1.2 Flashcards
1.2.1 - Rational Choice Theory
What are the roles for:
Individuals
Firms
Government
Individuals -
- utility- satisfaction from consumption of products and services
- assumption - consumers act to maximise utility
Firms:
- profit- the difference between revenue and cost
Producers act to maximise their profit
Government:
Improve economic and social welfare of citizens
What are rational agents
Agents who utilise theory to guide their decision making
People, government, firms, producers
How do agents make decisions?
A rational agent wants to maximise their utility
A rational consumer will want to consume something up to the point where marginal utility and price are equal
what is meant by demand
the amount of products that will be bought at a given price level
what does the demand curve show
how much will be consumed of a good at each and every price level
if the price is high then the demand is…?
if the price is low then the demand is…?
low
high
its a negative relationship between price and quantity
what does the law of demand state
that there is an inverse relationship between quantity demanded and the price of a good or service, ceteris paribus
what is the market demand curve
the summation of all the individual demand curves
what does a price change cause in a demand curve?
a movement along the demand curve
a price fall causes an_____ in demand
a price increase causes a ______ in demand
extension
contraction
an increase in demand causes a _____ in the demand curve
a decrease in demand causes an _________ ______in the demand curve
shift
inward shift
what is meant by price
what the buyer pays for a specific good or service
what is meant by quantity
the total number of units purchased at that price
what is meant by willingness to pay
desire to pay based on taste and preferences
what is meant by ability to pay
factors in a persons income, and whether or not they can afford the good or service
what is meant by subsitute goods
an increase in the price of one good will increase the demand of the other
what is meant by complement goods
an increase in the price of one good will cause a decrease in the quantity demanded of the other
what is the income effect
when prices fall, consumers can afford a greater quantity of goods/services (assuming income is fixed) so demand for these goods/services increases
what is the substitution effect
when the price of one good falls, consumers will buy more of the cheaper good/service and less of the more expensive ones, so demand increases for the cheaper goods and decreases for the costlier ones.
What is meant by diminishing marginal utility
the extra benefit to an individual of consuming a good or service
what does the law of diminishing marginal utility state
the more an individual consumes, the utility of the good/service decreases with every additional unit consumed
what causes demand to change
income
taste/preferences
time/seasons
advertising
what is meant by elasticities
used to look at the sensitivity of changes in one variable to changes in another
what is the Price Elasticity of Demand
a measure of the sensitivity of the quantity demanded to a change in the price of the good or service
what is the formula for PED
% change in price
what is meant by a perfectly inelastic supply
a situation in which firms can supply only a fixed quantity, so cannot increase or decrease the amount available: elasticity of supply is zero.
what is meant by a perfectly elastic supply
a situation in which firms will supply any quantity of a good at the going price: elasticity of supply is infinite
what is the formula for income elasticity of demand (YED)
% change in income
define income elasticity of demand
YED measures the responsiveness of demand to a change in income.
define cross elasticity of demand - XED
XED measures the responsiveness of demand to a change in price of another good.
define normal good and link this to income elasticity
a normal good is one where demand increases if income increases. it has a positive YED
define inferior good and link this to income elasticity
one where demand decreases if income increases. it has a negative YED
define substitute and link this to cross elasticity
a good which is alternative to another good. it has a positive XED
define complement good and link this to cross elasticity
a good which is used with, or at the same time as another good. it has a negative XED
name four factors that affect the Price Elasticity of Demand for a good and explain how these factors affect elasticity.
- availability of substitutes:
- if there are many close substitutes then PED will be more elastic as consumers can easily switch to an alternative product if the price of one product goes up
- if there are few or no close substitutes then PED will be less elastic as consumers cannot easily switch - necessity or luxury:
- if the good is a necessity, then the PED tends to be less elastic, especially if there are few or no substitutes.
- if the good is a luxury, then PED tends to be more elastic, especially if there are more substitutes. - Proportion of income spent on the product:
- if the proportion of income spent is high, then PED tends to be more elastic, as a rise in price will have more of an overall effect on that persons budget.
- if the proportion of income spent is low, then PED will be less elastic, as a rise in price will not have a significant effect on that persons budget. - Time:
- the longer the time period the more elastic the PED will be. This is because it takes time for consumers to change their buying habits and identify substitute or alternative goods. if none are available, then over times some new products will be released which are substitutes, reducing PED over time.
if demand is inelastic and price increases, what effect will this have on the firm’s total revenue?
