Markets and Price Determination

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Economics

Markets and Price Determination


Definition of a market

Market = A mechanism which brings together buyers and sellers for the purpose of exchanging goods and services

The market determines:

  • the price at which the good is traded
  • the quantity of the good that is traded at this price.

Markets come in many shapes and sizes, and can include:

  • Shops
  • Newspapers (e.g. Exchange and Mart)
  • Internet
  • Telephone lines
  • Cards in the newsagent’s window
  • Jumble sales
  • Car boot sales

Markets for goods can be:

  • local (e.g. Blackpool rock)
  • national (e.g. The Times newspaper)
  • International (e.g. crude oil).

Markets can be:

  • Formal – meet in a specific place, at a specific time, with only qualified traders being admitted (e.g. markets in shares, foreign currency and commodities like oil).
  • Informal – meet irregularly, with anybody allowed in to trade (e.g. car boot sale).

Markets can be:

  • Competitive –  many buyers and sellers (e.g. vegetable market)
  • Monopoly – only one seller and many buyers (e.g. postal service market).

Any market, no matter what its size or shape contains two groups, each exerting a market force that helps to determine the good’s price and quantity traded:

  • Buyers exert the market force of demand.

  • Sellers exert the market force of supply.

Demand

Demand = A consumer demands a good if he wants it, and is willing and able to pay for it.

Wants are unlimited, but demand is limited by factors like the good’s price and the consumer’s income, which restrict his ability to purchase it.

Factors affecting the demand for a product

  1. The price of the product 

 Law of demand = ‘all other things being equal, if the price of the good increases, the quantity demanded falls, and if its price decreases, the quantity demanded rises.’

Utility = the amount of satisfaction obtained from consuming a product.

Marginal utility = the amount of extra satisfaction obtained from consuming an extra unit of a product.

As the consumer consumes more of a product, the marginal utility obtained from it falls (diminishing marginal utility). This makes good sense: you will always enjoy your first bar of chocolate. But as you eat a second and third bar your enjoyment falls (i.e. diminishes), until you reach a sixth or seventh bar – by which time you will probably hate chocolate!

 

Rational consumers aim to maximise the utility they get from spending their money, so the price they pay for a unit of a product is no more than the marginal utility they obtain from that unit.

As the marginal utility from a product diminishes with extra consumption, it follows that the rational consumer will only demand more of a product if its price falls.

A demand schedule = a table showing the quantity of a product demanded at different prices.

A demand curve = a graph of the demand schedule.

 

Points to remember:

  • Always relate the quantity demanded to a suitable time period (e.g. per day, week, month, etc).

  • Always put price on the vertical axis and quantity on the horizontal axis.

  • Always use the correct terms – when price changes there is an increase or decrease in the quantity demanded.

If the price of pies rises from p1 to p2, the quantity demanded decreases from q1 to q2 per day (contraction of demand from A to B).

If the price of pies falls from p1 to p3, the quantity demanded increases from q1 to q3 per day (extension of demand from A to C).

Note: the market demand curve is obtained by adding together the individual demand curves of all the individual consumers of the product.

  1. The conditions of demand 

Condition of demand = anything other than the price of the product that causes the quantity demanded to change.

When a condition of demand changes, the product’s demand curve will shift to a new position.

 

 

If at price p, demand for the good increases from q to q1, the demand curve shifts right (D→D1).

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If at price p, demand for the good decreases from q to q2, the demand curve shifts left (D→D2).

 

The conditions of demand are ‘all other things’ that are assumed equal in the law of demand.


Conditions of demand include:

Normal good = a good whose demand increases when consumers have more income to spend (e.g. holidays, restaurant meals).

Inferior good = a good whose demand decreases when consumers have more income to spend (e.g. own brand products).

Substitute goods = goods that consumers see as alternatives to each other (e.g. margarine and butter, car and public ...

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