PRICE DETERMINATION IN A COMPETITIVE MARKET

MICROECONOMICS

Demand – The quantity of a good or service that consumers are willing and able to purchase at
given prices in a given time period

Market Demand – The quantity of a good or service that all consumers in a market are willing and
able to purchase at given prices in a given time period NOTE – Economists usually use this

Ceteris Paribus – A Latin phrase that means ‘other things being equal’ NOTE – It is used in
economics when we focus on changes in one variable while holding other influences constant

Law of Demand – A law that states that, ceteris paribus, there is an inverse relationship between
the quantity demanded and price of a product

Notional Demand – The desire or want for a product

Effective Demand – The willingness and ability to buy a product

Demand Curve – A graph that shows how much of a product will be demanded at any given price

Demand Schedule – The collection of data that is used to draw a demand curve for a product NOTE
– It’s essentially just a table showing different prices of a product and the different quantities
demanded of that product (that correspond with said prices)

Market – A place in which there are a set of arrangements allowing transactions to take place
between buyers and sellers NOTE – This does not have to be a physical place (e.g. buying a
product off of a website)

Sub-Market – A recognised or distinguishable geographic, economic or specialised subdivision of a

market, also known as a market segment

Composite Demand – Demand for a good that has various uses e.g. water (drinking, washing etc…)
On the diagram on the left, the y-axis is labelled ‘Price’ in
reference to the price of a particular product (e.g. it could
be the price of a coke can), and the x-axis is labelled
‘Quantity Demanded’ in reference to the effective demand
of the same particular product. At price P0 (some arbitrary
price such as £1.00, for example) the quantity demanded for
the product is Q0 (some arbitrary amount such as 2 units),
shown by point A on the demand curve (D). The demand
curve can be used to show what is expected to happen to
the quantity demanded of a product when its price changes.

If the price of said product increases from P0 to P1, the diagram shows that the quantity demanded of the product
should decrease from Q0 to Q1, shown by moving from point A to point B. This makes intuitive sense as you are likely
to buy less of a product when it becomes more expensive. This movement along the demand curve is known as a
contraction of demand. Conversely, if the price of said product decreases from P0 to P2, the diagram shows that the
quantity demanded of the product should increase from Q0 to Q2, shown by moving from point A to point C. This
makes intuitive sense as you are likely to buy more of a product when it becomes cheaper. This movement along the
demand curve is known as an extension of demand.

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Why the Demand Curve is Downwards Sloping:

• There are 3 reasons as to why the demand curve is thought to be downwards sloping:
 The law of diminishing marginal utility (satisfaction)
 The income effect
 The substitution effect
• The law of diminishing marginal utility (satisfaction):
 This law simply states that as more of a product is consumed, the marginal
(additional) benefit to the consumer falls, hence the consumer is prepared to pay
less NOTE – This makes intuitive sense. If you were thirsty and wanted to buy a
can of coke, you would be willing to pay a fairly high price. If, however, you were
in a position where you had already consumed 3 cans of coke, you wouldn’t be
quite so willing to buy another one at the same price, and so you would possibly
only consider buying another one if the price dropped even further. It could be
argued that, at a certain point, the price you are willing to pay may even drop to
0, as you have simply consumed more than enough of the product (e.g. 8 cans of
coke)
• The income effect:
 If we assume that the amount of income (money) you have is fixed, the income
effect suggests that as the price of a good falls, the amount of ‘leftover’ income you
have rises. As a result, at a lower price you can buy more of the same good from the
same amount of money, by simply using the ‘leftover’ income to buy more of the
good NOTE – You could also argue that when a product drops in price, it makes
you feel richer because your ability to buy the product has now increased (e.g. ‘I
can afford to buy 2 cans of coke rather than 1’)
• The substitution effect:
 As the price of one good falls, it becomes relatively less expensive than others
 Therefore, assuming other alternative products (substitutes) stay at the same price,
at lower prices, the good appears to be cheaper and so consumers will switch from
one expensive alternative (substitute) to the relatively cheaper one NOTE – For
example, imagine that, initially, the price of a Coca Cola can was £1.50 and the
price of a Pepsi can was £1. If the price of a Coca Cola can dropped to 50p, those
who were buying Pepsi cans are now more likely to switch to buying Coca Cola
cans. This is because the Coca Cola cans are now relatively cheaper compared to
Pepsi

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Whilst we have looked at price changes and what they do to the
quantity demanded of a product, it is also important to look at non-
price factors and how they can have an effect on the quantity
demanded of a product. If there is say, a decrease in average incomes,
possibly due to a recession (resulting in a lot of people being out of
jobs), then it is possible that without any change in price, the total
amount of people willing and able to purchase a given product (e.g. a
can of coke) may decrease, resulting in demand decreasing (shifting
to the left) from D to D1. This results in the same price of the product
(P0) resulting in a lower quantity demanded of the product (Q1 rather
than Q0), simply due to the fall in overall demand.

Conversely, if, for example, Coca Cola increased advertising of its products, then it is possible that the total amount
of people willing and able to purchase the product (a Coca Cola can, in this case) would increase, simply due to the
increased awareness. This is because some people who may have been happy to buy a Coca Cola can may not have
(simply due to not knowing about its existence), and those who already knew about it may have been reminded of
how much they like it. As a consequence, the increase in demand (shift to the right) from D to D2, can result in the
same price of the product (P0) leading to a higher quantity demanded of the product (Q2 rather than Q0), simply due
to the increase in overall demand. There are several non-price factors which have these effects (these will be listed
below).

PRIEST ALI (Demand Shifters / Determinants / Conditions):

P – Population – If there is a change in the size of the population, this will change the total amount
of people willing and able to buy any given product, thus changing demand e.g. increase in
population size (e.g. due to increased immigration)  increase in demand for any given product

R – Related Goods – If there is a change in the price of a substitute for a product, or a change in the
price of a complement for a product, this will lead to a change in demand for said product e.g.
increase in the price of a substitute product (e.g. Pepsi cans)  increase in demand for Coca Cola
cans NOTE – This is actually related to what is known as ‘cross elasticity of demand (XED)’. This
will be discussed in much greater detail, later in this chapter

I – Interest Rates – If there is a change in interest rates, this will change the cost of borrowing and
the amount of money received in return for those who save. This will change the total amount of
people willing and able to buy any given product, and so change demand as well e.g. decrease in
interest rates  cheaper to borrow, less return from savings  increase in total spending 
increase in demand for any given product NOTE – Interest rates will be discussed in far greater
detail in chapter 7.1

E – Expectations of Future Prices – If there is a change in the expectation of the future price of a
product, this will lead to a change in the current level of demand for said specific product e.g. price
of oil is expected to increase in the future  increase in demand for oil now

S – Seasons – If there is a change in seasons, this is likely to lead to a change in demand for a given
set of products e.g. winter is coming  increase in demand for winter jackets and coats, and a
decrease in demand for thin t-shirts and shorts (other products may be affected as well)

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T – Tastes – If there is a change in the tastes of consumers, such as a new fashion trend or a rising
social trend towards higher living standards (e.g. people wanting virtual reality products), this will
lead to a change in demand e.g. increasing fashion trend for jeggings  increase in demand for
jeggings

