Chapter 02 (Lecture-2 and 3)

The Working of
Competitive Markets
Business in a Competitive Market
 Importance of a firm’s market
environment
 A perfectly competitive market
 firms are price takers
 The price mechanism
 shortages: price rises
 surpluses: price falls
 equilibrium price
 appliesto both goods and input (e.g. labour)
markets
 Effect of changes in demand and supply
 the importance of incentives
a rise in demand
• price rises  quantity supplied rises
a fall in demand
• price falls  quantity supplied falls
a rise in supply
• price falls  quantity demanded rises
a fall in supply
• price rises  quantity demanded falls
 The interdependence of markets

 theinterdependence of goods and factor
markets
 effect of a rise in the demand for a good
• response in goods market
The price mechanism:
the effect of a rise in demand
Goods Market
Sg
Dg shortage Pg until Dg = Sg
(Dg > Sg) Dg

markets
• response in factor markets

The price mechanism:
the effect of a rise in demand
Goods Market
Sg
Dg shortage Pg until Dg = Sg
(Dg > Sg) Dg
Factor Market
Sf 
Sg Df  shortage Pf  until Df = Sf
(Df > Sf) Df 
Q Assume that there is a fall in
demand for a good.
Ceteris paribus, this will result in:
A. A rise in the price of the good and a fall in

the price of factors used to make it.
B. A rise in the price of the good and a rise in
C. A fall in the price of the good and a fall in
D. A fall in the price of the good and a rise in

markets
• response in factor markets
 theinterdependence of different goods

markets
Demand
 Relationship between demand and price
 the ‘law of demand’
• the income effect
• the substitution effect
 The demand curve
 constructing the demand curve
• individual and market demand curves
• assumptions
The demand curve:
the demand for potatoes (monthly)
Market demand for potatoes (monthly)
Point Price Market demand
100 (pence per kg) (tonnes 000s)
A 20 700
Price (pence per kg)
80
60
40
A
20
Demand
0
0 100 200 300 400 500 600 700 800
Quantity (tonnes: 000s)
A 20 700
80 B 40 500
60
B
40
A
20
Demand
0
0 100 200 300 400 500 600 700 800
A 20 700
80 B 40 500
C 60 350
C
60
B
40
A
20
Demand
0
0 100 200 300 400 500 600 700 800
A 20 700
D
80 B 40 500
C 60 350
C D 80 200
60
B
40
A
20
Demand
0
0 100 200 300 400 500 600 700 800
E Point Price Market demand
A 20 700
D
80 B 40 500
C 60 350
C D 80 200
60 E 100 100
B
40
A
20
Demand
0
0 100 200 300 400 500 600 700 800
Demand
 Relationship between demand and price
 the 'law of demand'
• the income effect
• the substitution effect
 The demand curve
 constructing the demand curve
• individual and market demand curves
• assumptions
 use of demand curves
• curves based on real data
• sketches
Demand
 Other determinants of demand

 tastes
 number and price of substitute goods
 number and price of complementary goods
 income
 expectations
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

An increase in demand
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
P • Expectations of a rise in price
An increase in demand is
Price
represented by a rightward
shift in the demand curve
D0 D1
O Q0 Q1
Quantity
Q Which way will the market demand for
petrol shift if the price of cars rises?
A. Right
B. Left
C. No shift (movement along the curve)

