Working of A Competitive Market

Course : ECON6093 - Business Economics
Effective Period : September 2020
The Working of Competitive

Markets
Session 2
Thank you
Acknowledgement
These slides have been adapted from:
Essential Economic for Business 6th Edition

JOHN SLOMAN, ELIZABETH JONES
LEARNING OBJECTIVES
1.Analyze the effect of demand determinants to the demand
curve
2.Analyze the effect of supply determinants to the supply
curve
3.Point out the dynamic concept of surplus, shortage and
equilibrium
4.Distinguish the differences of elastic, inelastic and unit
elastic demand and their impact to total
expenditure/revenue
Business in a
Competitive Market
• In a free market
– Consumers are free to decide what to buy with their incomes: free to
make demand decisions.
– Firms are free to choose what to sell and what production methods
to use: free to make supply decisions.
• A perfectly competitive market
– firms are price takers through price mechanism
• The price mechanism
– shortages: price rises
– surpluses: price falls
– equilibrium price - The price where the quantity demanded equals
the quantity supplied; the price where there is no shortage or surplus
– applies to both goods and input (e.g. labour) markets
Business in a
Competitive Market
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).
Business in a
Competitive Market
• 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 (ceteris paribus).
• Effect of changes in demand and supply
– 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 price mechanism:
the effect of a rise in
demand
Goods Market
Sg
Dg shortage Pg until Dg = Sg
(Dg > Sg) Dg¯
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 ¯
Demand
• Relationship between demand and price
– the ‘law of demand’ - when the price of a good rises, the
quantity demanded will fall
– Two reasons behind it:
• 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
The demand curve:
the demand for potatoes (monthly)
Market demand for potatoes (monthly)
250 Point Price Market demand

(pence per kg) (tonnes 000s)
200 A 50 700
Price (pence per kg)
150
100
A
50
Demand
Quantity (tonnes: 000s)


200 A 50 700
B 100 500
150
B
100
A
50
Demand


200 A 50 700
B 100 500
C C 150 350
150
B
100
A
50
Demand


D
200 A 50 700
B 100 500
C C 150 350
150 D 200 200
B
100
A
50
Demand

E
D
200 A 50 700
B 100 500
C C 150 350
150 D 200 200
E 250 100
B
100
A
50
Demand

Demand
• Other determinants of demand
– tastes
– number and price of substitute goods
– number and price of complementary goods
– income
– distribution of income
– expectations
– others …
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

E
D
200 A 50 700
B 100 500
C C 150 350
150 D 200 200
E 250 100
B
100
A
50
Demand

change in price  movement along D curve
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
Price
D0 D1
O Q0 Q1
Quantity
change in any other determinant of demand  shift in D curve

Supply
• Relationship between supply and price
– as price rises, firms supply more
• it is worth incurring the extra unit costs
• The higher the price, the more profitable  firms
switch from less profitable goods
• in the long run, new firms will be encouraged to enter
the market  the supply will rise
• 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)
250 e
Supply
d
200 P Q
a 50 100
c b 100 200
150 c 150 350
d 200 530
b e 250 700
100
a
50
0
0 75 150 225 300 375 450 525 600 675 750
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
– the number of suppliers
– others…
Supply
• Movements along and shifts in the supply curve
– change in price
 movement along S curve

– change in any other determinant of supply
 shift in S curve
– increase in supply  rightward shift
– decrease in supply  leftward shift
Market supply of potatoes (monthly)
250 e
Supply
d
200 P Q
a 50 100
c b 100 200
150 c 150 350
d 200 530
b e 250 700
100
a
50
0
0 75 150 225 300 375 450 525 600 675 750
change in price  movement along S curve
Shifts in the supply curve
P
S0 S1
Possible causes of a rise in
supply
• Fall in costs of production
• Reduced profitability of
alternative products that could
be supplied
• Increased profitability of goods
in joint supply
• Benign shocks Increase
• Expectations of a fall in price
O Q
change in any other determinant of supply  shift in S curve
Shifts in the supply curve
P
S2 S0 S1
Decrease Increase
O Q
change in any other determinant of supply  shift in S curve
Price and Output Determination
• Equilibrium price and output
– response to shortages and surpluses
– significance of ‘equilibrium’
– Equilibrium is the point where conflicting interests are
balanced. Only at this point is the amount that
demanders are willing to purchase the same as the
amount that suppliers are willing to supply. It is a point
which will be automatically reached in a free market
through the operation of the price mechanism.
– Market clearing A market clears when supply matches
demand, leaving no shortage or surplus. The market is
in equilibrium.
• Demand and supply curves
The determination of market equilibrium (potatoes: monthl
E e
250
Supply
D d
200
Cc
150
b B
100
a A
50
Demand
0
0 75 150 225 300 375 450 525 600 675 750
–response to shortages and surpluses
–significance of ‘equilibrium’
–effect of price being above equilibrium
• surplus  price falls
The determination of market equilibrium (potatoes: monthly)
E e
250
Supply
D SURPLUS d
200
(330 000)
Cc
150
b B
100
a A
50
Demand
0
0 75 150 225 300 375 450 525 600 675 750
–response to shortages and surpluses
–significance of ‘equilibrium’
– effect of price being above equilibrium
• surplus  price falls
–effect of price being below equilibrium
• shortage  price rises
E e
250
Supply
D d
200
Cc
150
b SHORTAGE B
100
(300 000)
a A
50
Demand
0
0 75 150 225 300 375 450 525 600 675 750
Equilibrium price and output:
the market demand and supply of potatoes (monthly)
Price of Total market Total market