A – Advertising – If there is a change in the level of advertising for a product (e.g. Coca Cola cans)
this will likely lead to a change in demand for said specific product (due to increased awareness)
e.g. increase in advertising for Coca Cola cans  increase in demand for Coca Cola cans

L – Legislation – For example, if a motorcycle helmet law is introduced, requiring that everyone
must wear a helmet on a motorcycle, this would lead to an increase in demand for motorcycle
helmets

I – Average Disposable Income – If there is a change in the level of average disposable income, this
will change the total amount of people willing and able to buy any given product, thus changing
demand e.g. average disposable income rises  rise in demand for any given product NOTE –
Disposable income is essentially people’s level of income after taxes have been deducted and
state benefits have been added. This concept hasn’t been discussed yet, but will be in chapter 7.1.
Also, bear in mind that the effects of average disposable income on demand depend on the YED
of the product (YED will be discussed later in this chapter)

Veblen / Snob Good – A good for which the quantity demanded increases as the price increases,
because of its exclusive nature and allure as a status symbol e.g. designer, luxury items with a
strong brand identity such as a Rolex watch NOTE – It leads to an upwards sloping demand curve,
contrary to the law of demand. It is a special case
Veblen / snob goods are thought to lead to what is known as
‘conspicuous consumption’. This is because, unlike a typical good,
the quantity demanded for a Veblen good increases as its price
increases because consumers see it as an exclusive status
symbol, resulting in an upwards sloping demand curve. The
goods are expensive so that only the very affluent can afford
them; the higher their price, the less likely other consumers can
afford them, and the more buyers perceive them to signal great
wealth and success. If a Veblen good’s price decreases, demand
will decrease because status conscious consumers will see it as
less exclusive (e.g. Michael Kors bags).
Elasticity – A measure of a variable’s sensitivity relative to a change in another variable

Price Elasticity of Demand (PED) – A measure of the responsiveness of quantity demanded relative
to a change in the price of a good or service
% 𝑐𝑐ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑
Price Elasticity of Demand (PED) Formula(s) – OR
% 𝑐𝑐ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑛𝑛 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛 𝑐𝑐ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑
×
𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛 𝑐𝑐ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝

Price Inelastic Demand – Where the percentage change in the quantity demanded of a product is
insensitive to a change in the price of the product (0 <|PED|< 1) e.g. if the price of Starbucks coffee
increased, there would be a fall in the amount of units (of coffee) they sold, but it would likely be

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a very small one due to the brand loyalty and addiction many of us have to companies like
Starbucks and their products

Price Elastic Demand – Where the percentage change in the quantity demanded of a product is
sensitive to a change in the price of the product (|PED| > 1) e.g. if the price of Walkers crisps
increased, you may feel inclined to buy a lot less as there are a lot of other substitutes in the form
of other crisp packet brands and also in the form of other snacks (e.g. peanuts, biscuits)

Price Unitary Elastic Demand – Where the percentage change in the quantity demanded of a
product is equal to a change in the price of the product (|PED|= 1)

NOTE – The ‘| |’ symbols mean ‘absolute value’ which essentially means the ‘positive value’. The
reason these symbols are used will make sense shortly
𝑁𝑁𝑁𝑁𝑁𝑁 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹−𝑂𝑂𝑂𝑂𝑂𝑂 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹
Percentage Change Formula – × 100
𝑂𝑂𝑂𝑂𝑂𝑂 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹

PED Conditions:

• Perfectly Price Inelastic Demand: |PED| = 0

• Price Inelastic Demand: 0 < |PED| < 1
• Price Unitary Elastic Demand: |PED| = 1
• Price Elastic Demand: |PED| > 1
• Perfectly Price Elastic Demand: |PED| = ∞

PED Numeric Example:

• Taking an iPhone 6s, for example, let’s imagine that the price of an iPhone 6s rose from
£540 to £594, resulting in the quantity demanded of the iPhone 6s falling from 10,000 units
to 9,500 units
• Plugging in the change in quantity demanded of the product into the percentage change
9,500−10,000
formula, results in × 100 = −5%
10,000
594−540
• Plugging in the price change into the percentage change formula, results in ×
540
100 = 10%
5
• Plugging these into the first PED formula gives us − = −0.5
10
• This negative value explains why we use the absolute (positive) value when interpreting
PED. Technically speaking you could just use the negative values and interpret them as they
are, but most people find it confusing to do so and so, for the sake of simplicity, just use the
positive version NOTE – Always remember, however, that the initial value you get from a
PED calculation should always be negative
• The negative value makes sense as the demand curve is downwards sloping, and so if price
increases, quantity demanded will fall, and if price falls, quantity demanded will rise,
meaning that there will always be a negative and a positive in the (percentage change)
fraction, resulting in a negative PED value
• Interpreting this PED value leads to the conclusion that the PED for iPhone 6s’s is inelastic,
or you could say that the demand for iPhone 6s’s is price inelastic. This is because |−0.5| =
0.5 and 0.5 < 1, which meets the inelastic PED condition (0 < |PED| < 1)
• This tells us that consumers of iPhone 6s’s are insensitive to changes in the price of the
product, and so their changes in demand (specifically, quantity demanded) of the product
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will change by an amount that is small relative to the price change NOTE – This would be
expected due to the brand loyalty that many consumers have for apple products. The
factors affecting price elasticity of demand will be discussed shortly
• If we had instead got, for example, a figure of -1.5, we would consider PED to be elastic (or
demand to be price elastic) as | − 1.5| = 1.5, and 1.5 > 1. Using a 10% price fall, for
example, would tell us that a 10% fall in the price of this product (with -1.5 PED) would lead
to a 15% rise in quantity demanded for said product
• Examples could of course be done to show a unit (or unitary) elastic PED outcome, but I
think with these numeric examples you should be well equipped enough to answer any
such questions
• NOTE – The perfectly price inelastic and perfectly price elastic conditions will be discussed
briefly later, however, bear in mind that they are just theoretical ideas and not likely to
be seen with any product in the real world

HITS BND (PED Determinants):

H – Habit-Forming Goods – Habit-forming goods (or addictive goods) tend to have very price
inelastic demand. This is because those who consume them become somewhat dependent on them
for utility (satisfaction) in their lives, and so price rises, for example, do little to affect their
consumption e.g. cigarettes

I – Proportion of Income – Goods that take up a larger proportion of income tend to have more
price elastic demand. This is because changes in the prices of such products have a greater effect on
the incomes of those who purchase them (they more heavily reduce, or increase, the ability of
those consumers to buy other products) e.g. a TV

T – Time Period (Short Run / Long Run) – Consumers are less likely to change spending habits in the
short run, however, in the long run they may become more aware of substitutes which increases
price elasticity of demand (makes PED more elastic)

S – The Availability and Closeness of Substitutes – The higher the amount of substitutes available
for a product, and the more closely related these substitutes are (the smaller the difference
between the product and its substitutes), the more price elastic demand is likely to be e.g. biscuits
(price elastic demand), or on the opposite end, petrol (not many close substitutes, so it has very
price inelastic demand) NOTE – This also depends on the ‘width’ of the market definition. The PED
for a single bakery is likely to be quite elastic as that single bakery has a lot of other close
substitutes in the form of other bakeries. If the definition, however, was widened to all bakeries,
and so we were looking at the PED for all bakeries, it would likely be more inelastic as there are
less close substitutes to bread