Inelastic is when PED is between 0 and -1. if price increases by 10% then quantity demanded will rise by than 10%. This means that total revenue will increaes
.
if demand is elastic and price increases, what effect will this have on the firms total revenue?
elastic is when PED is between -1 and -infinity. if price increases by 10% then quantity demanded will fall by more than 10%. this means that total revenue will fall
what is meant by supply
the quantity a producer is willing and able to supply onto the market at a given price, at a given time
what does a supply curve show
shows how much a producer would be willing to sell at each and every price
what are the main determinants for supply?
price costs of production natural disasters technology weather (for agricultural products)
draw a supply curve
price on y axis
quantity on x axis
a line going upwards (positive)
what does a point on the supply curve show
how much of a good will be produced at a price level
what would cause a movement along the supply curve?
a change in price
what would cause a shift in the supply curve?
a change in the conditions of supply
what would cause a shift to the right of the supply curve for oil?
if supply increased
if technology improved which meant that oil could be extracted more efficiently
what would cause a shift to the left of the supply curve for oil?
a shift to the left indicates a decrease in supply of oil
natural disaster
what are the five main causes of shifts in the market supply curve
- Changes in the unit cost of production
- Advances in production technologies
- The entry of new producers into the market
- Favourable weather conditions (eg for agricultural products)
- Taxes, subsidies and government regulations
what effect do taxes, subsidies and regulations have on the market supply curve
- indirect tax causes an inward shift of supply
- subsidies cause an outward shift of supply
- regulations increase costs - causing an inward shift of supply
what is meant by joint supply
joint supply is where an increase or decrease in the supply of one good will lead to an increase or decrease in the supply of a by-product.
what is meant by price elasticity of supply
price elasticity of supply measures the responsiveness of a quantity supplied to changes in its price
what range of values is there for price elasticity of supply and what does each value mean?
0 to +1 = inelastic
+1 to + infinity = elastic
+1 = unitary
+ infinity (perfectly elastic)
what is the formula for calculating price elasticity of supply?
% change in price
draw a diagram which shows a good that has inelastic/elastic/unitary price elasticity of supply.
inelastic - steep curve upwards
unitary - through origin
elastic - shallow curve upwards
name four factors that affect the price elasticity of supply for a good and explain how these factors affect elasticity.
hint - PASTA
- availability of producer subsitutes
- this is how easily a producer can switch to producing something else. the easier it is the higher the elasticity. - time
- the longer the time period, the easier it is for a firm to switch production to another good, so the higher the elasticity - spare capacity
- if a producer has spare capacity, it is easier for them to increase production quickly - availability of stocks
- if a product can be stored, then it is easier for supply to respond to price changes, as you can just pull products out of storage.
draw a supply and demand curve, and mark on it the point of equilibrium price and quantity
P - y axis
Q - x axis
Supply curve going upwards, demand curve going downwards
point of equilibrium marked as P* and Q*, where both curves meet
show on this diagram something that would cause the equilibrium price to rise/fall.
price will rise if demand rises, or supply falls.
price will fall if demand falls or supply rises
demand rises - d curve moves outwards
demand falls - d curve moves inwards
supply falls - s curve moves inwards
supply rises - s curve moves outwards
what is meant by equilibrium
where price = quantity
what is meant by excess supply
a situation in which the quantity of a good or service supplied is more than the quantity demanded, and the price is above the equilibrium level determined by supply and demand.
what is meant be excess demand
Excess demand is the situation where the price is below its equilibrium price. The quantity supplied is lower than the quantity demanded by the consumers.
draw a diagram to show excess supply and excess demand
excess supply - P1 is higher than P*
Q supplied is more than Q*
Q Demanded is less than Q*
bracket in between Qs and Qd - above
excess demand - P2 is lower than P*
Qs less than Q*
Qd more than Q*
bracket between Qs and Qd - below
what is meant by the market clearing price?
the price at which quantity supplied equals the quantity demanded, where there is no excess supply or demand.
in a competitive market, what effect would a new supplier entering the market have on supply?
a new supplier means supply rises so prices fall
what is meant by joint demand/complimentary goods
complimentary goods are goods which are consumed together.
Joint demand is when the demand for one product is directly and positively related to market demand for a related good or service.
give an example of two goods in joint demand
milk and cereal, phones and phone cases etc
what is the impact on both products if the market price for one of the goods was to increase? (complimentary goods)
if there was an increase in the price for milk then there would be less demand for milk, and people consume cereal with milk so the demand for cereal would decrease as well.
what is meant by a substitute?