Q Which way will the market demand
for petrol shift if petrol
becomes more expensive?
A. Right
B. Left
Supply
 Relationship between supply and price
 as price rises, firms supply more
• it is worth incurring the extra unit costs
• firms switch from less profitable goods
• in the long run, new firms will be encouraged to
enter the market
 The supply curve
 constructing the supply curve
• individual and market supply curves
• assumptions
 generally upward sloping
The supply curve:
the supply of potatoes (monthly)
Market supply of potatoes (monthly)
100
Supply
P Q
80
a 20 100
60
40
a
20
0
0 100 200 300 400 500 600 700 800
100
Supply
P Q
80
a 20 100
b 40 200
60
b
40
a
20
0
0 100 200 300 400 500 600 700 800
100
Supply
P Q
80
a 20 100
b 40 200
c c 60 350
60
b
40
a
20
0
0 100 200 300 400 500 600 700 800
100
Supply
d P Q
80
a 20 100
b 40 200
c c 60 350
60
d 80 530
b
40
a
20
0
0 100 200 300 400 500 600 700 800
100 e
Supply
d P Q
80
a 20 100
b 40 200
c c 60 350
60
d 80 530
e 100 700
b
40
a
20
0
0 100 200 300 400 500 600 700 800
Shifts in the supply curve
P
Possible causes of a rise in supply S0 S1
• 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
Increase
O Q
Shifts in the supply curve
P
S2 S0 S1
Decrease Increase
O Q
Q Which way will the market supply of
pizzas shift if the price of flour falls?
A. Right
B. Left
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
 Movements along and shifts in the

supply curve
 a change in supply
 a change in the quantity supplied
Price and Output Determination
 Equilibrium price and output
 response to shortages and surpluses
 significance of ‘equilibrium’
 Demand and supply curves
 effect of price being above equilibrium
• surplus  price falls
 effect of price being below equilibrium
• shortage  price rises
 equilibrium: where D = S
Equilibrium price and output:
The Market Demand and Supply of Potatoes (Monthly)
The determination of market equilibrium
(potatoes: monthly)
E e
100
Supply
D d
80
Cc
60
b B
40
a A
20
Demand
0
0 100 200 300 400 500 600 700 800
(potatoes: monthly)
E e
100
Supply
D d
80
Cc
60
b SHORTAGE B
40
(300 000)
a A
20
Demand
0
0 100 200 300 400 500 600 700 800
(potatoes: monthly)
E e
100
Supply
D SURPLUS d
80
(330 000)
Cc
60
b B
40
a A
20
Demand
0
0 100 200 300 400 500 600 700 800
(potatoes: monthly)
E e
100
Supply
D d
80
60
b B
40
a A
20
Demand
0
0 100 200 300 Qe 400 500 600 700 800
 Effects of shifts in the demand curve
 movement along S curve and new D curve
• rise in demand (rightward shift)  P rises
Effect of a shift in the demand curve
P
S
g Initial equilibrium
Pe1 at point g
D1
O Qe1 Q
P
S
g
Pe1
D1
O Qe1 Q
P
S
g
Pe1
D2
D1
O Qe1 Q
P
S
i New equilibrium
Pe2 at point i
g h
Pe1
D2
D1
O Qe1 Qe 2 Q
• fall in demand (leftward shift)  P falls
 Effects of shifts in the supply curve
 movement along D curve and new S curve
• rise in supply (rightward shift)  P falls
• fall in supply (leftward shift)  P rises
Effect of a shift in the supply curve
P
S1
g
Pe1
D
O Qe 1 Q
P
S1
g Initial equilibrium
Pe1 at point g
D
O Qe 1 Q
P
S2
S1
g
Pe1
D
O Qe 1 Q
P
S2
S1
k
Pe3
j g
Pe1 New equilibrium
at point k
D
O Qe3 Qe 1 Q
Q The diagram shows the market for cocoa.
Equilibrium is currently at point x. To which
equilibrium point (1, 2, 3, 4, 5, 6, 7 or 8) will the
market move if there is:
A. A rise in the cost of

producing cocoa? 8
B. A rise in wages in the
chocolate industry? 6
C. Speculation that the
price of cocoa will
fall? 5
D. Increased demand for
chocolate and a new
tax on cocoa? 1
• fall in demand (leftward shift)  P falls
 Effects of shifts in the supply curve
 movement along D curve and new S curve
• rise in supply (rightward shift)  P falls
• fall in supply (leftward shift)  P rises
 Applying this analysis to different
markets
Price Elasticity of Demand
 The responsiveness of demand to a
change in price
 the responsiveness of demand for an
individual firm
Market demand curve for an individual firm
under perfect competition
P
Pm D
O
Q
The demand for an individual firm’s product
D1
O
Q
Firm A
P P
D2
D1
O O
Q Q
Firm A Firm B
P P
6 D2
D1
O 100 O
Q Q
Firm A Firm B
P P
6 6
D2
D1
O 100 O 100
Q Q
Firm A Firm B
P P
10
6 6
D2
D1
O 90100 O 100
Q Q
Firm A Firm B
P P
10
7
6 6
D2
D1
O 90100 O 50 100
Q Q
Firm A Firm B
 The responsiveness of demand to a