B – Brand Loyalty – Products with strong brands tend to have more price inelastic demand. This is
because the loyalty consumers have to the product can make them care less about price changes,
simply due to their trust in the company or some particular liking they have towards the company
e.g. Apple and Starbucks products

N – Necessities – Goods that are necessities tend to have very price inelastic demands. This is
because without them, serving the basic functions of life would most likely be a struggle, and so
even if its price rises, it will not affect your consumption greatly as you essentially need it (to some
reasonable extent) for survival e.g. milk, water, bread etc…
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D – Durability – Goods that are expected to last a long time tend to have more price elastic demand
as the purchase can be delayed, whereas a product like milk will run out quickly and need to be
repurchased even if its price rises e.g. a table (more price elastic demand)

NOTE – Some of these points may seem slightly contradictory in the sense that some products fall
under several determinants in opposing directions, however, the idea is that each product has
certain push factors that ultimately determine whether or not the product is more LIKELY to have
price elastic or price inelastic demand

The diagram on the left shows that PED changes along

any demand curve that is a straight line. If we, for a
moment, use the second PED formula:
𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑐𝑐ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑
𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑖𝑖𝑛𝑛𝑛𝑛𝑛𝑛 𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷
× 𝑐𝑐ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
we will be able to show why this is true.

When the price is PE we can notice that the quantity demanded is 0, resulting in ‘Original Quantity Demanded’ in the
formula being 0. You may not know this if you don’t do Maths A-Level, but if we have a 0 on the bottom of a fraction,
that results in an undefined answer, specifically, infinity in this case (the condition for perfectly price elastic demand),
and so PED = ∞ at A. If we now move to PI we can see that price (PI) at this point is 0, and so ‘Original Price’ in the
formula is 0. Once again, you may only know this if you do Maths A-Level, but a 0 on top of a fraction results in a final
answer of 0 (the condition for perfectly price inelastic demand), and so PED = 0. From this we can deduce that the
midpoint of the straight line will have a point where PED = 1 (the condition for unitary price elastic demand), and so
we can see that PED does indeed change across a straight line. This effect occurs because when price is relatively
high, the initial quantity is very low. This means that a small change in price from a high price will result in a relatively
small percentage change in price, whereas the small change in quantity would result in a relatively large percentage
change as the initial quantity would be very small. The opposite is true at the bottom of the demand curve.

Total Revenue (TR) – The total amount of money received for goods sold or services provided over
a certain time period

Total Revenue (TR) Formula – 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 × 𝑄𝑄𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢

The diagram on the left shows the effects of elasticity on TR. As the demand
curve is price elastic in the top half, we can see the effects of a price drop
and its effect on TR. A price drop from P0 to P1, results in quantity demanded
increasing from Q0 to Q1. As the formula for TR is 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 × 𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄, the
change in TR is well shown by the coloured boxes. The initial TR is P0AQ00,
then changing to P1BQ10. The lost TR is shown by the red rectangle, and the
gained TR is shown by the green rectangle. From this, it is clear to see that a
fall in price along the elastic part of the curve, results in an increase in TR, as
the gain (the green rectangle) is greater than what is lost (the red rectangle),
and so, overall, TR has increased. The opposite is of course also true, and so
if you increase the price on the elastic part of the curve, TR will decrease.

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As the demand curve is price inelastic in the bottom half, we can see
the effects of a price rise and its effect on TR. A price rise from P0 to
P1, results in quantity demanded decreasing from Q0 to Q1. The
initial TR is P0AQ00, then changing to P1BQ10. Once again, the lost TR
is shown by the red rectangle, and the gained TR is shown by the
green rectangle. From this, it is clear to see that a rise in price along
the inelastic part of the curve, results in an increase in TR, as the
gain (the green rectangle) is greater than what is lost (the red
rectangle), and so, overall, TR has increased. The opposite is of
course also true, and so if you decrease the price on the inelastic
part of the curve TR will decrease.

The diagram on the left finalises the idea of the

demand curve and TR. Following the logic from
the two previous graphs, it essentially shows us
that along the price elastic part of the demand
curve (between A and B) we should decrease
the price until we reach unit elasticity at price PU
(regardless of whether the start price was PE or
in between PE and PU). The graph also shows
that along the price inelastic part of the demand
curve (between C and B) we should increase the
price until we reach unit elasticity at price PU
(regardless of whether the start price was PI or
in between PI and PU). Through this, a firm can
maximise their TR.

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Now (looking at the graphs on the previous page) you may be wondering ‘Why has the demand curve suddenly
changed slope to represent a price elastic or price inelastic demand curve?’. You may or may not have already
realised this, but this is to do with where the midpoint of each curve is. The fact that the diagram on the left is drawn
as a very shallow curve means that the midpoint of the curve (the part where it becomes unit elastic) is way off onto
the far bottom right of the graph. This basically ensures that if you want to show that something has price elastic
demand, the TR values, price, and quantity demanded changes, will make sense, because across the part of the
curve made visible |PED| > 1. For the graph in the middle, the demand curve is drawn as a very steep curve because
that means that the midpoint of the curve (the part where it becomes unit elastic) is way off in the top left of the
graph. This ensures that if you want to instead show that something has price inelastic demand, the TR values, price,
and quantity demanded changes, will make sense, because across the part of the curve made visible 0 <|PED|< 1.
You could basically say, it’s almost as if you are zooming in on a desired part of the previous demand curve graph,
and changing the slope so that you can deal only with what you want. When in an exam, if you are asked to talk
about high or low elasticity (price elastic or price inelastic demand), you will want to draw the demand curve the
same way as in the graphs (on the previous page) to make your point.

Just to ensure that you truly understand this for yourself and are not just taking my word for it, you can see the
effects of a price change on both curves. On the price elastic demand curve, you can see that the change (fall in this
case) in price from P0 to P1, is small relative to the change (increase in this case) in quantity demanded from Q0 to Q1,
hence showing that quantity demanded is very sensitive relative to changes in price. Having explained the idea of
how TR is shown using the coloured boxes, I won’t explain it again, so assuming you read the earlier parts it should
be clear visually to you that the effects on TR are the same as what was shown before on the old demand curve
(increase in TR when the price falls on the price elastic demand curve). Conversely, on the price inelastic demand
curve, you can see that the change (rise in this case) in price from P0 to P1, is large relative to the change (fall in this
case) of quantity demanded from Q0 to Q1, hence showing that quantity demanded is not very sensitive relative to
changes in price. Once again, assuming you read the earlier parts, it should be clear visually to you that the effects
on TR are the same as what was shown before on the old demand curve (increase in TR when the price rises on the
price inelastic demand curve). If, in a question, the curve you need to draw doesn’t need to be specifically elastic or
inelastic, then just draw the standard demand curve (on the right). The standard demand curve, just like all others,
will have elasticity change along it, but unlike the other two, it is not drawn in such a way that it is trying to show
only elastic or only inelastic changes.

The diagram on the left shows some extreme (mostly

theoretical) cases of PED. If |PED| = 0 that would result in
perfectly price inelastic demand (DPI). This would mean that
the quantity demanded of the product would be completely
insensitive to changes in price, and so the quantity demanded
would be fixed at QPI. If instead |PED| = ∞, that would result
in perfectly price elastic demand (DPE). This would mean that
the quantity demanded of the product would be an infinite
amount (unlimited quantity) at the price PPE. Firms would
have no incentive to lower price below this level, but if they
were to raise price above PPE, quantity demanded would fall
to 0.

