels)
CED and Marketing and Sales Strategies for Complements
CED allows firm to link marketing plans to pricing policies of other firms with goods of high negative CED with own. (complements) .Lowering of price of one goods leads to large increase in demand and sales for the other. e.g. collaborate or stock up more.
CED and Marketing and sales strategies for Substitutes
CED allows firm to make good less substitutable from its rivals so it is less affected by pricing policies of rival firms, and can be achieved through advertising or adding different features to product, to increase consumers' brand loyalty and make good less replaceable. e.g. good after sales service.
CED and Pricing Policies
CED allows prediction of effect on sales and revenue with change in price of rival's product. When product has high positive CED in relation to rival's product, both products are close substitutes of each other. Competitor lower price, firm has to respond by lowering price too to prevent huge loss of existing and potential customers, or be as cost efficient as possible in operations to lower his prices.
Tax incidence with perfectly price elastic supply
Change in equilibrium quantity, Consumers will bear full incidence of the tax, but producers will lose revenue, as the demand will decrease.
Indirect Subsidy with price elastic supply, inelastic demand
Change in equilibrium quantity, consumer receive greater share of subsidy as greater incentive must be provided to consumers who are less responsive to price changes to stimulate consumption.
Indirect subsidy with price inelastic supply, price elastic demand
Change in equilibrium quantity, producer receive greater share of subsidy.
Population
Change in population demographic and number will affect potential consumers or size of market, thus affecting demand. e.g. baby-boom will lead to increase in demand for baby products.
The Income Effect
Change in price of good/service that leads to a change in real income/purchasing power, thus change in quantity demanded. (Causes Demand Curve to slope downwards)
The Substitution Effect
Change in price on quantity of good/service demanded that leads to consumers switching to and from alternative products, ceteris paribus, (causes Demand Curve to slope downwards)
Taste and Preferences
Change in taste affects market demand for a particular good, e.g. KPOP. Climatic conditions and festivals (Seasonal Changes) can affect taste too.
PES = infinite
Coefficient indicates perfectly price elastic supply. producers are willing to produce any quantity at the prevailing price as marginal cost remain the same. infinitely small decrease in price will cause quantity supplied to fall infinitely to zero. horizontal supply curve.
PES >1
Coefficient indicates price elastic supply, and given % change in price of good will lead to greater % change in quantity supplied. gradual supply curve.
PES <1
Coefficient indicates price inelastic supply, given % change in price of good will lead to smaller % change in quantity supplied. steep supply curve. Curves that cut through negative y axis are also price inelastic.
PES =1
Coefficient indicates unitary price elastic supply as given % change in price of good will bring about equal % change in quantity supplied. all straight line supply curves from origin are unitary price elastic.
Tax incidence with perfectly price-inelastic demand
Consumers are not responsive to changes in price of good (vertical demand curve), (change in price leads to little change in demand) and change in price is equal to amount of per unit tax, therefore consumers pay full incidence. e.g. vaccines. No change in equilibrium quantity.
Tax incidence with Inelastic Supply, Elastic demand
Consumers are responsive to changes in price of good (gradual demand curve), producers are not responsive (steep supply curve, increase in price is less than the tax per unit, therefore producers bear larger tax incidence than consumers.
Tax incidence with perfectly price elastic demand
Consumers are responsive to changes in price of good (horizontal demand curve), (change in price in good leads to zero demand) and change price is equal to amount of per unit tax, therefore producers bear full incidence. (in order to not lose customers) No change in equilibrium quantity.
Usefulness of PED
Determines: 1) Pricing Decisions 2) Marketing Strategies 3) how to use indirect taxes 4) effectiveness of trade unions 5) relationship with primary commodities and manufactured goods
Pursuit of Self-interest
Each decision-making unit in economy aims to maximize benefit to self, thus driving economic activity in the free market system.
Natural Factors
Favorable climatic conditions can increase supply of agricultural products, but occurrence of natural hazards or disasters will decrease supply
Productive Efficiency
Firms produces goods by using fewest possible resources, producing maximum output with minimum cost.
Allocative Efficiency
Goods and services that are wanted by the economy are produced in the right quantities that maximizes society's welfare.achieved when Price=Marginal Cost, where value of good is equal to opportunity cost.
Indirect Tax
Government Policy; taxes imposed on expenditure of goods and services that increases the cost of production for firms, leading to a fall in supply.
Direct Subsidy
Government policy; Increase in subsidy payment made by government to consumers that will increase disposable income, Increasing Demand.
Direct Tax policy
Government policy; increase in tax on income will cause decreased in disposable income and decrease in Demand.
