1.2 Flashcards
Defiene demand
Demand refers to the quantity of a good or service that consumers are willing and able to purchase at various prices over a given period of time.
What is the underlying assumption behind rational decision making?
Firms are profit maximisers whereas consumers are utility maximisers.
What is the law of diminishing marginal utility?
The Law of Diminishing Marginal Utility states that as a person consumes more units of a particular good or service, the additional satisfaction (or utility) gained from each additional unit decreases.
Define PED
PED (Price Elasticity of Demand) refers to the measure of how much the quantity demanded of a good or service changes in response to a change in its price. It is calculated by dividing the percentage change in quantity demanded by the percentage change in price.
PED value analysis
PED will always have a negative value because teh demand curve is downwards sloping so price and quantity move in opposite directions
When price is demand INELASTIC, the value of PED will be between 0 and -1. Shows quantity demanded does not change by much
When price is demand ELASTIC, the value of PED will be less than -1. Quantity demanded is very sensitive to prce changes.
When price is demand unitary elastic, the value of PED wll be -1. This means that demand changes PROPORTIONALLY to a change in price.
When demand is perfectly price elastic the value of PED is infinity. This shows that when price changes the slightest bit, quantity demanded changes infinitely. Graph is a hroizontal line.
When demand is perfectly price inelastic, the value of the PED will be 0. This shows that quantity demanded reamins constant, no matter the change in price. Graph is a vertical line.
What are the factors influencing PED?
The SPLAT analogy is a helpful way to remember the factors that influence Price Elasticity of Demand (PED). Here’s how it breaks down:
S – Substitutes
The more substitutes available for a product, the more elastic the demand will be. If consumers can easily switch to a similar product when the price rises, demand becomes more sensitive to price changes.
P – Proportion of Income
If a good takes up a large portion of a consumer’s income, demand is more likely to be elastic because price changes will have a bigger impact on their budget (e.g., a new car vs. a packet of gum).
L – Luxury vs Necessity
Luxuries tend to have more elastic demand, as consumers can forgo purchasing them if prices rise. Necessities, on the other hand, often have inelastic demand because people need them regardless of price (e.g., medicine vs. designer clothing).
A – Addictiveness
Products that are addictive, like cigarettes or alcohol, tend to have inelastic demand because consumers are less responsive to price increases due to their dependency on the product.
T – Time Period
Over time, demand for a product can become more elastic. In the short term, people may not have many alternatives or may be unable to change their behavior, but over time, they may find substitutes or adjust their consumption habits.
PED and revenue
If demand is price inelastic, firms can incraese revenue by increasing price.
If demand is price elastic, firms can increase revenue by decreasing price.
XED
XED (Cross Elasticity of Demand) measures the responsiveness of the quantity demanded for one good to a change in the price of a different good. It shows how the demand for one product is affected by the price change of another product.
Positive XED: If XED is positive, the goods are substitutes (e.g., tea and coffee). An increase in the price of one will increase the demand for the other.
Negative XED: If XED is negative, the goods are complements (e.g., cars and petrol). An increase in the price of one will decrease the demand for the other.
YED
YED (Income Elasticity of Demand) measures how the quantity demanded of a good changes in response to a change in consumer income. It shows whether a good is a normal good or an inferior good based on how demand shifts as income increases or decreases.
Positive YED: If YED is positive, the good is a normal good. As income rises, demand for the good increases (e.g., luxury goods like vacations or expensive electronics).
Negative YED: If YED is negative, the good is an inferior good. As income rises, demand for the good decreases (e.g., instant noodles or second-hand clothing).
YED and normal goods
Normal goods can be split up into luxury goods, and necessities.
Normal goods have a YED value of greater than 0. Luxury goods have a YED value of greater than 1. Inferior goods have a YED of between 0-1.
As incomes rise, consumers spend more on luxury goods and their YED for inferior goods tends towards 0.