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 PRICE DETERMINATION IN A COMPETITIVE MARKET
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Now, if you’re looking at this thinking that it makes no sense, it’s
understandable, as this isn’t likely to make intuitive sense. The idea is that
if |PED| = 1, resulting in a unitary price elastic demand curve (DUnitary),
then any percentage change in price should be offset by an equal and
opposite percentage change in quantity demanded. This can be seen
reasonably well with the change (fall) in price from P0 to P1 being identical
in size to the change (increase) in quantity demanded from Q0 to Q1. This
results in there being no change in TR, as the lost TR is the same size as
the gained TR. If you get asked to identify a truly unitary price elastic
demand curve, in an exam, you know what it technically should look like.
It is very unlikely, however, that they would ever ask such a question.
When answering a question, if they don’t specify elasticity, unless you
know that demand should be price elastic or inelastic (e.g. demand for
cigarettes should be price inelastic), just use the standard demand curve.

Income Elasticity of Demand (YED) – A measure of the responsiveness of quantity demanded

relative to a change in income
% 𝑐𝑐ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑
Income Elasticity of Demand (YED) Formula –
% 𝑐𝑐ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖

Income Inelastic Demand – Goods for which a change in income produces a less than proportionate
change in quantity demanded (|YED|< 1)

Income Elastic Demand – Goods for which a change in income produces a greater than
proportionate change in quantity demanded (|YED| > 1)

Income Unitary Elastic Demand – Goods for which a change in income produces a proportionate
change in quantity demanded (|YED| = 1)
𝑁𝑁𝑁𝑁𝑁𝑁 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹−𝑂𝑂𝑂𝑂𝑂𝑂 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹
Percentage Change Formula – × 100
𝑂𝑂𝑂𝑂𝑂𝑂 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹

Normal Good – A good where the quantity demanded increases when income rises (YED > 0) NOTE
– There are two types of normal goods: superior (luxury) goods and necessity goods

Superior (Luxury) Good – A good where the quantity demanded increases by a proportionately
greater amount than a rise in income (YED > 1) e.g. iPhones (you are likely to buy a lot more if your
income rises)

Necessity Good – A good where the quantity demanded increases by a proportionately smaller
amount than a rise in income (0 < YED < 1) e.g. bread (if your income rose you probably wouldn’t
spend that much more money on bread)

Inferior Good – A good where the quantity demanded decreases when income rises (YED < 0) e.g.
bus travel (if your income rises, you are more likely to spend less on bus travel and just travel by
taxi or a personal car instead)

Giffen Good – A good where the quantity demanded decreases by a proportionately greater
amount than a rise in income (YED < -1) e.g. YED = -2: income rises by 10%  quantity demanded

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for good (Giffen good) falling by 20% NOTE – This is a special case (it’s an extreme type of an
inferior good) and will be discussed shortly

YED Numeric Example:

• Taking an iPhone 6s as an example, let’s imagine that average income rose from £20,000 to
£22,000, resulting in the quantity demanded of the iPhone 6s increasing from 10,000 units
to 12,000 units
• Plugging in the change in quantity demanded of the product into the percentage change
12,000−10,000
formula, results in × 100 = 20%
10,000
• Plugging in the average income change into the percentage change formula, results in
22,000−20,000
× 100 = 10%
20,000
20
• Plugging these into the YED formula gives us = +2
10
• The fact that the YED value is positive tells us that this must be a normal good, a good
whose quantity demanded increases when income rises
• The fact that YED is not only positive (YED > 0) but is indeed greater than 1 (YED = 2, and 2
>1) means that this is indeed a superior (luxury) good, one whose quantity demanded
increases by an amount that is proportionally larger than the rise in income (20% change in
quantity demanded > 10% change in average income)
• This is what we would expect with iPhones because it would be considered a luxury good, in
society, that people would consume much more of (buying it more often, or more in one
go) if they had more income
• If we instead got, for example, a figure of – 0.5 for the YED value, this would be considered
an inferior good. This would mean that quantity demanded for such a product would
actually fall as average income rose (i.e. people would consume less of it). For example, if
average income rose by 10%, quantity demanded, for such a product, would fall by 5%. This
would be representative of a product such as bus travel (you would prefer to travel by taxi
or a personal car) or tinned meat (you would rather eat fresh meat), whereby you would
decrease your spending on such items if your income rose
• Examples could be done to show a unit (or unitary) elastic or positive income inelastic
(necessity good) YED outcome, but I think that with these numeric examples you should be
well equipped enough to answer any such questions NOTE – I don’t believe that there is a
specific name for a good with a YED of 1, apart from it just being a normal good

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The graphs on the previous page show the different effects of a rise in average disposable income on different types
of goods. For a normal good (left graph) a rise in average disposable income should lead to a rise in demand from D
to D1, resulting in quantity demanded increasing from Q0 to Q1 at the same price P0. Whether or not the good is a
necessity or a superior (luxury) good, demand will still increase, the only difference is that the superior (luxury)
good’s demand curve would increase by more than the necessity good’s demand curve. For an inferior good (right
graph) a rise in average disposable income should lead to a fall in demand from D to D1, resulting in quantity
demanded falling from Q0 to Q1 at the same price P0. Keep this in mind in case AQA try to fool you in an exam.

Now, before you start thinking ‘Why are there two upwards sloping demand curves?’, notice that the y-axis has
changed from ‘Price’ to ‘Income’. The diagram on the left shows how quantity demanded changes relative to income
for the two types of normal goods: necessity goods and superior (luxury) goods. The demand for the necessity goods
is income inelastic (shown by the DNecessity curve) and the demand for the superior (luxury) good is income elastic
(shown by the DSuperior curve). We can see from the graph that an equal rise in income from Y0 to Y1, leads to quantity
demanded of the necessity increasing from Q0 to QN, and quantity demanded for the superior good increasing from
Q0 to QS. This graph makes it clear that the quantity demanded for the necessity has risen by an amount less than
proportionate to the rise in income (QN – Q0 < Y1 – Y0), and the quantity demanded for the superior (luxury) good has
risen by an amount greater than proportionate to the rise in income (QS – Q0 > Y1 – Y0). The graph on the right shows
the relationship between quantity demanded and income for an inferior good (shown by the DInferior curve). It simply
shows that a rise in income from Y0 to Y1, leads to a fall in quantity demanded from Q0 to QI. This graph makes it
clear that the quantity demanded for the inferior good has fallen by an amount less than proportionate to the
change in income (Q0 – QI < Y1 – Y0) as demand for most inferior goods is income inelastic.

NOTE – The concept of a Giffen good isn’t explicitly mentioned in the specification, and so if you
don’t understand it, I wouldn’t stress about it as it’s highly unlikely to show up in an actual exam

Giffen Good Conditions:

• Must be an essential staple good in a poor community with few, if any, substitutes
• The households must be so poor that they only consume staple foods
• The good must be a very inferior good (YED < -1)

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 PRICE DETERMINATION IN A COMPETITIVE MARKET
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A Giffen good is a special type of good that is considered to be
mostly theoretical. The necessary conditions for a Giffen good
result in this upwards sloping demand curve. We discussed
earlier that the reasons for the demand curve being downwards
sloping were largely due to the income and substitution effects.
With a Giffen good, the substitution effect is heavily weakened
due to the fact that as the price of the good rises, consumers
can’t switch to alternatives because they consider the good (the
Giffen good) to be an essential staple food for which there are
basically no other substitutes. Secondly, a rise in the price of this
essential staple food will basically lead to a fall in average
disposable income in the poor community, because that is
basically what everyone spends almost all of their income on.