change in price
 the responsiveness of demand for an
individual firm
 the responsiveness of market demand
Market supply and demand
S1
Price
The effect on price of a

a shift in supply depends on
the responsiveness of
P1
demand to a change in
price.
D
O Q1
Quantity
S2
S1
b
P2
Price
a
P1
D
O Q2 Q1
Quantity
S2
S1
b
P2
Price
c Curve D' is more elastic

P3 than curve D over any
a given price range
P1
D'
D
O Q3 Q2 Q1
Quantity
 Defining price elasticity of demand (PD)
 measurement: %QD / %P
 theuse of proportionate or percentage

changes
 the sign (positive or negative)
 the value (greater or less than one)

 The determinants of price elasticity of
demand
 thenumber and closeness of substitute
goods
• closeness of one product to another
• closeness of one brand to another
 theproportion of income spent on the
good
 the time period
Q The price elasticity of demand for holidays
in Greece is likely to be high because
A. people tend to book up a long time in advance.

B. there are plenty of different holidays abroad to
choose from.
C. expenditure on holidays account for a relatively
small part of people’s total income.
D. holidays at home provide no real alternative.
E. people need a holiday if they are to cope with
the year ahead – and they prefer holidays
abroad.
Price Elasticity of Demand and Business
 Price elasticity of demand and a firm’s
sales revenue (TR = P x Q)
Total expenditure
4
P(£) 2
Consumers’ total expenditure

=
1 firms’ total revenue
= D
£2 x 3m = £6m
0
0 1 2 3 4 5
Q (millions of units per period of time)
 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
a
4
D
0 10 20
Effects of a change in price on total expenditure:
price elastic demand
P Q TE
(a) Price rises; quantity falls proportionately more;

therefore total expenditure (P × Q) falls.
price elastic demand
P Q TE
(a) Price rises; quantity falls proportionately more;

P Q TE
(b) Price falls; quantity rises proportionately more;

therefore total expenditure (P × Q) rises.
• elastic demand
• inelastic demand
• TR changes in same direction as price
Inelastic demand between two points
Expenditure rises
as price rises
c
8
P(£)
a
4
0 15 20
price inelastic demand
P Q TE
(a) Price rises; quantity falls proportionately less;

price inelastic demand
P Q TE
(a) Price rises; quantity falls proportionately less;

P Q TE
(b) Price falls; quantity rises proportionately less;

• elastic demand
• applications to price decisions
 special cases
• totally inelastic demand:

Totally inelastic demand (PD = 0)
P
D
P2 b
P1 a
O Q1 Q
• elastic demand
 special cases
• totally inelastic demand

• infinitely elastic demand
Infinitely elastic demand (PD = )
P
a b
P1 D
O Q1 Q2
Q
• elastic demand
 special cases
• totally inelastic demand

• infinitely elastic demand
• unit elastic demand
Unit elastic demand (PD = –1)
P
Expenditure stays the

b same as price changes
20
a
8
D
O 40 100 Q
Other Elasticities of Demand
 Income elasticity of demand (YD)
 measurement: %QD / %Y
• normal goods (positive elasticity)
• inferior goods (negative elasticity
 determinants
• degree of ‘necessity’ of the good

 applications to business
• importance of perceptions of the product
• repositioning a product
Other Elasticities of Demand
 Cross-price elasticity of demand (CDab)

 measurement: %QDa / %Pb
• substitute goods (positive elasticity)
• complementary goods (negative elasticity)
 determinants
• closeness of complements or substitutes

• the time period
 applications to business
• effects of changes in competitors’ pricing
strategy
• strategies to make a product less cross elastic
Q If a rise in the price of good X
results in the amount of money spent
on good Y remaining the same, then
A. X and Y are perfect substitutes.

