The Prices of Other Products
- The demand for a product can also be affected by a change in the price of another, different product
- Two possible cases are recognised
- These are where there are substitutes and complements to the product in question
- Most products have substitutes.
- They occur when a good or product faces competition from another product
- In such situations, there is competitive demand
- To the economist, there is a relationship between the price of one product and the demand for a substitute
- If the price of a product goes up, then there will be an increase in demand for another product
- Alternatively, if the price for a product falls, then there will be more of a demand for this product, resulting in a fall in demand for the substitute, as this product will no longer be as price competitive
- Complements, on the other hand, tend to be jointly demanded
- If the price of a product increases, then it will lead to the rise in price of another product which is a complement, and a subsequent fall in demand for both of them
- There is therefore an inverse relationship between the price of the complement and the demand for the product that is jointly demanded.
- In order to make rational decisions with respect to demand in general, it is very important that consumers are aware of market prices
- The internet has allowed users to find accurate up-to-date information on a whole range of prices
- This has put on increased pressure on retailers to be competitive
Tastes and Fashion
- Consumer tastes constantly change, and there is obviously demand for a product when it’s to a consumer’s tastes
- If a thing is fashionable, it will be in high demand
- Examples include things like the latest mobile phones, clothing, and holidays.
- Taste, to some extent, is more personal
- Some people may like a particular product, while others may not want to consumer it, irrespective of its price
- A vegetarian, for instance, would never buy beef or chicken
- Advertising has a huge effect on demand, as it affects tastes and fashion
- Informative advertising, where the positive features of a product are promoted, can have a powerful effect on demand.
A Change in Demand due to a Change in Non-Price Factors
- It is clear that changes in consumer income, the prices of other products, and tastes in fashion cause a change in demand for a product
- When this occurs, it results in a shift of the demand curve or schedule
- This means that in a different amount of the good or service is now demanded at the same price
- This must not be confused with a movement along a demand curve, which is due to a change in the price of a product resulting in the change in the quantity demanded.
- A change in demand can product two results:
- An increase in demand, where the demand curve shifts to the right
- This means that more of the product is being produced at the same price
- A decrease in demand, where the demand curve shifts to the left
- This means that less of the product is now demanded at the same price
Supply
- Supply is what the producers of any type of product provide from the scarce resources available to them
- Through supply, they are aiming to meet the unlimited wants of consumers
- Supply in the market is in the hands of the producers
- This is whether we are dealing with tangible goods (mobile phones, food, clothing) or services
- Supply seeks to satisfy consumers, but the main motives of suppliers are to do with profit
- Economics assumes that the behaviour of a supplier is governed by the consistent need to maximise profits
- The producer’s function is to combine the factors of production together in an efficient and profitable way
- To do this, a producer needs to decide how to use the various factors of production to find the least costly and hence most profitable combination for the output they produce
- With the example of mobile phones, when the producer combines the factors of production, this involves:
- The assembly of components and parts
- Employing skilled labour
- Producing at a suitable location
- Hiring the business skills and contracts to survive
- Supply, therefore, can be increased by producing more or by releasing stocks of goods held in a warehouse
Relationship between price and Quantity Supplied
- Given the producer’s motivation to supply, it should be clear that there is a greater willingness to increase the quantity supplied when there is a rise in prices
- This is because firms are more likely to be making a greater profit
- So when price increases, the quantity supplied also increases
- If there is a fall in price, there will be a fall in the quantity supplied as producers are less likely to make a profit
The Supply Curve
- The supply curve is a representation between the price of a product and the quantity that is supplied
- Price is on the y axis, quantity supplied is on the x.
- The data for which a supply curve is derives is taken from a supply schedule
- This is a data set which shows how much of a product is likely to be supplied over a range of prices
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Obtaining this data is easier than for a demand schedule, as suppliers can control how much they are willing and able to supply at a particular price.
- Here we have assumed that there is only one supplier of self-catering holidays to Ibiza in June
- In other words, the supply curve is also the market supply curve
- If there is more than one supplier, the market supply curve is the sum of the individual supply curves of all producers.