With inferior goods, whilst it is true that if income rises then quantity demanded for the inferior good will fall, it is
also true that if income falls then quantity demanded for the inferior good will rise (it goes both ways). As stated
previously, the rise in price has caused average disposable income to fall and so now (according to theory) quantity
demanded for this inferior good (essential staple food) will rise. The resulting effect is this upwards sloping demand
curve. Technically speaking, however, this effect will not continue forever due to the fact that at some point the
poor consumers will simply have no more income to allocate to the product, and so likely run out of money. The only
case in which such an effect is thought to have maybe occurred in real life was during the Irish potato famine in the
19th century, but even that claim is still disputable.

Substitutes – Products that can be used for a similar purpose, such that if the price of one product
rises, demand for the other product is likely to rise e.g. PS4 and Xbox One

Complements – Products that tend to be consumed jointly, such that if the price of one product
rises, demand for the other product is likely to fall e.g. PS4 and PS4 video games, or tea and milk

Competitive Demand – Demand for products that are competing with each other NOTE – This type
of demand is associated with substitutes

Joint Demand – Demand for products which are interdependent, such that they are jointly
demanded NOTE – This type of demand is associated with complements

Cross Elasticity of Demand (XED) – A measure of the responsiveness of quantity demanded for one
product relative to a change in the price of another product
% 𝑐𝑐ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞𝑞 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝑜𝑜𝑜𝑜 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑋𝑋
Cross Elasticity of Demand (XED) Formula –
% 𝑐𝑐ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑜𝑜𝑜𝑜 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑌𝑌

𝑁𝑁𝑁𝑁𝑁𝑁 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹−𝑂𝑂𝑂𝑂𝑂𝑂 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹

Percentage Change Formula – × 100
𝑂𝑂𝑂𝑂𝑂𝑂 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹

Substitutes (XED Terminology) – Products which have a positive XED value NOTE – A little trick (for
any of you who play PS4) to remember is: PS+ = Positive Substitute

Complements (XED Terminology) – Products which have a negative XED value NOTE – A little trick
to remember is: CNN = Complement Negative Number

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MICROECONOMICS
XED Conditions:

• Two Products Have No Relation in Terms of Price Affecting Demand: XED = 0

• Substitutes: XED > 0 (positive XED value)
• Complements: XED < 0 (negative XED value)
• Weak Substitutes: 0 < XED < 1 (positive XED, but in between 0 and 1)
• Close Substitutes: XED > 1 (positive XED and greater than 1)
• Weak Complements: -1 < XED < 0 (negative XED, but in between -1 and 0)
• Close Complements: XED < -1 (negative XED and less than -1)
• Identical Products (Perfect Substitutes): XED = ∞ e.g. currency (a unit of a currency, such
as a $, from one foreign exchange market is exactly the same as one from another foreign
exchange market)
• One Good Must Be Bought Alongside the Other (Perfect Complements): XED = −∞ e.g. a
left shoe and a right shoe (although they are always sold in pairs in the real world)

XED Numeric Example:

• Taking Xbox Ones and PS4s as examples, let’s imagine that the price of Xbox Ones rose from
£250 to £275, and the quantity demanded of PS4s rose from 10,000 units to 12,000 units
• Plugging in the change in quantity demanded of PS4s into the percentage change formula,
12,000−10,000
results in × 100 = 20%
10,000
• Plugging in the price change of Xbox Ones into the percentage change formula, results in
275−250
× 100 = 10%
250
20
• Plugging these into the YED formula gives us = +2
10
• The fact that the XED value is positive tells us that these two goods must be substitutes,
goods with competitive demand
• The fact that XED is not only positive (XED > 0) but is indeed greater than 1 (XED = 2, and 2
>1) means that these products are indeed close substitutes, goods with a very strong
competitive demand (a 10% change in the price of Xbox Ones caused the amount of PS4’s
sold to increase by 20%, a clear indicator of the strength of their relationship)
• This is what we would expect for Xbox Ones and PS4s as they are both similar (in that they
are both video game consoles) and they are both similarly priced, meaning that when one
changes in price it is likely to affect the quantity demanded of the other strongly
• If we instead got, for example, a figure of – 2 for the XED value, these would be considered
complementary goods. This would mean that quantity demanded for product X would fall if
the price of good Y increased. For example, if the price of product Y rose by 10%, quantity
demanded for product X would fall by 20%. This would be representative of PS4s and PS4
video games, for example, as a PS4’s value is largely derived from the fact that you can play
PS4 video games on it. If said PS4 video games, for example, increased in price, this may
change your decision to buy a PS4 and thus result in a lower quantity demanded of PS4s
overall
• Examples could of course be done to show weak substitutes, weak complements and
products with no relationship, but I think that with these numeric examples, and the
conditions above, you should be well equipped enough to answer any such questions

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 PRICE DETERMINATION IN A COMPETITIVE MARKET
MICROECONOMICS

The above graphs simply show the potential effects of substitutes on each other. If the price of product Y increases
from P0 to P1, and product Y and product X are substitutes, this will lead to demand for product X increasing from D
to D1, resulting in quantity demanded (for product X) increasing from Q0 to Q1 with price staying at P0. The opposite
effect would of course occur if the price of product Y fell, in which case demand for product X would fall.

The above graphs simply show the potential effects of complements on each other. If the price of product Y
increases from P0 to P1, and product Y and product X are complements, this will lead to demand for product X falling
from D to D1, resulting in quantity demanded (for product X) falling from Q0 to Q1 with price staying at P0. The
opposite effects would of course occur if the price of product Y fell, in which case demand for product X would rise.

Now, before you start thinking ‘Why are there two upwards sloping
demand curves?’, notice that the y-axis is ‘Price of Product Y’ and
that the x-axis is ‘Quantity Demanded of Product X’. The diagram on
the left shows the difference between how the quantity demanded
of product X changes relative to the price of product Y, depending
on how weak or close (strong) the substitute relationship. The
demand curve representing a weak substitute relationship is shown
by the DWeak curve, and the demand curve representing a close
(strong) substitute relationship is shown by the DClose curve. We can
see from the graph that an equal rise in the price of product Y from
Y0 to Y1, leads to quantity demanded of product X increasing from
Q0 to QW (when the relationship is weak) and from Q0 to QC (when
the relationship is close / strong). This graph makes it clear that the
change in quantity demanded for product X is greater when the
relationship between the goods is stronger.