an alternative good, a good that replaces another one
give an example of a substitute good
ballpoint pen and fountain pen
what is the impact on both products if the market price for one of the goods was to increase? (substitute goods)
if theres an increase in the price of ballpoint pens, then demand falls for this product. consumers will switch to the alternative product - fountain pens and therefore the demand for this product increases
what is meant by composite demand
when one good is demanded for two or more reasons
give an example of a product that is in composite demand
milk, it can be used for drinking, butter, yoghurt etc
what is the impact on the product if there is an increase in the demand for one of the goods? (composite demand)
an increase in the demand for butter means there is there is less milk available so supply of yoghurt will decrease
what is meant by derived demand
when the demand for a good is driven by the demand for another good
give an example of a good whose demand for a good is derived by the demand for another good
the demand for oak wood is derived by the demand for oak furniture
what is the impact of on both products if there is an increase in the market demand for one good? (derived demand)
if demand for oak furniture increases, more people will be buying oak furniture then demand for oak will also increase
what is meant by joint supply
when one good is produced at the same time as another good
name two products that are in joint supply
beef and leather
what is the impact on both products if there is an increase in the supply for one of the goods? (joint supply)
for there to be more beef, more cows need to die, and killing cows produces leather, therefore the supply of leather will increase as well.
what are the three functions of the price mechanism? explain each one
- Rationing function
when there is a shortage of a product, price will rise and deter some customers from buying the product. - Signalling function
changes in price provides information to both producers and consumers about changes in the market condtions - Incentive function
changes in price provides incentives to producers to increase or decrease production
define consumer surplus
its a measure of the welfare that peoplem gain from consuming goods and services
define producer surplus
the difference between what the producer was prepared to sell the product at, and the price they receive.
draw a supply and demand diagram and shade the area of consumer and producer surplus
producer surplus is below the price level at equilibrium
consumer surplus is above the price level at equilibrium
show on the diagram what happens to consumer surplus if supply increases?
Supply shifts from S1-S2
Price falls from P1-P2
the consumer surplus is above the original triangle. Meets at the new equilibrium at P2, Q2
show what happens to producer surplus if demand rises
demand rises from D1-D2
market prices increase from P1-P2
this increases producer surplus.
new triangle is
define indirect tax
taxes on expenditure
give two examples of indirect taxes
Ad Valorem Tax - e.g. VAT are percentage of the price of product or service
Specific taxes - a set amount per unit of the product - parallel shift to a supply curve
show on a diagram the impact on supply of the increase of VAT
S1 increases to S2 - ad valorem tax labelled
P0 increases to P2 - Consumer tax benefit
P0 decreases to P1 - incidence of taxation on producer
Q0 decreases to Q1.
show on a diagram the impact on supply of excise supply, and shade the area of producer and consumer incidence
inward shift of supply - S1 - S1+tax. (parallel lines)
Q1 decreases to Q1+tax.
the burden on the consumer is above the equilibrium
the burden on the producer is below the equilibrium (p1Q1)
what is the tax revenue to the government
burden on consumer + burden on producer = total tax revenue to government
what happens to producer incidence if demand is elastic and VAT increases?
the burden on taxation falls mainly on the producer, because consumers will not accept an increase in the price level, so price will not rise significantly following the increase in tax. but the tax must be paid, so the producer will pay it by cutting profit margins
what happens to consumer incidence if demand is inelastic and VAT increases?
if demand is inelastic then the producer can pass more of the tax rise to the consumer, so the incidence on the consumer will rise. this is because producers know that consumers will not reduce consumption significantly following an increase in the price, so they will pass the tax on to the consumer with higher prices
define subsidy
a grant from the government, financial or otherwise, with aims of reducing cost of production.
show on a diagram the impact of a subsidy on supply, and shade the area showing benefit to producer and benefit to consumer
S curve shifts outwards to S+subsidy
P decreases to P1
Q increases to Q1
benefit to producer is above the equilibrium
benefit to consumer is below the equilibrium
how are consumers affected by a subsidy?
price falls so consumers benefit, as there is a consumer surplus, as output has risen
how are producers affected by a subsidy?
producer surplus rises because the price consumers pay + subsidy is higher than the price at the previous market equilibrium
how is the government affect by a subsidy?
producer and consumer surplus rise. however the governnment must pay the size per unit subsidy x total output. governments must pay for subsidies using tax revenues or government borrowing
how might other peoples behaviour alter a consumer’s choice?
- social/peer pressure - e.g alcohol, legal highs
- social norms - e.g becoming unacceptable to smoke
- emotional factors - e.g. someone you know has a problem with a product, so you decrease consumption of that product
how might habitual consumption be irrational?
an example is always buying the same meal at a restaurant. this may be irrational if there is an alternative to this meal available which may be better but you refuse to try out this meal/
give an example of where a consumer cannot make a rational choice due to a lack of information, or a lack of computational skill
bounded rationality is where consumers are rational to a point, but are limited by a lack of information , so they will use rule of thumb instead to make decisions
is giving to charity irrational?
it may seem irrational as it is a consumption choice which has no utility gain for the donator. this money could have been used to buy goods/services instead. it is only rational if you get pleasure from giving to others and this outweighs the benefit of spending it on yourself