Producer Surplus
- Producer surplus is much like consumer surplus
- As producers aim to maximise profits, they will be keen to supply to consumers who are willing to pay a price above what the producers are normally willing to accept
- If we go back to the previous table and suppose that the producer has a baseline price of £350 per holiday:
- This is what, on average, the firm might see as a fair price for a holiday to Ibiza
- However, there are more likely to be more consumers that are willing to pay over this price
- So, when they pay this, they will be providing additional revenue to the producer – above what is the normal expectation
- This is what is meant by producer surplus
Other Factors Affecting Supply
- Other factors, aside from price, that affects a producer’s willingness to supply are:
- Costs of production
- Size and nature of the industry
- Government policy and other factors
Costs of Production
- There are many things that can affect the costs of production
- Any change in any input can have an effect on the firm’s profits and willingness to supply the market.
- The most obvious is a change in the costs of the factors of production
- For example, oil prices have been rising over the years, and this clearly impacts upon a firm’s production costs
- How much is imports will depend upon how important these factors are for a firm’s production costs
- In some types of activity, labour costs are a high proportion of total costs
- This is true in service sector activities, such as retailing and transport
- Therefore, an increase in labour costs has to be passed onto the consumers in the form of higher prices
- In practise, it is difficult to generalise
- Labour in plentiful supply will usually not increase in price to the same extent as labour which is specialist and in short supply
- The extent of any change in the supply price will depend upon if a producer can be more efficient in their production process
- An example would be replacing workers in car manufacturing with machines (capital)
- Technological advances decrease production costs
Size and Nature of the Industry
- Some industries are more competitive than others
- Where this is the case (such as grocery retailing), minor increases in costs can have a big impact on supply
- Any cost increases in less price competitive markets can usually be passed on to consumers, with very little effect on profits
Government Policy
- Most product that firms supply are subject to indirect taxation such as VAT
- Any increase in this taxation will have to be passed on to the consumer through increase prices
- In turn, the increased prices will affect the producer’s willingness to supply
- Legislation and regulations can also affect a firm’s costs
- Health and Safety regulations invariable lead to higher production costs
- Such regulations tend to affect all firms, so any effect on the costs of production tends to affect all firms in a fair way
- In a few instances, the government is prepared to give an annual subsidy to firms
- This is in the form of a payment to reduce costs, and hence prices
- Examples are to farmers to keep food costs low, and to rail transport companies
- As a result, the supply of products is increased
Other Factors
- The supply of products is often subject to factors that suppliers have little or no influence
- An example is agriculture, where bad weather can destroy a whole season’s harvest
- Another example is that when foot and mouth disease spread, it reduced the supply of pork and beef coming onto the market
- To contrast, nutritionists claimed that pomegranate juice was very beneficial to one’s health, and as a result, the demand for pomegranate juice has increased
A Change in Supply due to a Change in Non-Price Factors
- Costs or production, size and nature of the industry, government policy and other uncontrollable factors can result in the change in supply of a product
- This means that a different quantity is now being supplied at the same price
- When this occurs, the supply curve is being shifted to either the left or the right
- There are 2 possibilities:
- An increase in supply, meaning that more will be supplied at the same price
- E.g. tax reduction or technological advance – shift to the right
- A decrease in supply, where less of a product is being supplied at the same price
- E.g. increased tax or a more expensive factor of production – shift to the left
- A change in supply must not be confused with a change in the quantity supplied, which is due to the price of the product alone
How Prices are Determined
- As consumers, for many of the things we purchase, price is a very important consideration
- We always want to pay the lowest price we can
- For suppliers, their decision on whether to supply the market is based heavily on the price that they can obtain
- Therefore, price is central to the way in which resources are allocated
- The price of any product is determined by demand and supply
- The equilibrium price, or clearing price, is where the amount consumers wish to buy and the amount producers wish to put up for sale are equal
- In other words, both parties in the market are satisfied
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Demand is being met, and there are no unsold products, so neither side will have any reason to want to change
- In practise, markets are often unstable and not always in equilibrium
- This is called disequilibrium – demand and supply are not equal
- Where this happens, the natural forces in the market result in the market price and output moving to the equilibrium position.
