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Business Economics Summary
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- Business Economics
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- Karel De Grote-Hogeschool (KdG)
This document summarises the macro and micro economics.
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CHAPTER 2 THE WORKING OF COMPETITIVE MARKETS (24)BUSINESS IN A PERFECTLY COMPETITIVE MARKET
THE PRICE MECHANISM UNDER PERFECT COMPETITION
Free market: one in which there is an absence of government. Individual producers and consumers are free to make their own economic
decisions
Perfectly competitive market: a market in which all producers and consumers of the product are price takers. (there are other features
of a perfectly competitive market)
Price taker: a person or firm with no power to be able to influence the market price
Price mechanism: the system in a market economy whereby changes in price, in response to changes in demand and supply, have the
effect of making demand equal to supply
The working of the price mechanism
Equilibrium price: the price where the quantity demanded equals the quantity supplied; the price where there is no shortage or surplus
Equilibrium: a position of balance, from which there is no inherent tendency to move away
KEY IDEA: people respond to incentives, such as changes in prices or wages. It is important, therefore, that incentives are appropriate
and have the desired effect.
A shortage of a product causes its market price to rise, and this eliminates the shortage ➔ If consumers decide they want more of a
good at the current price or if producers decide to cut back supply, demand will exceed supply. The resulting shortage will encourage
sellers to raise the price of the good. This will act as an incentive for producers to supply more, since production of each unit will now be
more profitable. It will also discourage consumers from buying so much.
A surplus causes price to fall and this eliminates the surplus. ➔ If consumers decide they want less of a good at the current price (or if
producers decide to produce more), supply will exceed demand. The resulting surplus will cause sellers to reduce the price of the good.
This will act as a disincentive to producers, who will supply less, since production of each unit will now be less profitable. At the same
time, it will encourage consumers to buy more.
THE EFFECT OF CHANGES IN DEMAND AND SUPPLY
A change in demand
- A rise in demand causes a shortage and hence a rise in price, which acts as an incentive for businesses to supply more, as it is
more profitable.
- A fall in demand causes a surplus and hence a fall in price. This then acts as an incentive for businesses to supply less.
A change in supply
- A rise in supply causes a surplus and hence a fall in price, this acts as an incentive for consumers to buy more.
- A fall in supply causes a rise in price, this acts as an incentive for consumers to buy less.
KEY IDEA: changes in demand or supply cause markets to adjust. Whenever such changes occur, the resulting ‘disequilibrium’ will bring
an automatic change in prices, thereby restoring ‘equilibrium’ (i.e. a balance of demand and supply).
RECAP BUSINESS IN A PERFECTLY COMPETITIVE MARKET
1. The more competitive the market, the less discretion the firm has in deciding its price. The price is determined by demand and
supply in the market ➔ price takers
2. Price changes act as the mechanism whereby demand and supply are balanced.
3. I there is a shortage, price will rise until it’s eliminated. If there is a surplus, price will fall until it’s eliminated.
,DEMAND
THE RELATIONSHIP BETWEEN DEMAND AND PRICE
Law of demand: the quantity of a good demanded per period of time will fall as the price rises and rise as the price falls, other things
being equal.
Income effect: the effect of a change in price on quantity demanded arising from the consumer becoming better or worse off as a result
of the price
Substitution effect: the effect of a change in price on quantity demanded arising from the consumer switching to or from alternative
products
Quantity demanded: the amount of a good that a consumer is willing and able to buy at a given price over a given period of time
Income effect of a price rise ➔ people feel poorer. They are not able to afford to buy so much of the good with their money. The
purchasing power of their income has fallen.
Substitution of a price rise ➔ the good is now dearer relative to other goods. People thus switch to alternative or substitute goods.
When the price of a good falls, the quantity demanded will rise. People can afford to buy more (the income effect), and they will switch
away from consuming alternative goods (the substitution effect)
THE DEMAND CURVE
Demand schedule for an individual: a table showing the different quantities of a good that a person is willing and able to buy at
various prices over a given period of time
Market demand schedule: a table showing the different total quantities of a good that consumers are willing and able to buy at various
prices over a given period of time
Demand curve: A graph showing the relationship between the price of a good and the quantity of the good demanded over a given
time period. Price is measured on the vertical axis; quantity demanded is measured on the horizontal axis. A demand curve can be for
an individual consumer or a group of consumers, or more usually for the whole market.