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MICROECONOMICS
The diagram on the left shows the difference between how the
quantity demanded of product X changes relative to the price of
product Y, depending on how weak or close (strong) the
complement relationship. The demand curve representing a weak
complement relationship is shown by the DWeak curve and the
demand curve representing a close (strong) complement
relationship is shown by the DClose curve. We can see from the
graph that an equal rise in the price of product Y from Y0 to Y1,
leads to quantity demanded of product X decreasing from Q0 to QW
(when the relationship is weak) and from Q0 to QC (when the
relationship is close / strong). This graph, just like the previous one,
makes it clear that the change in quantity demanded for product X
is greater when the relationship between the goods is stronger.
NOTE – The following set of lists are rough guides as to how you may wish to answer questions on
elasticities of demand. You would of course need to add in the specific detail needed to answer
the question, and also add the context they are asking for, but generally these guidelines should
help stop you from missing out key points

PED Question Response (Guidelines):

• Analysis:
• PED Coefficient – Elastic, Inelastic or Unit Elastic?
• 10% Example – PED = -1.5 (for example): Price goes up by 10%  Quantity demanded falls
by 15%
• Evaluation:
• Does the PED value correspond with economic theory? e.g. PED cannot be positive, or the
PED for cigarettes should not be elastic
• PED values are estimates and they may be unreliable
• Estimates can change over time
• Other factors can affect supply and demand
• The analysis likely assumes ceteris paribus, which may not apply e.g. demand could shift
left due to a fall in average disposable income

YED Question Response (Guidelines):

• Analysis:
• YED Coefficient – What type of good is it, and what is its elasticity?
• 10% Example – YED = 1.5 (for example): Income goes up by 10%  Quantity demanded
rises by 15%
• Evaluation:
• Does the YED value correspond with economic theory? e.g. A TV shouldn’t be an inferior
good
• YED values are estimates and they may be unreliable
• Estimates can change over time
• The analysis likely assumes ceteris paribus which may not apply e.g. if income tax has
risen, this may mean that whilst there has been an increase in income, for example,
disposable income may not have increased and so quantity demanded may not change
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 PRICE DETERMINATION IN A COMPETITIVE MARKET
MICROECONOMICS
XED Question Response (Guidelines):

• Analysis:
• XED Coefficient – Are the goods substitutes or complements, and are they close or weak?
• 10% Example – XED = 1.5 (for example): Price of product Y goes up by 10%  Quantity
demanded of product X rises by 15%
• Evaluation:
• Does the XED value correspond with economic theory? e.g. PS4s and Xbox Ones are not
complements, and so the XED value should be positive
• XED values are estimates and they may be unreliable
• Estimates can change over time
• The analysis likely assumes ceteris paribus which may not apply e.g. demand could shift
left due to a fall in average disposable income

How Elasticity is Calculated in Reality:

• Elasticities of demand and supply (will be discussed shortly) are calculated, in reality, using
the following data:
 Sample surveys
 Past records from within a company
 Competitor analysis
• NOTE – This really highlights to you the unreliability of this information in real life, but the
general theory of them is still useful to economic agents in some ways

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MACROECONOMICS

Aggregate Demand (AD) – The total demand for a country’s finished goods and services at a given
price level in a given time period NOTE – It shows planned expenditure at any given price level

Aggregate Demand (AD) Formula – C + I + G + (X – M) NOTE – As AD is planned expenditure at any

given price level, AD is essentially the same as the total expenditure of an economy. We know
that the total expenditure formula is C + I + G + (X – M), and so it can be seen that calculating AD
and calculating nominal GDP, is the same (i.e. they use the same formula)

Real GDP = Real Output = Real Income = Real Expenditure NOTE – Some people even call them
national output, national income or national expenditure, but I prefer to use the word ‘real’

First of all, notice that the y-axis has been labelled ‘Price Level’
NOT ‘Price’, and also that the x-axis has been labelled ‘Real
Output’ NOT ‘Quantity’, with point labels using the letter Y
rather than Q (AQA may actually deduct marks if you use Q
instead of Y). You could actually label the x-axis quite a few
other terms such as real GDP or real income, however, I prefer
to use real output as it links most smoothly with labour being
a derived demand. Now, AD basically shifts when there is a
change in any of its components. Let’s say that, for example,
consumption fell due to a rise in income tax. This would mean
that AD would be lower at any given price level, resulting in
AD decreasing from AD to AD1. This would cause real output
to fall from Y0 to Y1 with the price level remaining at P0.

Suppose that instead government spending rose as a result of increased government spending on education. This
would mean that AD would be higher at any given price level, resulting in AD increasing from AD to AD2. This would
cause real output to rise from Y0 to Y2 with the price level remaining at P0. Bear in mind, also, that changes in real
output represent changes in short run economic growth.

Why the AD Curve is Downwards Sloping:

• There are 3 reasons as to why the AD curve is thought to be downwards sloping:

 The wealth effect
 The interest rate effect
 The international trade effect
• The wealth effect:
 A fall in the price level will mean that deflation has occurred. Assuming nominal
income to be fixed, this will mean that real disposable income has increased due to
the fact that deflation means that the purchasing power of money has increased. As
a result, you are now wealthier and so are more likely to increase your spending on
goods and services (as you have a greater ability to do so), resulting in real
expenditure increasing
• The interest rate effect:
 A fall in the price level means that deflation is occurring. Governments (and central
banks) don’t like deflation and will want to do their best to try and stimulate

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MACROECONOMICS
economic activity. As a result, they will lower interest rates in a bid to increase
consumption and investment, and so this leads to a rise in real output (or real
expenditure, they are the same anyway)
• The international trade effect:
 As the price level of a country falls, this means that the goods made in said country
(some of which will later be exported) will likely, on average, fall in price. Ceteris
paribus, this will likely lead to exports becoming more price competitive (cheaper)
than imports, resulting in increased spending on exports (from foreigners, an
injection) and decreased spending on imports (from domestic consumers, a
leakage). As a result, real expenditure should rise

Wealth – A stock of assets that have a particular financial value at a point in time e.g. property,
shares, bank deposits etc…

Income – A flow of money earned over a period of time e.g. wages, salaries etc…

Savings – Disposable income minus spending

Availability of Credit – The funds available to economic agents for borrowing

Consumer Confidence – How optimistic consumers are about future economic prospects

Transfer Payments – Money transferred from one individual, or group, to another, not in return for
any goods or services e.g. state benefits

Disposable Income – Income after taxes on income have been deducted and state benefits have
been added NOTE – This is effectively the money that consumers have available for consumption
or saving

Interest Rates – The cost of borrowing money and the amount paid for lending savings to someone
else (e.g. a bank) NOTE – A very simplified explanation of this would be that if interest rates were
2%, that would mean that if you borrowed £100 from the bank, you would have to pay back £102
to the bank, and if you saved £100 in the bank, the bank would pay you back £102. What this
essentially means, is that lower interest rates incentivise you to borrow because it is cheaper to
do so, and higher interest rates incentivise you to save because there is potential to make a
higher return on your money

WIBI CUT (Consumption Determinants):

W – Wealth – If the amount and/or value of wealth people have increases, this means that people
will be more able to spend on products (you can borrow money against your house, for example)
and are also more likely to be willing to do so as consumer confidence would likely rise. Both effects
would likely lead to consumption increasing

I – Interest Rates – If interest rates fall, this means that people will get less returns on their savings
and that it will be cheaper for people to borrow. Reduced incentive to save, combined with
increased incentive to borrow, is likely to increase spending on goods and services, meaning that
consumption will rise

B – Benefits – If government spending on unemployment benefits increases, this will lead to a rise
in the disposable income of those who are unemployed. Those who are unemployed (and also low-

