MG1054 - Economics for Business (6th edition) Business and markets PDF

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MG1054 – International Business Environment

Glossary Economics for Business (6th Edition) PART B Business and markets CHAPTER 4 THE WORKING OF COMPETITIVE MARKETS

4.1 – Business in a competitive market The firm is greatly affected by its market environment, which is an environment that is often outside the firm’s control and subject to frequent changes. For many firms the market determines prices. The market also dominates firm’s activities. The more competitive the market is, the greater this domination becomes. In an extreme case the firm has no power at all to change its price and that is what we call a price taker, it has to take the market price given. In competitive markets, consumers are also price takers, they have to accept the price given in the stores and cannot change it. The price mechanism: In a free market individuals are free to make their own economic decisions. Consumers are free to make demand decisions and firms are free to make supply decisions. The decisions are transmitted through each other through their effect on prices through the price mechanism. The price mechanism works as follows: prices respond to shortages and surpluses. Shortages cause prices to rise (which will act as an incentive to producers to supply more and discourage people from buying more) and surpluses cause prices to fall (which has the opposite effect). The price when demand equals supply is called the equilibrium price. The effect of changes in demand and supply: In all cases of changes in demand and supply, the resulting changes act as both signals and incentives. A rise in demand is signaled by a rise in price. This then acts as an incentive for firms to produce more of the good: the quantity supplied rises. A fall in demand is signaled by a fall in price. This acts as an incentive for firms to produce less: the goods are now less profitable to produce. A rise in supply is signaled by a fall in price. This acts as an incentive for consumers to buy more. A fall in supply is signaled by a rise in price and acts as an incentive for consumers to buy less. When these changes happen it causes the market to adjust i.e. the resulting disequilibrium will bring an automatic change in prices and thereby restoring equilibrium. The interdependence of markets The interdependence of goods and factor markets: A rise in demand for a good will raise its price and profitability. Firms respond by supplying more. But to do this they’ll require more inputs, thus the demand for inputs will rise which will raise the price for the inputs. The suppliers of inputs will therefore supply more. The goods market therefore affects the factor markets. Also a rise of price of one good will encourage consumers to buy alternatives.

MG1054 – International Business Environment

4.2 – Demand When the price of a good rises, the quantity demanded will fall. This relationship is known as the law of demand. There are two reasons for this law:  People will feel poorer. The purchasing power of their income has fallen and they can’t buy as many goods with it as before. This is called the income effect of a price rise.  The good will now be dearer relative to other goods. People switch to substitute goods. This is called the substitution effect. Quantity demanded refers to the amount consumers are willing and able to purchase at a given price over a given period. It does not refer to what people would simply like to consume. The 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 (p.50) Other determinants of demand: Price is not the only factor that determines how much of a good people will buy. It’s also affected by the following:  Tastes: The more desirable the good, the greater the demand. Taste is affected by factors such as advertising, fashion, observations of other consumers etc.  The number and price of substitute goods: The higher the price of substitute goods, the higher the demand for this good as people switch from the substitutes.  The number and price of complementary (matching) goods: Complementary goods are those that are consumed together i.e. cars and petrol. The higher the price of complementary goods the fewer of them will be bought hence the less the demand for this good.  Income: As people’s income rise, their demand for most goods will rise. Such goods are called normal goods. However, as people get richer, they'll spend less on inferior goods such as cheap margarine and switch to butter.  Distribution of income  Expectation of future price changes: If people think that prices are going to rise in the future, they’re likely to buy more now before the price goes up. Movements along and shifts in the demand curve: In the demand curve it is assumed that none of the determinants of demand other than price changes. If one of those other determinants changes, we’d have to construct a whole new demand curve: the curve shifts. Example: If a change in one other determinant causes demand to rise the whole curve will shift to the right. If a change causes demand to fall, the curve will shift to the left. A shift in demand is referred to as a change in demand, whereas a movement along the demand curve as a result of a change in price is referred to as a change in the quantity demanded.