- Two cases are:
- Where the price set by producers is too high
- If the tour operator for holidays thinks that consumers would be willing to pay £400 for a holiday, they will supply 1,100 holidays
- Consumers, however, at £400, would only want to buy 650, leaving lots of unsold holidays or a surplus
- This situation cannot persist, so the tour operator is forced to reduce the price of these holidays, to clear the surplus supply
- When supply is greater than demand, price will fall
- Where the price set by producers is too low
- If the tour operator set prices at £200, consumers would be willing to buy 1,300 holidays
- However, at this price, the tour operator will only be able to provide 900 holidays, creating a shortage
- In this situation, companies looking to maximise profits will see this as an opportunity to raise prices and provide more holidays for the market.
- Prices will rise to the equilibrium price, which will be too high for some consumers, so demand will fall
- When demand is greater than supply, price will rise
Effects of a Change in Demand or Supply on the Equilibrium Position
- Within a market, the position of equilibrium could change due to:
- A change in demand, whereby the demand curve shifts to the right or left
- A change in supply, whereby the supply curve shifts to the right or left
- A more or less simultaneous change in demand and supply
- When looking at these effects, it is important to be mindful of the time scale
- Markets, especially on the supply side, cannot adjust quickly
- On the demand side, however, epidemics can have a rapid effect on the equilibrium price and quantity
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The usual assumption made is that all other market factors remain unchanged.
Elasticity
- We have no covered how much demand and supply changes when any factors, including price of the product changes.
- This is where the concept of elasticity comes in, which is:
- A numerical estimate
- It measures the response to a change in price or any other factors that determine the demand and supply of a product
- Elasticity explains things like:
- The price of a summer holiday in May or June is around 2/3rds of the price it is in August
- The demand for some products increases more than others when real disposable income increases
- It is often difficult for suppliers to respond quickly when there is a surge in demand for their products.
Price Elasticity of Demand (PED)
- PED measures how responsive the quantity demanded of a product is to a change in its price
- All other factors that affect demand are assumed to remain unchanged
- Mathematically, it is no more than the gradient of the demand curve
- For example, supposed a tour operator sells 5,000 holidays a month to Ibiza for a price of £400.
- When the price is increased to £440, the demand falls to 4,000 holidays per month
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So:
- This estimate of -2 indicates that the demand for holidays to Majorca is responsive to a change in the price of these holidays
- This is known as a price elastic of price sensitive situation
- The negative sign just shows that the quantity demanded has fallen as a result of the increase in price
- Not all products we buy are very responsive to a change in their price
- For example, if the price of household water were to increase by 10%, demand would hardly fall – maybe by 1%
- This would produce an estimate of PED to be -0.1
- This is price inelastic or price insensitive, meaning that the quantity demanded is not particularly responsive to a change in its price
- If PED > 1 – elastic
- If PED < 1 – inelastic
- If PED = 1 – unit PED (change in price causes a proportional change in demand)
- Variations in PED lead us to ask the question: ‘What determines the price elasticity of demand for a product or group of products?’
- There are three main determinants:
- The availability and closeness of the substitutes
- The relative exposure of the product with respect to income
- Time
- We know that a substitute is an alternative to a particular product
- In general, the greater the number of substitutes and the greater their closeness to a given product, then such a product is likely to be price elastic
- An example is baked beans
- There are many brands that are similar to each other, and so a rise in the price of one brand would result in a steep fall in demand, as more consumers would be buying other brands
- If a product takes up a very small percentage of a consumer’s income (e.g. a banana) – the doubling in price wouldn’t affect the quantity demanded that much –it’d be price inelastic
- The reverse is true
- If a product takes up a large part of a person’s income, then its demand would be more sensitive to a change in price – it’d be price elastic
- Time also plays a part, as it takes a while for consumers to change their spending habits
- As a result, they are quite likely to continue to purchase a product despite a price increase
- Over time, however, as consumers find out more about other substitutes, demand for a product is likely to become more price elastic.
