Final answer:
Prices are determined by the supply and demand balance in competitive markets, with price elasticity indicating how quantity demanded responds to price changes. Menu costs can cause prices to be sticky, meaning they may not adjust immediately to changes in market conditions.
Step-by-step explanation:
In a competitive market, prices are determined by the forces of supply and demand. When the market is in equilibrium, the price and quantity supplied are determined by the intersection of the supply curve and the demand curve. If demand increases, the curve shifts right, leading to a higher equilibrium price and quantity. Conversely, a decrease in demand shifts the curve left, resulting in a lower price and quantity.
Price elasticity is crucial because it measures how sensitive the quantity demanded is to a change in price. When products are elastic, small price changes can lead to significant changes in demand, while inelastic products see little change in demand despite price changes. This concept helps businesses in making pricing decisions and estimating the effects of price changes on their revenue.
Understanding these concepts allows businesses to anticipate changes in the market and adjust their pricing strategies accordingly. For instance, during times of excess capacity, a company might prefer to lower prices to increase demand, whereas in times of scarcity, they might increase prices. Economic models enable businesses to analyze different scenarios and determine the most effective pricing strategy.
However, not all prices adjust immediately due to menu costs. Businesses may incur expenses and face potential customer dissatisfaction when changing prices frequently. Hence, prices can be 'sticky,' adjusting more slowly to changes in supply and demand, especially from a macroeconomic perspective.