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income earners in general) tend to have a high marginal propensity to consume (MPC), meaning
that when given additional money they are likely to spend a very large proportion of it. As a result,
spending on goods and services will likely rise thus leading to higher consumption

I – Inflation – If inflation is very high and people expect prices to rise by a lot in the future, they may
decide to increase their spending now which would lead to an increase in their current consumption

C – Consumer Confidence – If consumer confidence increases for any reason (e.g. high economic
growth figure is published, average incomes are rising fast etc…) this can boost the level of
consumption

U – Unemployment – A decrease in the level of unemployment likely means that more people are
employed. More people in employment means that more people have incomes with which they can
spend on goods and services, and so this is likely to increase consumption

T – Income Tax – If income tax falls, this will lead to an increase in disposable income for a majority
of the population, which will likely lead to increased spending on goods and services and thus
consumption

NOTE – As you can see, just about anything that increases people’s disposable income is likely to
lead to an increase in consumption, as their ability to purchase goods and services would have
increased. Also note that anything that directly influences the level of saving is also likely to have
an effect on consumption

National Capital Stock – The total stock of capital goods that have accumulated over time in an
economy

Corporation Tax – A tax on a firm’s profits

Retained Profits – Profits kept by firms to finance investment or debt

Business Confidence – How optimistic firms are about future economic prospects

TIP SPIT CC (Investment Determinants):

T – Advances in Technology – A firm may buy new capital equipment if it thinks that it will produce
better quality products or produce products more cheaply. In either case, the firm would expect to
earn higher profits. In the first case it would be because the firm would anticipate higher demand,
and in the second case it would be because the firm would anticipate that its average cost of
production would fall. Additionally, if other firms are investing in more new technology, then a firm
may be forced to do so as well in order to stay competitive and maintain profit levels

I – Interest Rates – A rise in interest rates, for example, could decrease investment due to the
following reasons:

1. Higher interest rates will increase the opportunity cost of investment. This is because if a
firm chooses to invest, they forgo the potential returns they could be making by placing
their retained profits in a bank
2. Whilst a lot of investment comes from retained profits, some of it is done through
borrowing, which would now be more expensive
3. Firms will likely anticipate consumer spending falling because consumers are less likely to
borrow and more likely to save. Firms won’t want to invest in the face of falling demand
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4. Firms may lose out on potential investors that would have provided further funds for
investment. This would be because some potential investors may decide to just put their
money in savings accounts as the return for savings is now higher
The graph on the left is not in the specification,
but it shows nicely the relationship between
investment and the interest rate. The
investment demand curve is downwards
sloping because at high interest rates,
investment tends to be low, and at low interest
rates, investment tends to be high. If any non-
interest rate factor changed, however, such as
an increase in business confidence, this would
increase investment at any given interest rate
(in this example) and so cause investment
demand to increase from ID to ID1.

P – Price of Capital – Ceteris paribus, a reduction in the price of capital will lead to an increase in
investment, and an increase in the price of capital will lead to a reduction in investment

S – Subsidies – An increase in subsidies to firms effectively reduces the costs of production for said
firms, which in turn increases their level of retained profits. This means that they have more funds
available for investment which will likely lead to investment increasing NOTE – Another way of
thinking about it would be the firm simply adding the subsidy straight onto their profits.
Arguably, however, the more fully fledged explanation is to talk about their cost of production
effectively being reduced

P – Profits – A rise in profits (for any reason) is likely to increase a firm’s ability to invest, and also
likely to make a firm more willing to invest due to being more optimistic about the future. Both
effects are likely to increase investment

I – Real Disposable Income – If real disposable income rises, then demand for consumer goods and
services is also likely to rise. This means that firms will likely need to expand and will likely need to
do so through investment (assuming they were previously operating at full capacity) NOTE –
Consumption and investment are linked in the sense that rises in consumption can technically
lead to increases in investment

T – Corporation Tax – An increase in corporation tax, for example, decreases the amount of profits
that firms can retain and use for investment, and so this would likely reduce investment

C – Spare Capacity – Firms are more likely to invest when they are operating at, or close to, full
capacity, because with spare capacity it may be possible to increase output without investment

C – Business Confidence – If firms feel more optimistic about future economic prospects, they are
more likely to increase investment

NOTE – Consumption is thought to typically be the largest component of AD, and investment is
thought to be the most volatile

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Capital Output Ratio – The amount of capital needed to generate each unit of output
𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪
Capital Output Ratio Formula –
𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶

Accelerator Theory – A theory that states that the level of investment depends on the change of
the growth rate of national output NOTE – If national output was growing at a constant rate (e.g.
2%), then firms would invest exactly the same amount each year in order to maintain their
desired capital output ratio, meaning that the level of investment would be constant. If, however,
the growth rate of national output increased (accelerated), then investment would also increase
as firms would need to increase the level of capital goods (via investment) otherwise their capital
output ratio could fall below the desired level. The opposite would be true if the growth rate of
national output decreased. It is worth noting, however, that this theory is not foolproof as it does
not take into account any of the other determinants of investment (e.g. interest rates, business
confidence, spare capacity etc…)

FEET (Government Spending Determinants):

F – Government’s View on the Extent of Market Failure and its Ability to Correct it – In countries
where there is a high level of state intervention, government spending usually forms a larger
proportion of AD than in countries where free market forces play a more dominant role

E – The Level of Economic Activity – If there is high levels of unemployment, a government may
raise spending (on anything) to increase AD and thus the real output of the economy. On the other
hand, if there is a very high inflation rate, a government may instead reduce its spending

E – Election Cycles – Voters can put pressure on the government to increase spending, and equally
a government may also decide to increase spending, just before a general election, in order to gain
votes

T – The Threat of Social Collapse – The threat of war, terrorism or rising crime may lead to the
government increasing spending on police and/or the military

X – M = Net Exports (NX) = Net Trade = Trade Balance NOTE – A lot of this time we have been
calling X and M, exports and imports, which is true to some extent but it’s worth clarifying on
what is actually going on. X or exports is really export revenue (the value of exports) and M or
imports is really import expenditure (the value of imports). For now, this won’t be of great
importance, but later we will learn about how the PED of imports and/or exports can affect this.
So from here onwards, I will mostly be using the terminology of export revenue and import
expenditure

Tariff – A tax on imports

IRI PIE (Net Exports (X-M) Determinants):

I – Inflation – If UK inflation, for example, was increasing at a rate faster than that of our major
trading partners, this would likely make our exports less price competitive (as they would, on
average, be rising in price), and the imports of our major trading partners more price competitive.
The resulting effect would likely be a fall in export revenue and a rise in import expenditure

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R – Government Restrictions on Free Trade – If a country (let’s say country A) removes a trade
restriction, such as a tariff, this will likely lead to an increase in import expenditure in country A, as
imports would now be cheaper without the tax. If another foreign country (let’s say country B)
removed tariffs on its imports, which happens to include country A’s exports, this will likely lead to
an increase in export revenue for country A as their exports will now be cheaper in country B