- Also, where consumption of a product can be delayed (new car, new kitchen), demand for that product is likely to be price elastic.
Income Elasticity of Demand (YED)
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The sign is important, as it indicates whether there is an increase or decrease in the quantity demanded following a change in income
- Most products have a positive YED – these are called normal goods
- This means that as real disposable income increases, demand for these products will also increase
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E.g. holidays, wine, clothes, electronics, etc.
- The extent of the response of demand to the change in income can vary.
- Two examples are:
- Where the estimate of income elasticity of demand is < 1 –income inelastic
- Where income elasticity of demand (YED) is > 1 – income elastic
- Some goods have a very large income elasticity of demand – these are called superior goods
- Demand for them increases considerably more in relation to the change in income
- Definitive examples are hard to list, as it is subjective.
- What is a normal good for one person could be a superior good to a person on lower income
- Examples of inferior goods are own-brand supermarket products, second hand goods, coach travel, etc.
- Better substitutes are available, but for a family on low income, such alternatives are out of their reach.
Cross Elasticity of Demand (XED)
- XED is derived from what was previously stated – that the price of substitutes and complements can affect the demand for a particular product
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- It measures the relationship between two different products, so the sign and size of the XED are relevant
- A positive estimate indicates that the two products are substitutes
- A negative estimate means that they are complements
- A zero estimate means that there is no particular relationship
- The size of the XED indicates the strength of the relationship between a change in the price of one product and the change in demand for another product
- Where products are good or close substitutes, the value of the XED will be higher than if they are only modest substitutes.
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Similarly, for the complements, a high value of XED is indicative of products with a high degree of complementarity.
Price Elasticity of Supply
- Price Elasticity of Supply (PES) is the supply equivalent of PED
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- PES indicates how much additional supply a producer is willing to provide for the market following a change in the price of the product
- Given that the supplier wants to maximise profits, it follows that the PES will always be positive
- Obviously, if the price falls, it would be unusual for the supplier to produce more goods for the market in a free market solution
- The size of the PES is therefore very important, and can take the following values:
- This means that the PES is inelastic
- Supply is not very responsive to a change in the price of the product
- PES if elastic
- Producers are able to respond with a relatively large change in supply if price rises
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A change in price causes an exactly proportional change in the quantity supplied
- In practise, suppliers are not always able to respond to a change in price with the same speed as consumers
- This is because for most products, it takes time for producers to alter their production schedules in response to market need, unless they can draw upon stocks.
- For farmers, this time lag could be as much as a year – the time it takes to alter the mix of their production
- Large parts of the service sector face a rather different supply issue.
- In the long term, the supply of their products is more elastic than in the short term
- In the case of hotel or air-craft, supply is perishable as the product can’t be stored
- If a hotel room is not sold on a particular night, this represents a loss to the business.
- So there are three main factors that determine the PES of a product:
- Availability of stocks of the product
- Availability of factors of production
- Time period
- Stocks or inventory allow supplies to store products in a warehouse
- This relates to elasticity of supply as they can be quickly distributed if demand increases and henceforth price
- Equally, if price falls, goods can be stored, depending on how perishable they are
- For example, supermarkets like ASDA carry a certain amount of ‘buffer stock’, which can be released if market conditions change
- For service sector businesses like hotels, supply is infinitely inelastic since the product cannot be stored, it has to be consumed on a particular day or time period otherwise it is lost.
- With regards to the factors of production and its effect on PES, labour is usually the most available.
- Provided there is spare capacity, additional works can be used to increase output, often in a short time span
- Here, elasticity of supply is relatively elastic
- For some businesses, it is the availability of capital that determines whether a firm can increase output
- When new machinery has to be purchased and installed, the elasticity of supply will be inelastic
- The risk is that market conditions may change before any increased production can reach the market
- With regards to time, where it takes a long time for supply to be adjusted, supply will be inelastic
- In the longer term, however, supply will normally be more price elastic
- An example is travel companies – they have to reserve flights up to a year in advance for some consumers - making supply price inelastic
- The problem companies then face is if demand is low, they are left with unsold holidays
- Price will therefore have to fall in order to clear excess supply
Business Relevance of Elasticity Estimates
- Elasticity measure have considerable practical business relevance
- For example, knowledge of PED is an essential input when a firm is generating a pricing strategy which enables them to maximise sales revenue.