Indirect Subsidy
Government policy; payment made to producers and decrease cost of production, leading to increase in supply.
YED and firm's response to changes in income
Households' incomes expected to rise/rise, firms can produce more income elastic goods (luxury goods), make product more income elastic by making it more luxurious, stock up more of normal and luxury goods in anticipation of rise in demand, plan to expand number of retail outlets. Households' income falling/expected to fall, firms can stock up on or switch to producing goods that are more income inelastic in demand, focus marketing efforts on groups that view the good as essential, promote good as 'value for money' to budget conscious.
Habitual Consumption
If consumption of good is a necessity or habitual, price is inelastic. (e.g. rice in Asian countries, insulin for diabetics)
Expectation of future price changes (Supply)
If price is expected to rise, producers temporarily reduce the amount they sell in the market and build up stocks to release them when the price rise to make maximum profit, thus resulting in decrease of supply at that time.
Private Ownership of Property
Individuals have the right to own, control and dispose of resources, Producers have the right of income earned from products.
Computation Issues
It is difficult to determine exact elasticity values as values for different consumer groups may differ due to factors like income differences, social and cultural differences, thus data sample collected may not be accurate. historical data may not be relevant for current use given the dynamic economy.
Ceteris Paribus Assumption
It is difficult to make accurate predictions as effect of changes have to be seen occurring and interacting together instead of separately and ceteris paribus cannot hold in reality.
Price Floors
Legally established minimum price to prevent prices from falling below a certain level, which must be set above equilibrium price.
PED relationship with manufactured goods
Manufactured goods have higher PED as they have plenty of substitutes. when price change, quantity demanded is generally more responsive than primary commodities.
Demand Curve
Maximum price that consumers are willing and able to pay for each quantity of the good.
Price Elasticity of demand
Measure of the degree of responsiveness of the quantity demanded of a good to a change in its price, ceteris paribus
Substitutes availability
More substitutes for a good, the closer they are (characteristics), consumers are more likely to switch when price of goods increases, thus the demand for good is more price elastic. dependent on definition of good (broad: less elastic, narrow: more elastic) e.g. food vs oranges.
Tax incidence with perfectly price-inelastic supply
No change in equilibrium quantity, producers are unable to respond to change in price of good (vertical supply curve) (change in price due to demand leads to little change in supply) , thus producers will bear full incidence of per unit tax.
PES and Time Period
Over short time period, firm may be unable to increase or decrease any of resources to change the quantity it produces, thus PES is highly inelastic or may be be perfectly inelastic. Vice Versa. The more time firms have to adjust their inputs, the larger the PES.
Interrelated markets
Price change in one market affects another.
PED>1
Price elastic Demand; change in price leads to greater than proportionate change in quantity demanded. Gradual demand curve.
PED<1
Price inelastic demand; change in price leads to less than proportionate change in quantity demanded. Steep demand curve.
Applications of PES concept
Primary Commodities have lower PES as the time needed for quantity supplied to respond to price changes is very long as compared to manufactured products.(e.g. planting season for agricultural goods) Large price fluctuations means large revenue fluctuations.
PED relationship with primary commodities
Primary commodities have low PED as they are goods arising from the use of natural resources and has little or no substitutes, like food which is a necessity. Fluctuations in supply of primary commodities results in large fluctuations in prices, affecting producer's income.
The Law of Demand
Quantity demanded of a good/service is inversely related to its price, ceteris paribus. (specific time period, consumers are rational, all other non-price factors are constant.) Shifts Demand Curve.
Number of Firms
Result of Economic liberalization or deregulation; increase in number of firms producing goods increases supply as market supply is the sum of all individual supplies
Price Floors: Firm Inefficiency
Result of Price Floor: As producers have a minimum guaranteed price and their profits are protected, they do not have incentives to cut cost by using more efficient methods of production, which leads to firm inefficiency.
Price Floors: Overallocation of resources to the production of the good and allocative inefficiency
Result of Price Floor: New producers may be attracted to the the market, creating even greater surpluses. Therefore, too many resources will be allocated to the good, resulting in larger than social optimum quantity produced, which results in allocative inefficiency.
Price Floors: Surpluses
Result of Price Floor: To deal with surpluses, the government will have to buy up the surplus and store,destroy or sell it abroad in other markets.Storing requires additional storage cost for government. Exporting requires granting subsidy to lower price of good to make it competitive in world market as domestic price + price floor means higher price for domestic products vs other countries'.
