Price determination in a competitive market
In a competitive market, price and quantity traded are determined by the interaction of demand, the quantity of a good or service consumers are willing and able to buy at each price, and supply, the quantity producers are willing and able to sell at each price.
Before you start
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Method
- Define demand as the quantity of a good consumers are willing and able to buy at a given price in a given time period, and state the law of demand, an inverse relationship between price and quantity demanded, other things being equal.
- List the non-price determinants of demand that shift the whole demand curve: income, the price of substitute and complementary goods, tastes and preferences, advertising, population/demographics, and expectations of future price changes.
- Define supply as the quantity of a good producers are willing and able to sell at a given price in a given time period, and state the law of supply, a direct relationship between price and quantity supplied, other things being equal.
- List the non-price determinants of supply that shift the whole supply curve: costs of production, the number of firms/producers in the market, technology, indirect taxes and subsidies, and, for some goods, the weather or other external shocks.
- Define market equilibrium as the price at which quantity demanded equals quantity supplied, and describe the adjustment process from disequilibrium: at a price above equilibrium there is excess supply, putting downward pressure on price; at a price below equilibrium there is excess demand, putting upward pressure on price.
- Practise distinguishing a shift of a curve, caused by a change in a non-price determinant, from a movement along a curve, caused only by a change in the good's own price, and always specify which curve shifts, and in which direction, before finding the new equilibrium.
- Apply demand and supply analysis to a real or given scenario: identify which curve is affected by the change described, in which direction it shifts, and state the resulting direction of change in both equilibrium price and equilibrium quantity.
Worked example
The market for umbrellas is initially in equilibrium at a price of 12 pounds and a quantity of 5,000 units per month. An unusually wet season is forecast. Using demand and supply analysis, explain the likely effect on the equilibrium price and quantity of umbrellas.
- Identify which curve is affected: consumer tastes/preferences for umbrellas increase due to the wet weather forecast, a non-price determinant of demand, so the demand curve is affected, not supply.
- State the direction of the shift: demand for umbrellas increases, so the whole demand curve shifts to the right, more umbrellas demanded at every price.
- Locate the new equilibrium: the new demand curve intersects the unchanged supply curve at a higher price and a higher quantity than before.
- State the result: the equilibrium price rises above 12 pounds and the equilibrium quantity rises above 5,000 units per month.
- Explain the adjustment: at the original price of 12 pounds, quantity demanded now exceeds quantity supplied, excess demand, so price is bid up by consumers competing for limited stock, until a new, higher equilibrium price restores balance.
Practice questions
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Q1State the law of demand.Show answer
Answer: As the price of a good falls, the quantity demanded of it rises, other things being equal, giving a downward-sloping demand curve.
Q2State the law of supply.Show answer
Answer: As the price of a good rises, the quantity firms are willing to supply of it rises, other things being equal, giving an upward-sloping supply curve.
Q3Name two non-price determinants of demand.Show answer
Answer: Any two of: income, the price of substitutes or complements, tastes and preferences, advertising, population, or expectations of future prices.
Q4Name two non-price determinants of supply.Show answer
Answer: Any two of: costs of production, the number of firms in the market, technology, indirect taxes/subsidies, or, for some goods, weather conditions.
Q5Define market equilibrium.Show answer
Answer: The price at which quantity demanded exactly equals quantity supplied, so there is no tendency for the price to change.
Q6At a price above the market equilibrium price, is there excess demand or excess supply? What effect does this have on price?Show answer
Answer: Excess supply, quantity supplied exceeds quantity demanded at that price, which puts downward pressure on price until it falls back towards equilibrium.
Q7A rise in the price of flour (an input) causes bakeries to supply fewer loaves of bread at every price. Is this a movement along the supply curve or a shift of it? Explain.Show answer
Answer: A shift - a change in the cost of a raw material is a non-price determinant of supply, so the whole supply curve for bread shifts left, rather than a movement along the existing curve, which would only be caused by a change in the price of bread itself.
Exam-style questions
Written in the style of a A Level Economics exam paper, with a full mark scheme.
Using a demand and supply diagram, explain the likely effect on the equilibrium price and quantity of a good if a successful advertising campaign increases consumer demand for it, while its production costs remain unchanged.
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Evaluate the extent to which changes in demand and supply, rather than government intervention, should be relied upon to determine prices in a market for an essential good such as bread.
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