Define supply
Supply refers to the quantity of a good or service that producers are willing and able to offer for sale at different prices over a specific period of time. Typically, as the price of a good increases, the quantity supplied also increases, following the law of supply, because producers are motivated to sell more at higher prices to maximize profits.
What would cause shifts in supply?
- Cost of production
- Productivity of the workforce
- Taxes and subsidies
- Technology
- Discoveries of natural resources
Define PES
PES (Price Elasticity of Supply) measures the responsiveness of the quantity supplied of a good to a change in its price. It indicates how much producers are willing to increase or decrease the quantity they produce when the price of the good changes.
PES value analysis
PES is always positive, because the supply curve is upward sloping, so price and quantity move in the same direction.
When supply is price inelastic, less than 1, it means that the quantity supplied of a good or service is not very responsive to changes in its price. In other words, even if the price increases or decreases, the quantity that producers are willing and able to supply changes only slightly.
When supply is price elastic, greater than 1 , it means that the quantity supplied of a good or service responds significantly to changes in its price. In other words, producers are willing and able to increase (or decrease) the quantity they supply when the price rises or falls, often because production can be easily adjusted.
When supply is perfectly price inelastic (PES = 0), it means that the quantity supplied does not change at all in response to changes in price. In other words, producers are unable to increase or decrease the quantity they supply, no matter how high or low the price goes.
When supply is perfectly price elastic (PES = ∞), it means that the quantity supplied can change infinitely in response to even the smallest change in price. In other words, producers are willing to supply any quantity of the good at a specific price, but they will not supply it at any other price.
What are the factors that determine the price elasticity of supply?
Time period:
In the short run, firms may not be able to adjust production easily, so supply tends to be more inelastic.
In the long run, firms have more flexibility to adjust their production processes, so supply is more elastic.
Availability of factors of production:
Spare capacity:
If a firm has spare capacity or unused resources, it can increase production quickly, making supply more elastic.
If the firm is already operating at full capacity, supply will be more inelastic.
Stock levels
If a firm holds large stocks, it can quickly increase supply when prices rise, making supply more elastic.
Production speed:
If a product can be produced quickly, supply tends to be more elastic.
Substitute ability:
If a firm can easily switch between different types of inputs, then supply is more elastic. This means that the firm can respond quickly to price changes by adjusting its production methods.
If the resources used in production are highly specialized or difficult to substitute, supply tends to be more inelastic. Firms may not be able to quickly change their production processes, so their response to price changes is slower.
What are surpluses and shortages?
murpluses are when there is excess supply. This is when the price is set above the equilibrium price. Eventually, the market forces of supply and demand will bring this back down to equilibrium price.
Firms see that they have a lot of stock, that is being unsold because consumers are unwilling to pay high prices, so firms start reducing prices to clear stock and now there is an increase in quantity demanded, but because prices are lower there is a decrease in quantity supplied, and eventually equilibrium price is reached.
When there is a shortage, this means there is excess demand. This is when the price is set below the equilibrium price. Eventually, the maret forces will bring the price back up to equilibrium.
Excess demand means consumers are qucly buying stock, and firms see this and they raise prices, knowing that the product is in high demand so people are willing to pay more. Now as prices increases, people demand less while producers produce more and eventually, equilibrium price is reached.
What are the key functions of the price mechanism
Signaling Function 📢
Prices act as signals to both producers and consumers.
A rising price signals producers to increase supply and consumers to reduce demand.
A falling price signals producers to cut supply and consumers to buy more.
Incentive Function 💰
Prices provide incentives for producers and consumers to change their behavior.
Higher prices motivate firms to produce more because they can earn higher profits.
Lower prices encourage consumers to buy more, boosting demand.
Rationing Function ⚖️
When resources are scarce, prices help ration them among those who are willing and able to pay.
Higher prices limit demand, ensuring goods go to those who value them most.