Price Floors: Negative Welfare Impacts
Result of Price Floor: minimum price leads to changes in consumers' and producers' surplus, therefore allocative inefficiency, a dead-weight welfare loss is experienced.
Perfect Competition
Situation where there are large number of producers and consumers, each having insignificant share of market and thus have no influence of demand and supply of market. No monopoly of market.
Producers' Surplus
The difference between the minimum price a producer is willing and able to accept and the actual price. Extra benefits to producer. Does not refer to profit.
Income Proportion Spent on good
The higher the income proportion spent on a good, the more people will reduce their consumption when prices increase as even small increases in price will take up more of the consumer's income. Thus, the more elastic the price is of demand. (They feel it very much)
PES and Factor mobility
The more easily and quickly resources can be shifted from one indutry to another where price is increasing, the greater the responsiveness of quantity supplied to changes in price,as marginal cost is lower as compared to a situation with less factor mobility. Therefore higher PES .
PES and No. of Firms
The more firms there are in the industry, more price elastic the supply as it is easier to obtain resources, as some firms have spare capacity or not utilised resources, therefore, higher PES.
Time Period
The more time consumer has to respond to price changes (change consumption pattern/find alternatives), the more price elastic the good is. Short Run curves are steeper than Long Run curves.
Law of Supply
The quantity supplied is directly related to the price of a product, ceteris paribus. (specific time period, producers are rational and all non-price determinants are held constant)
PED =1
Unitary price elastic demand (unitary=relate to unit); change in price leads to proportionate change in quantity demanded; curve is rectangular hyperbola.
Income
When consumer income increase, demand for normal goods (and luxury) will increase too. When consumer income increase, demand for inferior good will decrease. (Negative relationship).
Interrelated Goods
When price of original good increase, demand for original good will decrease and demand for substitute good will increase. When price of original good increase, demand for original good will decrease and demand for complement good will decrease too.
YED and firm's target
YED can help firms segment market into different income groups and tailor products to consumers of different income groups. e.g. high class shops in orchard and cheap shops in bedok.
YED and Govt
YED can help govt predict demand pattern according to changes in the income levels of the population, and in turn, allowing government to change policies.
YED >1
YED coefficient when demand for good is income elastic as % increase in income producers greater % increase in quantity demanded. e.g. Luxury Goods.
0 < YED < 1
YED coefficient when demand for good is income-inelastic as % increase in income produces smaller % increase in quantity demanded. e.g. necessities like food.
YED > 0
YED coefficient when the good is a normal good as an increase in income will lead to an increase in demand for that good.
YED < 0
YED coefficient when the good is an inferior good as increase in income will lead to fall in demand for good.
Resource Market
a market in which households sell and firms buy resources or the services of resources.
Price elasticity of Demand (PED)
a measure of how much the quantity demanded of a good responds to a change in the price of that good, computed as the % change in quantity demanded/ % change in price. (change in quantity/change in price x original price/original quantity). always negative. Steepness of demand curve.
Market Equlibrium
a situation in which the quantity of a product demanded equals the quantity supplied; market clearing price
Demand Schedule
a table that lists the quantity of a good a person will buy at each different price, ceteris paribus.
Marginal Social Benefit
additional benefit to society of the last unit of good produced or consumed.
Marginal Social Cost
additional cost to society of the last unit of good produced or consumed.
Demand
amount that consumers are willing and able to purchase at a given price over a given period of time
Minimum wages
causes labour surplus/unemployment: low-skilled workers who are now paid higher wage rates will be replaced by higher-skilled workers or machines which provide better substitutes for the same labour offered by the low-skilled workers, thus unemployment of low-skilled workers. Degree of unemployment will depend on elasticities of demand and supply of labour in the industry. also result in illegal workers employment.
Cost of Production
changes in the price of resources will change cost of production, causing changes in the level of profits. in turn affecting supply of good.
PES =0
coefficient indicates Perfectly price inelastic supply where there is no change in quantity supplied regardless of change in price. Same quantity supplied regardless of price of good. e.g. Picasso Painting.
Price as Signal
communicates information to decision making-units. When price increase, the new price signals to producers and consumers that there is a shortage in supply.
Consumer sovereignty
consumers are free do decide what to buy with their income, the power of consumers to decide what gets produced
Choosing indirect Taxes using PED
decision by government based on: The lower the PED for the taxed good, the greater the government tax revenues, as indirect taxes shift the supply curve upwards, and if demand is price inelastic, increase in price due to taxation leads to less than proportionate fall in quantity demanded. (Po to P1 >Qo to Q1) usually on goods like cigarettes and alcohol.
