Business in Competitive Markets. 9th of October

Markets and Competition What happens To the price of petrol when war breaks out in Iran To the price of mangoes when farmers have an abundant year To the number of tourists when the tsunami hit Sri-Lanka All of the above show the workings of Supply and Demand Supply and Demand are the forces that make market economies work. They determine the following Quantity of Goods produced Price of which goods are sold

What is a Market? A group of buyers and sellers of a particular good or service. Characteristics of markets Organized markets Less Organized markets. A competitive market is a market which has many buyers and sellers so that each has a negligible impact on price. For today’s class we will assume that markets are perfectly competitive. The goods offered for sale are exactly the same so that no single buyer or seller has influence over price.

Demand Law of Demand The claim that other things equal the quantity Quantity Demanded – the amount of a good that buyers are willing and are able to pay. Market Demand – the sum of all individual demand for a particular good or service Law of Demand The claim that other things equal the quantity Demanded of a good falls when the price of The good increases. Teach a parrot the terms 'supply and demand' and you've got an economist. Thomas Carlyle

Demand Relationship between demand and price The demand curve the ‘law of demand’ the income effect the substitution effect The demand curve constructing the demand curve individual and market demand curves assumptions 2

Price of Related Goods Substitutes Complements Two goods for which an increase in price of one leads to an increase in demand for the price of the other Complements Two goods for which an increase in the price of one leads to a decrease in demand for the other.

Market demand for potatoes (monthly) Point Price (pence per kg) 20 40 60 80 100 Market demand (tonnes 000s) 700 500 350 200 100 A B C D E D C Price (pence per kg) B A Demand Quantity (tonnes: 000s)

Demand Other determinants of demand tastes number and price of substitute goods number and price of complementary goods income distribution of income expectations 3

Demand Movements along and shifts in the demand curve change in price  movement along D curve change in any other determinant of demand  shift in D curve increase in demand  rightward shift decrease in demand  leftward shift 3

P Price O Q0 Q1 Quantity An increase in demand D1 D0 Possible causes of a rise in demand Tastes shift towards this product Rise in price of substitute goods Fall in price of complementary goods Rise in income Expectations of a rise in price P Price D0 O Q0 Q1 Quantity

Supply Law of Supply Quantity Supplied The amount of a good that sellers are willing and able to sell. Law of Supply The claim that other things equal the quantity Supplied of a good increase when the price of The good increases.

Market supply of potatoes (monthly) d P 20 40 60 80 100 Q 100 200 350 530 700 a b c d e c Price (pence per kg) b a Quantity (tonnes: 000s)

Supply Other determinants of supply costs of production profitability of alternative products (substitutes in supply) profitability of goods in joint supply nature and other random shocks aims of producers expectations of producers 5

Supply Movements along and shifts in the supply curve change in price  movement along S curve change in any other determinant of supply  shift in S curve increase in supply  rightward shift decrease in supply  leftward shift 5

Shifts in the supply curve Possible causes of a rise in supply Fall in costs of production Reduced profitability of alternative products that could be supplied Increased profitability of goods in joint supply Benign shocks Expectations of a fall in price S0 Increase O Q

Shifts in the supply curve Decrease Increase O Q

Price and Output Determination Equilibrium price and output response to shortages and surpluses shortage (D > S)  price rises surplus (S > D)  price falls significance of ‘equilibrium’ 7

Equilibrium price and output: The market demand and supply of potatoes (monthly)

The determination of market equilibrium (potatoes: monthly) Supply D d C c Price (pence per kg) B b a A Demand Quantity (tonnes: 000s)

The determination of market equilibrium (potatoes: monthly) Supply D d C c Price (pence per kg) b SHORTAGE (300 000) B a A Demand Quantity (tonnes: 000s)

The determination of market equilibrium (potatoes: monthly) Supply D d SURPLUS (330 000) C c Price (pence per kg) b B a A Demand Quantity (tonnes: 000s)

The determination of market equilibrium (potatoes: monthly) Supply D d Price (pence per kg) b B a A Demand Qe Quantity (tonnes: 000s)

Effect of a shift in the demand curve P S i Pe2 g h Pe1 D2 D1 O Qe1 Qe2 Q

Effect of a shift in the supply curve k Pe3 j g Pe1 D O Qe3 Qe1 Q

Surplus and Shortage Surplus – A situation where Qs is greater than Qd Shortage – A situation where Qd is greater than Qs No change in Supply An increase in supply Decrease in supply No change in demand P.Q No change P down Q up P up Q down Increase in Demand P ambiguous P is up Q ambiguous Decrease in demand P down Q down

Production Possibilities Frontier A graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology. Example Economy can produce 300 shirts or 100 cakes Producing at the PPF causes the market to be “efficient” It is easy to see trade offs and opportunity costs Opportunity Cost = the slope of the PPF Line Slope = Change in Y/ Change in X 300-0/100/0 = 3

