1.2 How Markets Work Flashcards
What are the underlying assumptions of rational economic decision making for
a) consumers?
b) producers?
a) Consumers set out to maximise their utility
b) Firms aim to maximise profits
Define demand
The quantity of a good or a service that consumers are willing and able to buy at any given price in a given time period
What is the difference between individual demand and and market demand?
Individual demand is the demand for a good or service from a single consumer, whereas market demand is the level of demand from all potential buyers
Define what diminishing marginal utility is
It describes the situation where a consumer gains less additional utility from consuming a product the more of it that is consumed
What is the law of demand?
There is an inverse relationship between the price of a good or service and the quantity demanded of it
What is the snob effect/ Veblen effect?
Where there is a direct relationship between price and demand, because expensive goods and services can be flexed on others
What are normal goods?
A good where demand rises in response to an increase in consumer incomes
What are inferior goods?
A good whose demand decreases when consumer incomes rise
Define substitutes
Two goods are substitutes if the demand for one good rises when the price of the other good rises
Define complementary goods
Two goods are compliments if the rise in the price of one of the goods leads to a fall in demand for the other good
Define elasticity
A measure of sensitivity of one variable to changes in another variable
Define price elasticity of demand (PED).
How do you calculate it?
A measure of the responsiveness of quantity demanded to a change in the price of a good or service.
%∆ QD/ %∆ Price
Will PED be negative or positive, providing its not a snob good?
Negative
When is a good or service
a) relatively elastic?
b) relatively inelastic?
c) unitary elastic
a) When PED is greater than 1
b) When PED is less than 1
c) When PED=1
When PED is elastic, what happens to total revenue when prices rise and fall?
When prices rise, total revenue falls.
When prices fall, total revenue rises.
When PED is unitary, what happens to total revenue when prices change?
There is no change to total revenue
What happens to total revenue when PED is inelastic, and prices rise and fall?
When price rise, revenue rises.
When prices fall, revenue also falls.
Why is it incorrect to say that a demand curve is either elastic or inelastic?
Because it has different elasticities at different points of the curve
When is PED
a) perfectly inelastic
b) perfectly elastic
a) PED=0
B)PED is infinity
How do substitutes affect PED?
The more substitutes a good or service has, the more elastic PED is
Would PED of a good or service be elastic or inelastic if
a) it’s a necessity?
b) it’s a luxury good?
a) inelastic
b) elastic
How does the price of a good or service as a percentage of a consumers income affect PED?
If the price is a small % of consumer income, PED tends to be relatively inelastic.
If it takes up a large % of consumer income, PED tends to be elastic.
How does the time period affect PED, and why is this?
PED tends to become more elastic in the long term.
This is because in the short term, habit or commitments exist. Also, in the long term, more substitutes will enter the market.
Define income elasticity of demand (YED)
How do you calculate it?
A measure of sensitivity of quantity demanded to a change in consumer incomes.
%∆ QD/ %∆ Incomes
Will YED be positive or negative for
a) normal goods?
b) inferior goods?
a) positive
b) negative
What does YED tend to be for
a) luxury goods?
b) necessities?
a) YED is greater than 1
b) YED is less than 1
Define a luxury good
A good in which as incomes rise, consumers spend proportionally more on the good
Define a necessity
A good in which as incomes rise, consumers spend proportionally less on the good
Define cross-price elasticities of demand (XED)
A measure of sensitivity in quantity demanded of a good or service to a change in price of another good or service
How do you calculate XED?
%∆ QD for good X / %∆ Price for good Y
If XED is positive or negative, are the two goods substitutes or complements?
When XED is positive, they are substitutes.
When XED is negative, they are complements.
When XED is low or high, what does this mean?
What if XED is 0?
When XED is very high or very negative, the goods are closely related.
If XED is low, they are weak substitutes or complements.
If XED is 0, they are unrelated goods.
In what two ways can price elasticity of demand be helpful?
1) Examining the impact of tax revenue following changes in indirect taxes
2) The impact of a subsidy when prices are decreased
How are PED and YED important to firms?
PED helps to work out effects on revenue if they change prices.