I – Real Disposable Income at Home or Abroad – If real disposable incomes are falling at home
(country A), possibly due to a recession at home, this may lead to an increase in export revenue as
domestic firms attempt to compete harder in international markets, rather than at home due to the
low levels of domestic consumption (caused by the falling incomes). Additionally, the low levels of
domestic consumption may lead to lower import expenditure as consumers will have less
disposable income to spend on imports. If a foreign country (country B) experiences falling real
disposable income (due to a recession as well), and happens to be a major trading partner to
country A, their fall in import expenditure means that country A’s export revenue will fall (Country
A’s exports are Country B’s imports). The opposite would of course occur if real disposable incomes
were rising in either of the countries

P – Productivity – A general rise in productivity in the UK, for example, is likely to lower average
costs of production for many firms, meaning that they will be able to supply more products, many
of which will be exports, at lower prices. This increase in price competitiveness of UK exports and
reduction in price competitiveness of imports is likely to lead to an increase in export revenue and a
reduction in import expenditure

I – Innovation – A rise in innovation (and thus technology) is likely to increase the quality of exports.
This should cause the demand curve for exports to increase due to their increased quality
competitiveness, relative to imports, resulting in an increase in export revenue and a fall in import
expenditure

E – Exchange Rates – If a country’s exchange rate rises, for example, this will lead to the country’s
imports becoming cheaper and its exports becoming more expensive. This means that the imports
have become more price competitive whilst the exports have become less price competitive, and so
there would likely be a rise in import expenditure and a fall in export revenue NOTE – If the £:$
exchange rate increased from £1:$1 to £1:$2, you can see that for the same amount of money
(£1) a UK citizen is getting more dollars and thus will find it cheaper to buy American imports
now. For a US citizen, they will now need to pay more dollars ($2, rather than $1) for the same
amount of pounds (£1), and so they will now find it more expensive to buy UK exports

NOTE – Bear in mind that whether or not AD will shift will depend on the overall change in its
components. If consumption rose, causing AD to increase by 10%, but investment fell, causing AD
to fall by 15%, AD would fall (assuming the other components didn’t change)

Multiplier Effect – The process by which any change in a component of AD (or injection or
withdrawal) results in a greater final change in real GDP

NOTE – You do not actually need to know all of the following marginal propensities and the
formulas, but I have included them as I believe they make the multiplier effect easier to
understand

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Marginal Propensity to Consume (MPC) – The proportion of additional income that is spent on the
consumption of goods and services NOTE – This can be looked at for individuals or entire
economies (and the same is true for the upcoming terms). For individuals, we would say that
those who are poor tend to have a high MPC compared to wealthier people who are, on the
contrary, thought to have a higher MPS (and thus low MPC) due to the idea that they are more
likely to have satisfied most of their consumption needs. For an economy, it would be a general
trend. For those of us in the UK, for example, we generally have a very high MPC, whereas those
living in Japan tend to have a low MPC, and instead tend to have a high MPS
𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒊𝒊𝒊𝒊 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄
Marginal Propensity to Consume (MPC) Formula – NOTE – This will either be
𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒊𝒊𝒊𝒊 𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊
the income of an individual or of the entire economy (national income). The same thinking is
relevant to the upcoming terms as well. Additionally, all changes on the top of the fraction (for all
of these terms) is in money terms e.g. change in consumption = £20bn (for the UK)

Marginal Propensity to Save (MPS) – The proportion of additional income that is saved
𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒊𝒊𝒊𝒊 𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔
Marginal Propensity to Save (MPS) Formula –
𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒊𝒊𝒊𝒊 𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊

Marginal Rate of Tax (MRT) – The proportion of additional income that is taxed
𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒊𝒊𝒊𝒊 𝒕𝒕𝒕𝒕𝒕𝒕𝒕𝒕𝒕𝒕
Marginal Rate of Tax (MRT) Formula –
𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒊𝒊𝒊𝒊 𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊

Marginal Propensity to Import (MPI) – The proportion of additional income that is spent on
imports
𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒊𝒊𝒊𝒊 𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊
Marginal Propensity to Import (MPI) Formula –
𝒄𝒄𝒄𝒄𝒂𝒂𝒏𝒏𝒏𝒏𝒏𝒏 𝒊𝒊𝒊𝒊 𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊

Marginal Propensity to Withdraw (MPW) – The proportion of additional income that leaks (is
withdrawn) from the circular flow of income NOTE – It is basically all of the leakages from the
circular flow of income

Marginal Propensity to Withdraw (MPW) Formula – 𝑴𝑴𝑴𝑴𝑴𝑴 + 𝑴𝑴𝑴𝑴𝑴𝑴 + 𝑴𝑴𝑴𝑴𝑴𝑴

𝟏𝟏 𝟏𝟏 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒊𝒊𝒊𝒊 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓 𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐
Multiplier Formula(s) – 𝒌𝒌 = OR 𝒌𝒌 = or 𝒌𝒌 =
𝑴𝑴𝑴𝑴𝑴𝑴 𝟏𝟏−𝑴𝑴𝑴𝑴𝑴𝑴 𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒊𝒊𝒊𝒊 𝑨𝑨𝑨𝑨 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 (𝒆𝒆.𝒈𝒈.𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊)
NOTE – the multiplier is called ‘k’ in this

Multiplier Example:
1 1
• If 𝑘𝑘 = = = 2 this means that the size of the multiplier is 2, and also that half of any
𝑀𝑀𝑀𝑀𝑀𝑀 0.5
1
increase in national income leaks out of the circular flow because MPW is 0.5 =
2
• This means that if £5 billion where injected into the economy, £2.5 billion would leak out
but the other £2.5 billion would go back around, and then of that £2.5 billion (that has gone
back around), £1.25 billion would leak out, and so on
• You would get £8.75 billion (the initial £5 billion + £2.5 billion + £1.25 billion) and this would
continue until national income increased by a total of £10 billion (twice as big as the initial
injection of £5 billion, which makes sense as the multiplier was 2)
• A positive multiplier effect can be explained verbally as well. If there was a rise in national
income due to a new housing project from the government, for example, this would lead to

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an increase in factor incomes, particularly in the form of wages (for the labour employed)
and rent (for the land used). How much of this stays in the economy and how much of it
leaks out basically determines the size of the multiplier, and so leads to the effects talked
about previously
• You can also get negative multiplier effects as well. This would be when an initial decrease
in an injection (or an increase in a leakage) leads to a greater final decrease in real GDP, the
opposite of a positive one essentially
• Let’s say AD decreased due to a decrease in export revenue, leading to real output falling.
This fall in real output would likely lead to firms laying off workers as labour is a derived
demand. This now means, however, that there are more people who are unemployed and
on benefits (getting a lot less money than they used to), leading to lower consumption,
lower AD and so on
The multiplier effect can be shown on a graph with AD
simply shifting two times. It first may increase from AD to
AD1, due to an increase in investment (∆ 𝐼𝐼 = change in
investment), causing real output to increase from Y0 to Y1.
The multiplier effect, however, may cause AD to increase
from AD1 to AD2, causing real output to increase from Y1 to
Y2. You can see that the initial change in the component of
AD, investment, has led to a greater final change in real
output, that was twice the size of the initial injection. When
we draw AD diagrams, however, we just skip the curve in
the middle (AD1), and so you could just say (in writing) that
your diagram assumes a multiplier effect (if you want to).

NOTE – The difference between the multiplier effect and accelerator theory, is that with the
multiplier effect, investment comes before the real output change, whereas with accelerator
theory, the change in real output occurs first and then investment comes after

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