Marketing Decision using PED
decision firms make based on how to make their goods' demand more price inelastic to increase total revenue through price increase. As degree of elasticity can be determined by availability of close substitutes, the firm can reduce its substitutability by other products through product differentiation and advertising to make its good more irreplaceable and demand more price inelastic.
Price Ceilings
legally established maximum price to prevent prices from rising above a certain level, where producers are prohibited from selling above the stipulated price. Must be set below the market equilibrium price to be effective. Aimed to achieve equity
Pricing Decisions using PED
decision firms make based on: As total revenue received by firms is equivalent to the total spending by the consumers (TR =Price X Quantity), the effect of price change on TR depends on the PED. Increase in price does not always lead to increase in total revenue and vice versa. If Demand is price elastic, decrease in price leads to increase in total revenue as the decrease in revenue due to lower price is more than offset by the increase in revenue from the increase in quantity demanded. VICE VERSA. (Fall in price from P0 to P2 will lead to greater proportionate increase in quantity demanded from Q0 to Q1, P0Q0 is smaller then P1Q1) Ceteris Paribus.
Effectiveness of Trade unions using PED
decision made by trade unions based on how price inelastic the demand for the final product, that requires labour to produce, when asking for increase in wages. Increase in wage leads to increase in production cost and fall in supply, which leads to leftward shift of the supply curve and an increase in the price of the final product. If demand for final product is price inelastic, the fall in quantity demanded will be less than proportionate to the increase in price (Po to P1 > Qo to Q1), resulting in rise in total revenue, Thus firms will be more willing to agree to higher wage rate.
Derived Demand
demand for one good or service that occurs a a result of the demand for another intermediate/final good or service.
Consumers' Surplus
difference between maximum amount that consumers are willing to pay for a given quantity of a good and what is actually paid. indicates level of satisfaction that consumers derive from buying good (e.g. discount). Bigger the surplus, larger the satisfaction.
Supply Schedule
different quantities of a good that all the producers in the industry are willing and able to supply at various prices over a given period of time, ceteris paribus.
Incidence
distribution of burden of taxation between consumers and producers which is dependent on price elasticity of both demand and supply of good. e.g. consumers pay as a result of indirect taxation through producers increasing selling price.
Expectation of future prices (Demand)
expectation of change in price of good and services can cause demand to change before actual price change, ceteris paribus. e.g. COE prices
PED = infinity
infinitely price elastic demand; change in price leads to an infinitely large change in quantity demanded (e.g. suddenly plummeting to zero). occurs under perfect conditions if a firm increase price, consumers will immediately substitute it, losing all demand. horizontal demand curve.
Price Mechanism
invisible hand that allocates resources based on self-interest of consumers and producers. Price conveys information to consumers and producers.
Marginal Unit
last additional unit
Cross elasticity of demand (CED)
measure of the degree of responsiveness of demand of a good to a change in the price of another good, ceteris paribus. helps predict how much the demand curve for a particular good will shift in response to a change in the price of another good. (% change in quantity demanded of good A/% change in price of good B)
Price Elasticity of Supply (PES)
measure of the degree of responsiveness of quantity supplied to a change in the commodity's own price, ceteris paribus. gives indication of ease at which form's production can be expanded when price changes. Steepness of Supply curve. (% change in quantity supplied/ % change in price)
Income Elasticity of Demand (YED)
measurement of the degree of responsiveness of demand of a good to a change in consumer's income, ceteris paribus. Helps predict how much the demand curve will shift for a given change income, ceteris paribus. (% change in quantity demanded/% change in income)
Price as Incentive
motivates decision-making units to respond to information. When price increase, the new price motivates producers to increase supply to maximize profit and motivates consumers to decrease demand to maximize satisfaction.
Indirect Subsidies
negative tax or payment to producers by the government, lowers cost of production, shifting supply curve downwards by amount of subsidy since lowest market price needed to induce the firm to produce each unit is reduced by the amount of the subsidy.
Indirect subsidy with perfectly price-elastic supply
no change in equilibrium price, consumers receive full subsidy as more incentive must be given to consumer to respond to price change and stimulate consumption. horizontal supply curve.
Indirect Subsidy with perfectly price-inelastic supply
no change in equilibrium price, producers receive full subsidy, as more incentives must be given to producers to respond to price changes and stimulate production. vertical supply curve.
