3.1.

2 The Allocation of Resources in Competitive Markets

The Determinants of the Demand for Goods and Services Price, Income and Cross Elasticities of Demand Candidates should know that the demand curve shows the relationship between price and quantity demanded, and understand the causes of shifts in the demand curve. Candidates should be able to calculate price, income and cross elasticities of demand and understand the factors that influence these elasticities of demand. They should understand the relationships between price elasticity of demand and firms total revenue (total expenditure), and between income elasticity of demand and normal and inferior goods. The Determinants of the Supply of Goods and Services Price Elasticity of Supply The Determination of Equilibrium Market Prices Candidates should be aware that, other things being equal, higher prices imply higher profits and that this will provide the incentive to expand production. They should understand the causes of shifts in the supply curve. Candidates should be able to calculate price elasticity of supply and understand the factors that influence price elasticity of supply. Candidates should understand how the interaction of demand and supply determines equilibrium prices in a market economy. They should understand the difference between equilibrium and disequilibrium, and between excess demand and excess supply. Candidates should be able to apply their knowledge of the basic model of demand and supply to markets, including commodity markets such as oil and copper markets, agriculture, health care, housing, sport and leisure.

Applications of Demand and Supply Analysis to Particular Markets The Interrelationship Between Markets

Candidates should be aware that changes in a particular market are likely to affect other markets. They should, for example, be able to explore the impact of the introduction of a new product and a new supplier in a competitive market. Candidates should understand the implications of joint demand, demand for substitute goods, composite demand, derived demand and joint supply.

How Markets and Prices Allocate Resources

Candidates should understand the rationing, incentive and signalling functions of prices in allocating resources and co-ordinating the decisions of buyers and sellers in a market economy. They should also be able to use the economists model of the market mechanism to assess the effectiveness of markets in allocating resources.

THE DETERMINANTS OF THE DEMAND FOR GOODS & SERVICES

Demand Effective demand Market demand Contractions in demand Extensions in demand Normal goods Inferior goods Complementary products Price Elasticity Subsidies Incidence of tax The amount that consumers are willing and able to buy at each given price level. Demand supported by the ability to pay for a good/service. Total demand in a market for a good at each given price. Falls in quantity demanded caused by rises in prices. Increases in demand caused by changes (falls in price). Goods or services that will see an increase in demand when incomes rise. Goods or services that see demand fall when income rises. Goods that are consumed together. The responsiveness of demand to a change in the price level. Payments by government to producers to encourage production of a good or services. The proportion of a tax that is passed onto the consumer. If most of a tax rise is added to the consumer then the incidence is said to be high, When demand is price inelastic then the incidence of tax tends to be high.

Income elasticity of demand Normal goods Inferior goods Substitutes Buffer stocks Inflationary pressure Market

The proportion to which demand changes when there is change in income. Goods or services that will see an increase in demand when incomes rise. Goods or services that will see demand fall when income rises. Goods that can be used as alternatives to another good. An intervention system that aims to limit the fluctuation of the price of a commodity. Occurrences that are likely to lead to increased prices. A set of arrangements by which buyers and sellers are in contact to exchange goods or services and through which resources are allocated.

Factors shifting the demand curve (to the right=increase, to the left=decrease): Changes in income Advertising and publicity Prices of substitute products and services (competing alternatives) Prices of complementary products Fashion Changes in quality Weather conditions The law Uncertainty over future prices Composite demand increase in demand for one use will reduce availability of the good of the alternative use Derived demand demand increases come from the demand for another good or service

PRICE, INCOME & CROSS PRICE ELASTICITIES OF DEMAND

PeD 0 -1<x<0 Price elasticity (Ped) = % change in Quantity demand in good X (Qdx) % change in Price of good X (Px) What its called What it means Effect on a firms total revenue
Perfectly inelastic Price inelastic demand When price changes there is no effect on demand. When price falls demand increases but by a smaller proportion. When prices fall, because demand doesnt change, revenue falls Total revenue will fall, as there are more customers but each one paying a proportionately lower price and therefor overall expenditure falls. Total revenue will remain the same from a price cut. Total revenue will rise. A fall in price leads to infinite increases in total revenue.