Price Elasticity of Demand The responsiveness of demand to a change in price The responsiveness of demand for an individual firm In a competitive market individual firms are too small to have any influence on the market price. In some other situation, firms may have some discretion in choosing their prices. Firms want to know how much the quantity demanded will fall if price is increased. 8

Elasticity of Supply and Demand Price Elasticity of Demand We use absolute numbers even though Qd is negatively related to its price. |Ped|= △Q/△P = 20/10 = 2

Different Types of Demand Perfectly Inelastic Demand Inelastic Demand Unitary Elastic Demand Elastic Demand Perfectly Elastic Demand

Determinants of Price Elasticity Sustainability Nature of the Product Proportion of Income Definition of Market The Possibility of new purchases Time Horizons Addiction Complementary goods Price expectations

Market demand curve for an individual firm under perfect competition Pm D O Q

The demand (market) for an individual firm’s product 10 7 6 6 D2 D1 O O 90 100 50 100 Q Q Firm A Firm B

Importance of Price Elasticity of Demand to Business Decision Making Price elasticity of demand and a firm’s sales revenue (TR = P x Q) Elastic demand and sales revenue Inelastic demand and sales revenue

Consumers’ total expenditure Q (millions of units per period of time) = firms’ total revenue £2 x 3m = £6m D Q (millions of units per period of time)

Importance of Price Elasticity of Demand to Business Decision Making Price elasticity of demand and a firm’s sales revenue (TR = P x Q) effects of a price change on sales revenue elastic demand TR changes in same direction as quantity

Elastic demand between two points Expenditure falls as price rises P(£) b 5 10 a 4 20 D Q (millions of units per period of time)

Importance of Price Elasticity of Demand to Business Decision Making Price elasticity of demand and a firm’s sales revenue (TR = P x Q) effects of a price change on sales revenue elastic demand TR changes in same direction as quantity inelastic demand TR changes in same direction as price

Inelastic demand between two points Expenditure rises as price rises. c 8 15 P(£) a 4 20 D Q (millions of units per period of time)

Importance of Price Elasticity of Demand to Business Decision Making Price elasticity of demand and a firm’s sales revenue (TR = P x Q) effects of a price change on sales revenue elastic demand TR changes in same direction as quantity inelastic demand TR changes in same direction as price applications to price decisions special cases totally inelastic demand

Totally inelastic demand (PD = 0) b P1 a O Q1 Q

Importance of Price Elasticity of Demand to Business Decision Making Price elasticity of demand and a firm’s sales revenue (TR = P x Q) effects of a price change on sales revenue elastic demand TR changes in same direction as quantity inelastic demand TR changes in same direction as price applications to price decisions special cases totally inelastic demand infinitely elastic demand

Infinitely elastic demand (PD = ) b D P1 Q2 O Q1 Q

Importance of Price Elasticity of Demand to Business Decision Making Price elasticity of demand and a firm’s sales revenue (TR = P x Q) effects of a price change on sales revenue elastic demand TR changes in same direction as quantity inelastic demand TR changes in same direction as price applications to price decisions special cases totally inelastic demand infinitely elastic demand unit elastic demand

Unit elastic demand (PD = –1) Expenditure stays the same as price changes. a 20 b 100 8 D O 40 Q

Other Elasticities of Demand Income elasticity of demand %QD / %Y measurement determinants degree of ‘necessity’ of the good rate at which desire is satisfied level of income of consumers applications to business importance of perceptions of the product repositioning a product 11

Other Elasticities of Demand Cross-price elasticity of demand %QDa / %Pb measurement determinants closeness of complements or substitutes time period applications to business effects of changes in competitors' pricing strategy strategies to make a product less cross-price elastic 11

Price elasticity of supply Price elasticity of supply refers to the responsiveness of supply to a change in price. Similar to demand, price elasticity of supply can be elastic or inelastic.

Price Elasticity of Supply Meaning of price elasticity of supply Measuring price elasticity of supply %QS / %P elastic and inelastic supply Determinants of price elasticity of supply amount that costs rise as output increases time period immediate short run long run 11

Response of supply to an increase in demand S short-run S long-run b P2 c P3 P1 Supply is more elastic in the long run. a D2 D1 O Q1 Q2 Q3 Q

Q The short-run (retail) supply of freshly cut flowers is much less elastic than that of pot plants because: households generally keep pot plants much longer before throwing them away. fresh flowers are more likely to be purchased for special occasions. the price of freshly cut flowers fluctuates much more than that of pot plants. supplies of fresh flowers fluctuate much more with the weather and the season. florists cannot keep freshly cut flowers as long as pot plants. E. Once they are cut, the supply is virtually fixed. The florist cannot choose to sell a given bunch of flowers next week or next month instead of today if today’s demand is low. Note: A and B refer to demand. C is an effect of supply inelasticity, not a cause. D refers to shifts in the supply curve.