B. X and Y are perfect complements.
C. The cross-price elasticity of demand for Y with
respect to X is infinite.
D. The cross-price elasticity of demand for Y with
respect to X is 1.
E. The cross-price elasticity of demand for Y with
respect to X is 0.
Price Elasticity of Supply
 Price elasticity of supply (PS)
 measurement: %QS / %P
 elastic and inelastic supply

Supply curves with different price elasticity of supply
P
S1
P0
O Q0 Q
P
S1
Supply is more elastic
between any two prices S2
along curve S2 than S1
P0
O Q0 Q
P
S1
P1
P0
O Q0 Q1 Q
P
S1
P1
P0
O Q0 Q1 Q2 Q
Price Elasticity of Supply
 Determinants of price elasticity of supply
 amount that costs rise as output increases
 time period
• immediate
• short run
• long run
Q In which one of the following cases
is good X likely to have a more price-
elastic supply than good Y?
A. It is more costly to shift from producing X to
another product than from Y to another product
B. The supply of Y is considered over a longer
period of time than X.
C. X is a minor by-product of Y.
D. Consumers find it easier to find alternatives to Y
than to X.
E. The cost of producing extra units increases more
rapidly in the case of Y than in the case of X.
Markets and Adjustment over Time
 Short-run and long-run adjustment

 short- and long-run demand curves
 Price expectations and speculation

 stabilising speculation
 destabilising speculation
Markets where Prices are Controlled
 Minimum prices
 justification
 effects
Minimum price: price floor
P
S
Pe
O Q
Minimum price: price floor
P
S
minimum
surplus
price
Pe
O Qd Qs Q
 Minimum prices
 justification
 effects
 dealing with resulting surpluses

 Maximum prices
 justification
 effects
Maximum price: price ceiling
P
S
Pe
O Q
Maximum price: price ceiling
P
S
Pe
maximum
price
shortage
O Qs Qd Q
 Minimum prices
 justification
 effects
 dealing with resulting surpluses

 Maximum prices
 justification
 effects
 dealing with resulting shortages
 rationing
 underground or shadow markets

Q Which one of the following controls would
involve setting a minimum price rather than a
maximum price of a good (or factor)?
A. Controls on rents to protect tenants on low
incomes.
B. Controls on wages to protect workers on low
incomes.
C. Controls on basic food prices to protect
consumers on low incomes.
D. Controls on transport fares to protect passengers
on low incomes.
E. None of the above.

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Chapter 02 (Lecture-2 and 3)

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The Working of

 The interdependence of markets

 The interdependence of markets

• response in factor markets

A. A rise in the price of the good and a fall in

 The interdependence of markets

• response in factor markets

 theinterdependence of different goods

 Other determinants of demand

 number and price of substitute goods

 number and price of complementary goods

 change in any other determinant of demand

• decrease in demand  leftward shift

C. No shift (movement along the curve)

 Movements along and shifts in the

A. A rise in the cost of

 The responsiveness of demand to a

The effect on price of a

c Curve D' is more elastic

 theuse of proportionate or percentage

 the sign (positive or negative)

 the value (greater or less than one)

A. people tend to book up a long time in advance.

Consumers’ total expenditure

(a) Price rises; quantity falls proportionately more;

(a) Price rises; quantity falls proportionately more;

(b) Price falls; quantity rises proportionately more;

(a) Price rises; quantity falls proportionately less;

(a) Price rises; quantity falls proportionately less;

(b) Price falls; quantity rises proportionately less;

• totally inelastic demand:

• totally inelastic demand

• totally inelastic demand

Expenditure stays the

• degree of ‘necessity’ of the good

 Cross-price elasticity of demand (CDab)

• closeness of complements or substitutes

A. X and Y are perfect substitutes.

 elastic and inelastic supply

 Short-run and long-run adjustment

 Price expectations and speculation

 dealing with resulting surpluses

 dealing with resulting surpluses

 underground or shadow markets

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