1 x>1 Infinity

Unitary price PeD Price elastic demand Perfectly elastic demand

A change in price brings about the same proportionate change in demand. A fall in price means demand rises proportionately more than the price cut.

Factors that determine PeD: The availability of substitutes more and closer substitutes mean demand is more elastic. Time horizon the longer the time elapsed since a price change, the more elastic is demand. Necessity luxury goods have a more elastic demand. Proportion of income spent the higher the proportion of income spent on a good, the more elastic demand is. Brand loyalty - (e.g. bread) tend to have a more inelastic demand than specific brands (Hovis) Income elasticity of demand = % change in Quantity demand % change in income

If ve, these goods are called inferior goods If +ve, these goods are called normal goods If x>1, these goods are called luxury goods Cross price elasticity = % change in the quantity demanded of good A % change in price of good B

If +ve, it shows the goods are substitutes. If -ve, it shows the goods are complementary goods.

THE DETERMINANTS OF THE SUPPLY OF GOODS AND SERVICES & PeS

Price elasticity of supply (PeS) = % change in Quantity supplied % change in Price Commodities have a generally inelastic supply as its difficult to increase short-term production, unless a firm has stock-piled raw materials, making it elastic. Factors affecting the price elasticity of supply: Time in the short term a firm might not be able to produce extra output and so they cannot meet extra demand. Raw materials often price inelastic as you need to discover resources before supply can increase. Stock availability firms with stocks are likely to have a more elastic short-term supply, as they can react to increases in demand quickly. Ease of switching between alternative productions if firms can switch between production of different goods, (e.g. different types of shirts), its supply is more elastic. Availability of spare capacity firms with spare capacity can easily expand output quickly, compared to firms at full capacity. The number of firms in a market/how easy a firm can enter the market If there are few barriers to entry and exit of a market, firms will move into a market swiftly. This is more elastic. If there are no restrictions on foreign workers, rises in average wages acts as an incentive for new migrants to quickly come to the UK. The ability to alter production methods if a firm can transfer to alternative production methods, e.g. more capital intensive production, then the supply curve will become more elastic.

THE DETERMINATION OF MARKET EQUILIBRIUM PRICES

With the help of a demand and supply diagram explain a change in demand: Axes labelled (price and quantity or P and Q will do) (1 mark) Original demand and supply curves correctly labelled (1 mark) Co-ordinates drawn in at the initial equilibrium and labels such as P 1 and Q1 (1 mark) Rightward shift of the demand curve (2 marks) Co-ordinates drawn in at the new equilibrium and labels such as P 2 and Q2 (1 mark) Any other relevant feature of the diagram (e.g. the amount of excess demand at the original equilibrium after the demand curve has shifted) (1 mark)=

APPLICATIONS OF DEMAND AND SUPPLY ANALSIS TO PARTICULAR MARKETS 1. Income elasticity of demand 2. Demand and supply diagrams 3. Government failure 4. Market failure 5. Determinants of demand and supply 6. Normal, inferior, composite goods etc. Housing Market Shortage in supply: PeS is very low takes time to build houses Government intervention through planning controls limits building site availability Pressure from existing residents against new houses, due to strain on amenities. Shortages in factor markets as the UK lacks builders Demand outstrips supply: People choose to live alone, and people live longer Lots of immigrants this does help reduce skilled labour constraint though Rising incomes lead to increased demand on housing Houses are seen as an investment good 3