YED helps to work out whether real consumer incomes are rising, or if the economy is heading into a recession.
How does XED help firms?
To anticipate changes in QD of their good or services when prices of other goods and services are changing.
What causes a movement along the demand curve?
A change in price
What factors cause a shift in the demand curve?
P Population A Advertising S Substitutes I Income F Fashion and taste I Interest rates C Complements (prices of extras needed)
What is derived demand?
The demand for a factor of production used to produce another good or service.
What type of goods are said to be in joint demand?
Complementary goods
What is composite demand?
Occurs when a good has more than one use- an increase in demand for one product leads to a fall in supply of the other.
Define supply
The quantity of a good or service that a producer is willing and able to produce at a given price in a given time period
What is the basic law of supply?
As the price of a product rises, firms will supply more of the good.
What relationship does the supply curve show?
The relationship between market price and how much a firm is willing and able to sell.
What causes a movement along the supply curve?
A change in price
What factors cause a shift in the supply curve
P Productivity I Indirect taxes N Number of firms T Technology S Subsidies W Weather C Costs of production
What does the price elasticity of supply measure (PES) ?
It measures the responsiveness of quantity supplied to changes in price
How do you calculate PES?
%∆ QS/ %∆ Price
What is the value for PES when PES is
a) elastic?
b) inelastic?
c) unitary elastic?
d) perfectly inelastic?
e) perfectly elastic?
a) PES is greater than 1
b) PES is less than 1
c) PES=1
d) 0 (QS is the same at every price)
e) PES = infinity
What factors effect PES? (5)
- Availability of stocks
- Ease of switching production
- Spare capacity
- Complexity of production
- Time scale
What happens to PES in the long run?
PES becomes more elastic in the long run, as firms can increase their factors of production, whereas in the short term it is hard to increase FOP.
What is consumer surplus?
A measure of welfare that people gain from consuming goods and services.
The difference between the total amount that consumers are willing and able to pay for a good or service and the total amount they do pay.
What area on a supply and demand diagram shows consumer surplus?
The area under the demand curve and above the market price.
What is producer surplus?
The difference between the price producers are willing and able to supply a good or service and the price they actually receive.
What area on a supply and demand diagram represents producer surplus?
The area above the supply curve and below current market price.
What are the 3 functions of the price mechanism to allocate resources?
- Signalling
- Incentive
- Rationing
How do prices act as a signalling device?
Prices reflect consumer preferences and changes in market conditions.
It sends signals to producers as to whether demand is high or low for a product at a given price.
How do prices act as a rationing device?
When demand outweighs supply, prices are raised to ration consumers
How do prices act as incentives?
As prices rise, this gives firms more incentive to supply a good or service
What can occur as a result of producer surpluses, and how would this look on a diagram?
Firms will be attracted to these surpluses and will enter the market.
This will leads to an outwards shift of supply, pushing prices down.
What may happen in the long run if demand in a market is low, and how would this look on a diagram?
Firms may exit the market, leading to an inwards shift of supply and an increase in price
Define allocative efficiency
A point achieved when society is producing an appropriate combination of goods relative to consumer preferences
Define marginal cost
The cost of producing an additional unit of output
Define indirect tax
A tax levied on expenditure on goods and services
What does the addition of an indirect tax look like on a diagram?
- Supply shifts to the left
- Resulting in a higher price, so less quantity
demanded - Consumer burden above producer burden
Define the incidence of tax
The way in which the burden of paying tax is divided between buyers and sellers
If demand was price inelastic, who would have the larger burden of tax?
Consumers
What does the total burden of tax equal?
Government revenue from the tax
Define an ad valorem tax
A tax that takes a percentage of the price rather than a fixed amount
What does an ad valorem tax look like on a diagram?
New supply curve is non parallel to old supply curve and moves away from old supply curve.
Define a subsidy
A grant given by the government to producers to encourage production of a good or service
What does the addition of a subsidy look like on a diagram?
- Supply shifts right
- Price falls, rise in demand
- Producer burden above consumer burden
Give the reasons why consumers may not always act rationally
- Habitual behaviour
- Consumer weakness at computation
- Influence of other’s behaviours