MG1054 – International Business Environment 4.3 - Supply When the price of a good rises, the quantity supplied will also rise, there are three reasons for this.  As firms supply more, they are likely to find that, beyond a certain level of output, cost 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. Firms will thus be encouraged to produce more of it by switching from producing less profitable goods.  Given time, if the price of a good remains high, new producers will be encouraged to set up a production. Total market supply thus rises. The first two determinants affect supply in the short run and the third affects it in the long run. The 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: Like demand, supply is not determined simply by price. The other determinants of supply are as follows:  The cost of production: The higher the costs of production, the less profit will be made at any price. As costs rise, firms will cut back on production, switching to alternative products whose costs have not risen so much. The main reasons for a change in costs are as follows: o Change in input prices: costs of production will rise if wages, raw material prices, rents etc. rise. o Change in technology: technological advances can fundamentally alter the costs of production. o Organizational changes: various cost savings can be made in many firms by reorganizing production. o Government policy: costs will be lowered by government subsidies and raised by various taxes.  The profitability of alternative products: If some alternative product becomes more profitable to supply than before, producers are likely to switch from the first good to this alternative.  The profitability of goods in joint supply: when two goods are produced at the same time. An example is the refining of crude oil to produce petrol. Other grade fuels will be produces as well such as diesel and paraffin. If more petrol is produced, then the supply of these other fuels will rise.  Nature shocks and other unpredictable events  The aims of producers: A profit-maximizing firm will supply a different quantity form a firm that has a different aim, such as maximizing sales.  Expectations of future price changes: If price is expected to rise, producers may temporarily reduce the amount they sell and build up their stock and release them when the prices are up.  The number of suppliers: If a new firm enters the market, supply is likely to change.

MG1054 – International Business Environment Movements along and shifts in the supply curve: The principle here is the same as with demand curves. If any determinant (other than price) of supply changes the whole supply curve will shift. A rightward shift illustrates an increase in supply. A leftward shift illustrates a decrease in supply. 4.4 – Price and output determination Equilibrium price and output: When supply matches demand the market is said to clear. There is no surplus or shortage. This is the only sustainable price (equilibrium price) and the only price at which consumers and producers are mutually reconciled. Movement to a new equilibrium: The equilibrium price will remain unchanged only so long as the demand and supply curves remain unchanged. If either shifts, a new equilibrium will be formed. If one of the determinants of demand changes, the whole demand curve will shift and will move along the supply curve to the new intersection point. Likewise if one of the determinants of supply changes (other than price) the whole supply curve will shift and move along the demand curve. CHAPTER 5 Business in a market environment

In chapter 4 we examined how prices are determined in perfectly competitive markets: by the interaction of market demand and market supply. In practice however, many firms are not price takers; they have some discretion in choosing their price. Such firms will face a downward sloping curve. If they raise their price, they’ll sell less; if they’ll lower their price, they’ll sell more. Such firms want to know how responsive demand is to a rise in price. This responsiveness is measured using a concept called elasticity (The responsiveness of one variable to a change in another. The more elastic variables are, the more responsive the market is to changing circumstances). 5.1 – Price elasticity of demand Defining price elasticity of demand: We want to compare the size of the change in quantity demanded of a given product with the size of the change in price. (skoða sýnidæmi bls. 64) Percentage of change in quantity demanded Percentage of change in price Elasticity is measured in percentage terms (proportionate) for the following reasons:  It allows comparison of quantity changes (demand) with monetary changes (price)  It is the only sensible way of deciding how big a change in price or quantity is. The sign (positive or negative): If price increases (positive), the demand will fall (negative) and vice versa.

MG1054 – International Business Environment The value (greater or less than 1): This tells us whether demand is elastic or inelastic.  Elastic (>1): This is where a change in price causes a proportionately larger change in the quantity demanded.  Inelastic (...