Allocative Function 🔄
Prices help allocate resources to where they are most needed.
If demand for a good rises, its price increases, attracting more producers to supply it.
This ensures resources move to their most efficient and profitable use.
Define consumer and producer surplus
Consumer surplus is the difference between what consumers are willing to pay and what they actually pay, while producer surplus is the difference between the price producers receive and the minimum price they are willing to accept.
What is an indirect tax?
An indirect tax is a tax imposed on goods and services.
There are 2 types: Ad valorem and specific tax
Ad Valorem:
A percentage-based tax on the price of a good or service.
The tax amount increases as the price increases.
Specific:
A fixed amount of tax per unit sold, regardless of the good’s price.
When drawing Ad valorem tax, the supply curves should not be parallel, because we are showing percentages, but when drawing specifc tax, the supply curves should be parallel because the amount paid is nto dependant on the quantity.
Diagrammatic analysis of taxes:
When a tax is imposed this causes the supply curve to shift inwards (supply falls), this is because it causes the cost of production to increase.
To work out the tax burden:
- Draw old equilibrium price
- Find the new quilibrium and draw dotted line to price
- Go down to the old supply curve and draw dotted line to price.
The burden that that consumer pays is between the old equilibrium and the new equilibrium.
The burden that the producer pays is between the old equilibrium and the old supply curve.
Incidence of tax when demand and supply is price inelastic.
When demand is price inelastic, and a tax is imposed, supply shifts left so price increases. However the quanity demanded by consumers does not change by much, so firms can pass these high costs onto consumers via higher prices, so when demand is inelastic, consumers pay a greater burden.
When supply is price inelastic this means that producers are unable to easily supply less/more when price changes. This means they recieve a lower price, and they bear a higher burden of the tax.
Incidence of tax when supply and demand is price elastic
When demand is elastic, consumers are highly responsive to changes in price. If a tax is imposed, the price of the good or service increases, and consumers, who can easily find substitutes or reduce their consumption, will significantly reduce the quantity they purchase. As a result, producers cannot pass the full burden of the tax onto consumers because doing so would cause a substantial decrease in sales. Since consumers can easily adjust their behavior, producers are forced to absorb more of the tax burden, leading to a larger portion of the tax being borne by the producers rather than the consumers. Essentially, because demand is elastic, consumers reduce their demand when prices rise, and producers, facing a reduction in quantity sold, bear more of the cost.
When supply is elastic, producers are more responsive to price changes and can adjust the quantity they produce more easily. If a tax is imposed, producers can reduce their supply or switch to producing other goods that are more profitable, which prevents them from bearing the full burden of the tax. Consumers, however, are less able to adjust their behavior in the short run, especially if demand is inelastic, and will continue to buy the product even at higher prices. In this case, the tax burden is more likely to fall on consumers, as producers can pass on much of the tax cost by increasing the price, knowing that consumers are relatively less sensitive to the price change. Thus, when supply is elastic, producers bear less of the burden, while consumers bear a greater share of the tax.
Define subsidies
A subsidy is a financial assistance provided by the government to individuals, businesses, or industries to encourage the production or consumption of certain goods or services. Subsidies are typically aimed at reducing the cost of production or lowering the price for consumers, making the goods or services more affordable or accessible.
Diagrammatic analysis of subsidies
Subsidies reduce the cost of production for firms, and therefore the supply curve shifts outwards.
Draw equilibrium price
Draw supply shifting out
Draw new equilibrium price
Go from new equilibrium up to old supply curve and draw dotted line to the price axis
Why do consumers not behave rationally?
- Consumer weaness at computation
Consumer weakness in computation refers to the inability or difficulty consumers face in accurately processing and analyzing the information required to make rational decisions in the marketplace. This weakness arises from several factors that limit consumers’ capacity to fully understand, evaluate, and compare all the relevant options or outcomes. - Habitual behaviour
- Influence of other peoples behaviour and social norms