,OTHER DETERMINANTS OF DEMAND
Factors that might affect your demand of a product:
- Tastes - Expectations of future price changes ➔ If people think that
- The number and price of substitute goods prices are going to rise in the future, they are likely to buy
- The number and price of complementary goods more now before the price does go up and so demand will
- Income increase
KEY IDEA: people’s actions are influenced by their expectations. People respond not just what to what is happening now (such as a
change in price), but to what they anticipate will happen in the future.
Substitute goods: a pair of goods which are considered by consumers to be alternatives to each other (tea and coffee). As the price of
one goes up, the demand for the other rises
Complementary goods: a pair of goods consumed together (cars and petrol). As the price of one goes up, the demand for both will
fall
Normal goods: goods whose demand rises as people’s incomes rise
Inferior goods: goods whose demand falls as people’s incomes rise
MOVEMENTS ALONG AND SHIFTS IN THE DEMAND CURVE
A change in one of the determinants of your demand for books, excluding
price: say your income rises. Assuming book are a normal good, this
increase in income will cause you to buy more at any price: the whole curve
will shift to the right.
➔ an increase in demand is represented by a rightward shift in the
demand curve
KEY IDEA: partial analysis: other things remaining equal (ceteris paribus). In economics it is common to look at just one determinant of
variable such as demand or supply and see what happens when the determinant changes. For example, if price is taken as the
determinant of demand, we can see what happens to quantity demanded as price changes. In the meantime, we have to assume that
other determinants remain unchanged. This is known as the ‘other things being equal’ assumption (or, using the Latin, the ‘ceteris
paribus’ assumption). Once we have seen how our chosen determinant affects our variable, we can then see when another determinant
changes, and then another, and so on.
Change in demand: the term used for a shift in the demand curve. It occurs when a determinant of demand other than price changes
Change in the quantity demanded: the term used for a movement along the demand curve to a new point. It occurs when there is a
change in price
RECAP DEMAND
1. When the price of a good rises, the quantity demanded per period of time will fall ➔ law of demand.
2. The law of demand is explained by the income and substitution effects of a price change
3. On the demand curve, the price is plotted on the vertical axis and quantity demanded per period of time on the horizontal axis.
The resulting demand curve is downward sloping
4. Anything that influences the goods you buy and how much of them, will be a determinant of demand.
5. A rightward shift represents an increase in demand, a leftward shift represents a decrease in demand
, SUPPLY
SUPPLY AND PRICE
Example: farmer deciding what to do with your land ➔Your decision will depend on a large extent of the price that various vegetables
will fetch in the market, and likewise the price you can expect to get from sheep and wool.
When the price of a good rises, the quantity supplied will also rise:
- As firms supply more, they are likely to find that, beyond a certain level of output, costs rise more and more rapidly. Only if price
rises will it be worth producing more and incurring these higher costs.
- The higher the price of the good, the more profitable it becomes to produce
- Given time, if the price of a good remains high, new producers will be encouraged to set up in production. Total market supply thus
rises.
➔the first two determinants affect supply in the short run. The third affects supply in the long run.
THE SUPPLY CURVES
Not all supply curves are sloping ➔ this depends largely on the time period over which the response of firms to price changes is
considered.
Supply schedule: A table showing the different quantities of a good that producers are willing and able to supply at various prices
over a given time period. A supply schedule can be for an individual producer or group of producers, or for all producers (the market
supply schedule).
Supply curve: A graph showing the relationship between the price of a good and the quantity of the good supplied over a given period
of time.
OTHER DETERMINANTS OF SUPPLY
As with demand, supply is not determined simply by price. The other determinants of supply are as follows:
- The costs of production → the higher the cost of production, the less profit will be made at any price
- The probability of alternative products → if some alternative product becomes more profitable to supply, perhaps due a rise in its
price or a fall in its production costs, producers are likely to switch from the first good, thus cutting its supply, to this alternative.
(carrots and potatoes)
- The profitability of goods in joint supply → when one good is produced, another good is also produced at the same time. (petrol
and other fuels)
- Nature ‘random shocks’ and other unpredictable events → the weather and diseases affecting farm output.
- The aims of producers → a profit-maximising firm will supply different quantity form a firm that has different aim, such as maximising
sales
- Expectations of future price changing → if price is expected to rise, producers may temporarily reduce the amount they sell. (housing
market)
Substitutes in supply: these are two goods where an increased production of one means diverting resources away from producing the
other
Goods in joint supply: these are two goods where the production of more of one lead to the production of more of the other
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