- But how might this data be collected and what are the general limitations of elasticity data?
- All elasticity measures require information to be collected at two separate points in time
- The formulas make this clear by indicating that ‘change’ is being measured
- The information can be collected by means of:
- Sample surveys of consumers (price and YED)
- Past records from within a company (PES)
- Competitor analysis (XED)
- Given the nature of how the data is collected, it is necessary to appreciate that:
- The data gathered will be estimates, since the data collected might be inaccurate
- Over time, there could be other factors that aren’t in the forecast that affect the demand of supply of a product
- Prices may fall due to this, which produces an unfair elasticity estimate
Use of PED
- PED is widely used by businesses when pricing their products in the market
- It is evident in the transport market where the market’s segmented on a time basis
- Most firms like this seek to maximise their revenue by charging peak and off-peak fees or prices
- In applying market knowledge of PED, companies are pursuing an objective of maximising revenue
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Companies are aware that where demand is inelastic, an increase in price leads to an increase in total revenue.
- The business situation in both graphs is clearly beneficial, as revenue increases
- What is not beneficial is for a firm to reduce prises if demand is inelastic or to increase prices where demand’s elastic
Use of Income Elasticity of Demand
- In most economies, real disposable income tends to rise over time
- This is significant to businesses that produce goods and services because with a highly positive YED can expect to do well in the future
- Oppositely, firms producing goods with a negative YED might do badly
- An exception to this is where a business changes the image of a product so that YED becomes position
- Upmarket baked beans and spam are examples, as they’re not marketed as superior, but used to be inferior products
- In economies such as the UK, where living standards continue to increase, there has been a growth in markets in the service sector, such as overseas holidays, eating out and health spas.
- So these types of businesses would seem to have good business prospects in the long term
- Estimates of YED can provide a basis for forecasting market demand
- When economies force uncertain short term economic prospects, then demand for income elastic products will fall
- This is because consumers are forced to substitute their demands towards inferior goods and services
- Products with a low YED are unlikely to be affected by a rise or fall in living standards
Use of Cross Elasticity of Demand
- Estimates for XED are useful in competitive markets
- Where there are close substitutes, and hence a high positive XED with other products, then the firm are likely to cut prices to increase market share
- This occurs in practise between:
- Low cost airlines, train and bus companies on identical routes
- Well known brands of identical grocery or electronic products
- Products such as wine and butter that are produced in different companies but are virtually the same
- In such cases, there are close substitutes
- Increasing prices is dangerous, as you can lose market share to a rival, which is difficult to regain
- The case of compliments also has implications for firms
- This is because the price of two complimentary goods may not be close
- Here, XED will be high and negative
Use of Price Elasticity of Supply
- PES is always positive – it shows the affect of the relationship between price and quantity supplied
- In many types of business, supply is price inelastic in the short term, as it is often difficult to switch resources into a market
- An exception to this is firms that hold onto stocks in anticipation of a price rise
- In the long term, however, supply is more likely to be price elastic as resources can be re-allocated to respond to the increase in market price
- In general, firms will try to make their supply as elastic as possible, as they want to increase sales to maximise profits
- If prices are falling, an elastic supply will enable them to move resources away from such products and into alternatives where there’s a normal relationship between a change in price and the change in quantity supplied.
Allocative Efficiency
- For efficiency to happen, the factors of production must be fully employed to meet consumers’ needs
- The prices charged by the producers should be at the lowest level
- With allocative efficiency, scarce resources are used to produce the goods and services that consumers actually demand.
- To achieve this, quantity supplied must be equal to the quantity demanded
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In other words, the market must function at the equilibrium position
- It is invariable the case that in practice, markets don’t work efficiently
- Consumers are therefore losing out, since it is not possible to produce what they want in the right quantities
- This is how allocative efficiency is seen from a microeconomic perspective