Rental Market Here is an example of government intervention: The government feels rents are too high, and so establishes a price ceiling. As a result, demand outstrips supply. Owners try to evict tenants to sell properties as income from renting has fallen. Far fewer properties are available to rent as a result. A black market with properties above the maximum price are sold. As a result, the government abandons the policy, and instead subsidises poor tenants. This in effect moves the supply curve to the right, as owners will receive the market rate. Additionally, the government may commission housing to increase accommodation. Agricultural markets Economists accept that the agricultural market is a special case: In free markets, agricultural prices fluctuate from year to year depending on the level of output affecting farmers incomes. Production in many parts of the world is still subject to unplanned variation due to weather, pests, natural disasters etc. There is a huge disparity in the methods of production used, ranging from subsistence agriculture in sub-Saharan Africa to commercial farms in the US. Both demand and supply of agricultural products tend to be extremely inelastic, meaning a small change in output/demand triggers large price changes. This can result in resource misallocation. In some parts of the world the farming community is able to exercise influence over politicians, leading to domestic firms being protected from foreign competition. This effectively imposes a price floor on agricultural products. The government may also grant subsidies to ensure sufficient food production and reduce instability of farmers incomes. One example is over-production especially in Europe where there are large surpluses. The excess is sold onto the market, which depresses the price. As a result, farmers in developing countries who dont benefit from tariffs find it difficult to compete. The long term problem is that agricultural products have a low YeD. This is coupled with increased supply due to technology leading to increased productivity. This leads to depressed prices. In some cases, one measure against this is to set up buffer stocks. This prevents huge price increases in bad times and low farmers incomes when harvests are good. However, there are problems associated with buffer stocks: Who finances buffer stocks? Establishing target prices - consumers want a low price, but producers want a high price. The problems faced by buffer stocks as technology changes, and demand patterns change. Problems of storage costs and perishability, and in reverse problems of no supplies. The oil market 41.7% of all oil supplies are organised by a cartel known as the OPEC. By reducing supply, they can cause the price of crude oil to increase. This leads to increased inflationary pressure in economies, as firms try to pass increased costs and prices onto consumers. The government imposes extremely heavy taxation on both petrol and diesel, as demand is extremely inelastic. The leisure market Many activities have a perfectly inelastic supply curve, such as football matches. For many such events, a maximum price is imposed to increase affordability. This leads to increased demand that outstrips supply. A number of outcomes result: First come, first served if the match is popular, there are long queues of fans. Rationing where the club rations available tickets to its genuine supporters. But how are these genuine supporters identified? A black market in tickets where touts have managed to buy tickets and sell them above the maximum price. This is an example of the price system re-establishing an equilibrium.

Computer games market

Lots of brand loyalty, as software tends to be dedicated to one particular console.

THE INTERRELATIONSHIP BETWEEN MARKETS Composite demand A good demanded for more than one purpose so that an increase in demand for one purpose reduces the available supply for the other purpose, typically leading to higher prices, e.g. milk Derived demand When the demand for one good or service comes from the demand for another good or service, e.g. demand for cars stimulating demand for steel. Joint supply When the production of one good also results in the production of another. Minimum price A price floor below which the price of a good or service is not allowed to decrease. Maximum price A price ceiling above which the price of a good or service is not allowed to increase. Impacts of changes in demand and supply on associated markets: 1. Factor markets initial change in demand for one good will lead to a change in demand for the factors of production that are used to make it. 2. Joint supply where the increase in supply for one good increases the supply of another. 3. Composite demand increase in demand for one good reduces supply of another. 4. Complementary goods markets when demand for one product rises, so does demand for associated markets. 5. Substitute markets where changes to prices of substitutes affect demand for another good. An increase in demand and derived demand: Using the purchase of central heating, suppose the demand for central heating increases: There will be a shift outwards of the demand curve. This produces a disequilibrium situation as supply remains the same, and so prices rise. The market functions of allocation and incentive indicate to the producer that more factors of production needs to be allocated to this product and that increasing prices mean increased revenue. As the price rises some consumers will leave the market as the rationing function rations the product to those who can afford it. Supply extends up the supply curve S as more central heating equipment is produces. The change for demand for central heating affects the demand for engineers. The demand curve shifts to the right, and the excess demand triggers the allocative and incentive functions. For example, school leavers will have an incentive to train as engineers, and this means the supply of engineers increases. Additionally, demand falls as the increases wages lead to consumers dropping out of the market the rationing function. PRICE CEILINGS AND FLOORS A price ceiling leads to excess demand (a shortage), as suppliers find it unprofitable, and consumers find it cheap. A price floor leads to excess supply (a surplus). Note that minimum prices below the free market equilibrium have no effect, nor does a maximum price above the free market equilibrium. Zero pricing is when goods are provided free at the point of use. Examples are the NHS and with road use. This means that there is excess demand, leading to long waiting times or traffic jams: We can solve this by implementing charges e.g. congestion charge in London, where demand for road space is rationed. Ideally, we would charge different prices for different times of the day to ration demand at peak times when demand exceeds supply. 5