potatoes demand supply
(pence per kilo) (tonnes: 000s) (tonnes: 000s)
50 700 (A) 100 (a)
100 500 (B) 200 (b)
150 350 (C) 350 (c)
200 200 (D) 530 (d)
250 100 (E) 700 (e)

E e
250
Supply
D d
200
150
b B
100
a A
50
Demand
0
0 75 150 225 300 Q3e75 450 525 600 675 750
• 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 Qe Q
1
P
S
g
Pe
1
D1
O Qe Q
1
P
S
g
Pe1
D2
D1
O Qe Q
1
P
S
i New equilibrium at
Pe point i
2
g h
Pe
1
D2
D1
O Qe Qe Q
1 2
• Effects of shifts in the demand curve

– movement along S curve and new D curve
• rise in demand (rightward shift)  P rises
• 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 Q
1
P
S1
g Initial equilibrium
Pe1 at point g
D
O Qe Q
1
P
S2
S1
g
Pe
1
D
O Qe Q
1
P
S2
S1
k
Pe3
j g
Pe1 New equilibrium at
point k
D
O Qe Qe Q
3 1
Applications of the Market
• Case study: the stock market

– fluctuations in share prices
• historical changes
Financial Times Stock Exchange Index (FTSE)
and Retail Price Index (RPI): 3/1/84 = 1000
8000
7000
6000 FTSE
100
5000
4000
3000
Retail Price Index
2000 (RPI)
1000
Note: FTSE figures based on end-of-month values

Sources: Based on data from Consumer Price Inflation time series dataset MM23 and various, 2019
Applications of the Market
• Case study: the stock market

– fluctuations in share prices
• historical changes
• importance of demand and supply
– factors influencing demand
• the dividend yield
• the price of and/or return on substitutes
• incomes and wealth
• expectations
– factors affecting supply
– share prices and business
Price Elasticity of Demand
• Elasticity
– responsiveness of one variable to a change in another
– helps us understand how markets respond to changes in
demand or supply
• Defining price elasticity of demand (PeD)
– responsiveness of demand to a change in price
• responsiveness of demand for an individual firm in a
competitive market
Market demand curve for an individual firm
under perfect competition
P
Pm D
O
Q
The demand for an individual firm’s product
P P
10
7
6 6
D2
D1
O 90100 Q O 50 100 Q
Firm A Firm B
• Elasticity
– responsiveness of one variable to a change in another
– helps us understand how markets respond to changes
in demand or supply
• Defining price elasticity of demand (PeD)
– responsiveness of demand to a change in price
• responsiveness of demand for an individual firm in a
competitive market
• responsiveness of market demand
Market supply and demand
S1
Price
The effect on price of a shift

a in supply depends on the
P1 responsiveness of 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

– the use of proportionate or percentage changes
– the sign (positive or negative)
– the value (greater or less than one (ignoring sign))
• elastic demand (ε > 1)
• inelastic demand (ε > 1)
• unit elasticity (ε = 1)
• Elastic demand (e > 1). This is where a change in price causes a

proportionately larger change in the quantity demanded. In this
case the price elasticity of demand will be greater than 1, since
we are dividing a larger figure by a smaller figure.
• Inelastic demand (e < 1). This is where a change in price causes
a proportionately smaller change in the quantity demanded. In
this case the price elasticity of demand will be less than 1, since
we are dividing a smaller figure by a larger figure.
• Unit elastic demand (e = 1). This is where the quantity
demanded changes proportionately the same as price. This will
give an elasticity equal to 1, since we are dividing a figure by
itself.
• The determinants of price elasticity of demand
– The number and closeness of substitute goods
• closeness of one product to another
The more substitutes there are for a good and the closer they are as
substitutes, the greater will be the price elasticity of demand.
• closeness of one brand to another
The price elasticity of demand for a product in general will be relatively low
compared to the price elasticity of demand for a more narrowly defined
product.
– The proportion of income spent on the good
The higher the pro-portion of our income we spend on a good, the more we will
have to reduce our consumption of it following a rise in price: the more elastic
will be the demand.
– The time period
The longer the time period after a price change, the more elastic is the demand
likely to be.
and Consumer Expenditure
• Price elasticity of demand and firms’ total sales

revenue (TR)
– TR assumed to the same as total consumer
expenditure on firms’ product
– TR = TE = P x Q
– For example, if consumers buy 3 million units (Q) at

a price of £2 per unit (P), they will spend a total of
£6 million (TE).
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)
• Price elasticity of demand and firms’ total sales revenue