Upward pressure
occurs when there is a shortage of goods, when competition among consumers drive up the market price in order to outbid each other. Producers will increase quantity supplied at higher prices to make profit. Market Price wil rise until equilibrium price is reached.
downward pressure
occurs when there is surplus of goods, when producers are unable to sell all their output at current price. They will compete to sell excess supplies by lowering proces and consumers `
Specific Tax
per unit indirect tax that is constant sum levied on each unit of good sold, and will shift supply curve vertical upwards by amount of tax.
ad valorem tax
percentage indirect tax that results in upward anti-clockwise pivot of the supply curve.
PED =0
perfectly price inelastic demand; change in price will not lead to change in quantity demanded. vertical demand curve. e.g. drug addicts will continue demand for drugs despite change in prices
Interest Rate
price of borrowing money; increase in interest rate will increase cost of purchase thus reduce demand
Tax incidence with Elastic Supply, Inelastic demand
producers are responsive to changes in price (gradual supply curve) whereas consumers are not reponsive (steep demand curve). Increase in price is less than the tax per unit, therefore consumers bear larger of tax incidence than producers.
Joint Supply
production of goods that are derived from a single product; Increase in price of one leads to an increase in its quantity supplied and also increase in supply of the other joint product. e.g. beef and leather.
Competitive Supply
production of one or the other good and services by a firm when the goods compete for the use of the same resources, thus producing more of one means producing less of the other. Increase in price of one will lead to increase in supply of one and decrease in supply of the other as firms reallocate resources to make more profit.
Purpose for Price Floors
provide income support for farmers by offering prices for their products that are above market-determined prices, as agricultural products supply is subjected to price fluctuations due to uncertain weather conditions and market demand is price-inelastic, which results in significant fluctuations in farmer's income. Also protect low-skilled, low-wage workers by offering them wage above equilibrium level.
Applications of CED
provides in formation on the effects of their products' demand when faced with change in the price of rival's product or complementary products. 1) Pricing policies 2) Marketing and Sales Strategies
Dynamic Market
quantity and price level always tends toward equilibrium but seldom meet equlibrium
Shortage
quantity demanded exceeds quantity supplied, exerting upward pressure on the price.
Supply
quantity of goods/service that producers are willing and able to offer for sale at each given price over a given period of time; points moves along the supply curve.
disequilibrium
quantity of product demanded does not meet quantity supplied; there are shortages and surpluses of the good in the market.
Exchange Rate
rate at which a country's currency exchanges for another currency; Changes in rate of exchange will affect foreign demand for a country's goods and services.
Efficient market-based economy
relies solely on market forces of demand and supply to allocate resources. Requires: 1) Private ownership of property 2) Freedom of choice and enterprise 3) Pursuit of self-interest 4) Competition
State of Technology
represents the economy's stock of knowledge about how resources can be combined most efficiently. Innovation within the industry will improve the techniques of production, increasing the productivity of resources, this cost per unit of output will be lower.
Supply curve
represents the minimum price at which producers are willing and able to supply for each quantity of the good and service.
Free Market System
resources are allocated according to market forces of demand and supply; level of demand and supply determines prices and quantities traded.
Change in Supply
responds to changes in non-price determinants of supply, ceteris paribus, Shifting the Supply Curve
Change in Quantity Demanded
responds to changes in price of good, ceteris paribus, Moving along the Demand Curve
Change in quantity supplied
responds to changes in price of good, ceteris paribus, Moving along the Supply Curve
Change in Demand
responds to non-price determinants, ceteris paribus, Shifting the Demand Curve.
PES and Length of Production Period
shorter the time period for producers to convert resources in products, the more price elastic the supply for the good. e.g. manufactured goods have shorter production time period as compared to agricultural goods.
CED < 0
shows 2 goods are complements and price of one good leads to fall in demand for other good. Larger the absolute value, the greater the complementarity between 2 goods.
CED >1
shows that two goods are close substitutes as demand for one respond greatly to the changes of price in the other. Value=degree of substitutability.
0<CED<1
shows two goods are not close substitutes as demand for one does not respond very much to changes in the price of the other.
CED > 0
shows two goods are substitutes and the increase in price of one good will lead to an increase in the demand for the other good.
CED = 0
shows two goods are unrelated, and change in price of one is unlikely to affect demand for the other.
Price
signal and incentives, adjusts to clear shortages and surplus in market. Results in reallocation of resources.
PES and Stocks and spare Capacity
the easier the good can be stored, the more price elastic the supply as it is easier to respond to price increases. (e.g. more space to store excess stocks in the case of price drop) The higher the form spare capacity, the more easily production can be increased in response to price increases. (e.g. more equipment) Therefore, higher PES.
Product Market
the market in which households purchase the goods and services that firms produce