(TR)
– TR assumed to the same as total consumer expenditure
on firms’ product
– TR = TE = P x Q
– effects of a price change on consumer expenditure /
sales revenue
• elastic demand
– TE 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.
P Q TE
(b) Price falls; quantity rises proportionately more;

therefore total expenditure (P × Q) rises.
• Price elasticity of demand and firms’ total sales

revenue (TR)
– TR = TE = P x Q
– effects of a price change on sales revenue
• elastic demand
• inelastic demand
– TE changes in same direction as price
Inelastic demand between two points
Expenditure rises
as price rises
c
8
P(£)
a
4
0 15 20
Effects of a change in price on total expenditure:
price inelastic demand
P Q TE
(a) Price rises; quantity falls proportionately less;

therefore total expenditure (P × Q) rises.
P Q TE
(b) Price falls; quantity rises proportionately less;

therefore total expenditure (P × Q) falls.
Totally inelastic demand (PÎD = 0)
P
D
P2 b
P1 a
O Q1 Q
• Price elasticity of demand and firms’ total sales revenue

(TR)
– TR = TE = P x Q
• elastic demand
• applications to price decisions
– special cases
• totally inelastic demand
• infinitely elasticity demand
Infinitely elastic demand (PÎD = ¥)
P
a b
P1 D
O Q1 Q2
Q
• Price elasticity of demand and firms’ total sales revenue (TR)

– TR = TE = P x Q
• elastic demand
• applications to price decisions
– special cases
• totally inelastic demand
• infinitely elasticity demand
• unit elastic demand
Unit elastic demand (PÎD = –1)
P
Expenditure stays the

b same as price changes
20
a
8
D
O 40 100 Q
Price Elasticity of Supply
• Price elasticity of supply (PS)
• Price elasticity of supply The responsiveness of

quantity supplied to a change in price: the
proportionate change in quantity supplied divided by
the proportionate change in price.
– measurement: %QS / %P
– elastic and inelastic supply

Supply curves with different price elasticity of supply
P
S1
Supply is more elastic
between any two prices S2
along curve S2 than S1
P1
P0
O Q0 Q1 Q2 Q
Other Elasticities
• Determinants of price elasticity of supply
– amount that costs rise as output increases
– time period
• immediate
• short run
• long run
.
Thank You
TEXTBOOK:
Essential Economic for Business
6th Edition
JOHN SLOMAN
ELIZABETH JONES

Working of A Competitive Market

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Course : ECON6093 - Business Economics

Effective Period : September 2020

The Working of Competitive

These slides have been adapted from:

Essential Economic for Business 6th Edition

Changes in demand or supply cause markets to adjust.

250 Point Price Market demand

Quantity (tonnes: 000s)

250 Point Price Market demand

Quantity (tonnes: 000s)

250 Point Price Market demand

Quantity (tonnes: 000s)

250 Point Price Market demand

Quantity (tonnes: 000s)

Quantity (tonnes: 000s)

 movement along D curve

– decrease in demand  leftward shift

Quantity (tonnes: 000s)

change in any other determinant of demand  shift in D curve

 movement along S curve

Price of Total market Total market

50 700 (A) 100 (a)

100 500 (B) 200 (b)

150 350 (C) 350 (c)

200 200 (D) 530 (d)

250 100 (E) 700 (e)

• Effects of shifts in the demand curve

• Effects of shifts in the demand curve

• Case study: the stock market

Note: FTSE figures based on end-of-month values

• Case study: the stock market

The effect on price of a shift

c Curve D' is more elastic

• Defining price elasticity of demand (PD)

– measurement: %QD / %P

• Elastic demand (e > 1). This is where a change in price causes a

• Price elasticity of demand and firms’ total sales

– For example, if consumers buy 3 million units (Q) at

• Price elasticity of demand and firms’ total sales revenue

(a) Price rises; quantity falls proportionately more;

(b) Price falls; quantity rises proportionately more;

• Price elasticity of demand and firms’ total sales

(a) Price rises; quantity falls proportionately less;

(b) Price falls; quantity rises proportionately less;

• Price elasticity of demand and firms’ total sales revenue

• Price elasticity of demand and firms’ total sales revenue (TR)

Expenditure stays the

• Price elasticity of supply The responsiveness of

– measurement: %QS / %P

– elastic and inelastic supply

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