1.2 How Markets Work Flashcards
What 2 approaches can be followed to make assumptions about the behaviour of economic agents
- deduction (start with hypothesis)
- induction (collect evidence)
Deductive schools of economics & famous economists
- classical school (Adam smith)
- neoclassical school (Alfred Marshall)
Inductive school of economics & famous economists
- behavioural school (Richard Thaler)
- Keynesian school (Joan Robinson)
Classical & neoclassical economics decision making
- decision makers assumed to be rational
Consumers: aim to maximise utility (buying products that maximise utility)
Firms: aim to maximise profit (producing as efficiently as possible & making things consumers want & can afford)
Utility
= the satisfaction or benefit derived from consuming a good
What do economic agents require to make rational decisions
- time
- information
- ability to process information
Behavioural economics
Based on evidence & observations to develop assumptions
- assumes individuals have bounded rationality
Bounded rationality
Individuals wish to maximise utility but are unable to do so due to:
- lack of time
- lack of information
- inability to process information
What aspects of human behaviour prevent rational decision making?
- habitual behaviour
- consumer inertia (satisfied)
- people influenced by the behaviour of others
- consumer weakness of computation (don’t understand data)
Demand
The quantity of a good or service purchased at a given price over a given time period
Law of demand:
As price of good decreases, quantity demanded increases (extension in demand = movement down demand curve)
As price of good increases, quantity demanded decreases (contraction in demand = movement up demand curve)
Relationship between price & quantity on demand curve, distinction between movements & shifts in demand curve
Inverse relationship
Movement along curve = change in price
Shift in curve = conditions of demand change, outside factors
The conditions of demand: (cause shift in demand curve)
What influences demand
- population size
- changes in price of substitute goods
- changes in price of complement goods
- population (age) structure
- incomes
- advertising
- change in consumer tastes/preferences (utility)
Substitute goods
Two alternative products that could be used for the same purpose
Complement goods
Products used together
Law of diminishing marginal utility
How did this influence shape of demand curve
= the marginal utility of a good or service declines as more of it is consumed by an individual. Economic actors receive less and less satisfaction from consuming incremental(increasing) amounts of a good.
( as more of a product is consumed the marginal (additional) benefit to the consumer falls, hence consumers are prepared to pay less = inverse relationship between price and quantity)
Revenue
Income a government / company receives
= price x quantity
Supply
Quantity of a good or service that firms are willing to sell at a given price over a given time period
Shape of supply curve & WHY
Linear relationship between price & quantity (upward sloping)
Firms are motivated to produce by profit
So if prices are higher, firms will increase production
Cost of producing a unit increases as output increases (firms need to use more resources which increases production costs, prices of factors of production to firm will increase as firms bid for more)
Law of supply
Ceteris paribus:
- as price of good increases, quantity supplied increases (extension in supply = movement up supply curve)
- as price of good decreases, quantity supplied decreases (contraction in supply = movement down supply curve)
Raw material
Any material in its natural condition before it has been processed for use
Conditions of supply (causes shift in supply curve)
What influences supply
- changes in production costs (subsidies)
- improvements in technology / innovation
- number of firms in market
- changes in price of related goods
- weather conditions
- firms expectations about future prices (may hold onto supply, tactical to gain most profit)
Excess demand
If price is set below equilibrium
= demand is greater than supply
(suppliers are willing to supply less than consumers demand, prices can be increased)
= there is a shortage in the market
Excess supply
If price is set higher than equilibrium
= supply is greater than demand
(suppliers willing to supply more than consumers demand, prices will have to fall)
= too many products, firms have unsold goods
Equilibrium price (market clearing price)
Only price where demand of consumers is equal to supply of producers in the market
= where demand & supply curve crosses
(all products in market are bought & cleared out)
Direct tax
A tax levied directly on an individual or organisation
Indirect tax
A tax levied on a good or service
Specific tax
Tax is the same fixed amount at all prices
- causes parallel shift in supply curve
Eg. Fuel duty, beer duty
Ad valorem tax
Tax increases as amount sold rises
- causes non-parallel shift in supply curve
Eg. VAT (value added tax), import tariffs
Why do government impose taxes
- to raise government revenue (to spend on hospitals, schools, roads)
- to discourage certain economic activities (viewed as harmful - smoking)
(causes left shift in supply curve & demand curve)
Subsidy
Money given by the government to encourage production
Why do government give subsidies to firms
To encourage production (electric cars, gym memberships)
causes right shift in supply curve
Price elasticity of demand (PED)
PED equation
Measures the responsiveness of demand given a change in price
PED = percentage change in quantity demand
———————————————————
Percentage change in price
Types of PED
Relatively elastic PED = change in price causes a proportionately larger change in demand (PED>1, gentle curve)
Perfectly elastic PED = change in price causes demand to fall to 0, demand is very responsive to price (PED=infinity, horizontal curve)
Relatively inelastic PED = change in price causes a proportionately smaller change in demand (PED<1, steep curve)
Perfectly inelastic PED = change in price causes no change in demand, demand is unresponsive to price (PED=0, vertical curve)
Unitary elastic PED = change in price causes a proportionately equal change in demand (PED=1, straight proportionate curve)
Determinants (factors influencing) of PED
Number of substitutes — more substitutes = PED more elastic (greater degree of consumer switching when there is a price change)
Necessity / luxury — necessity = PED more inelastic (people require product no matter the price)
Addictiveness — more addictive = PED more inelastic (hard for people to stop buying or switch even if price changes)
Time — more time = PED more elastic (time gives consumers the opportunity to find alternatives)
Proportion of income spent on product — greater proportion of income spent on product = PED more elastic (consumers will be less able to afford price increases)
Price elastic of supply (PES)
PES equation
Measures responsiveness of supply given a change in price
PES = percentage change in quantity supplied
———————————————————
percentage change in price
Types of PES
Relatively elastic PES = change in price causes a proportionately larger change in supply (PES>1, gentle curve, start on price axis)
Perfectly elastic PES = change in price causes quantity supplied to fall to 0, supply is very responsive to price (PES=infinity, horizontal curve)
Relatively inelastic PES = change in price causes a proportionately smaller change in supply (PES<1, steep curve, start on quantity axis)
Perfectly inelastic PES = change in price causes no change in supply, supply is unresponsive to price (PES=0, vertical curve)
Unitary elastic PES = change in price causes a proportionately equal change in supply (PES=1, straight proportionate curve)
Determinants (factors influencing) of PES
Time required to produce the product — long production time = PES more inelastic (firms won’t be able to respond to changes in price rapidly)
Level of spare capacity — greater spare capacity = PES more elastic (factors of production are available to use in production, firm likely to respond quickly by increasing production)
No. of stocks / finished goods available — more finished goods available = PES more elastic (firms able to respond to price rise by releasing some/all stocks on to market straight away)
Time — more time = PES more elastic (time gives firms opportunity to expand or reduce production)
Perishability of the product — more perishable product = PES more inelastic (harder to build up stocks of product)
How does PED & PES affect indirect taxes / subsidies
PED more elastic = demand will fall, tax will be effective at reducing output lower incidence of tax on consumer, supplier will cover majority,
PED more inelastic = demand will not fall by large amount, tax will be ineffective at reducing output, tax mainly passed onto consumer, but higher tax revenue for gov
Consumer surplus
Extra amount of money consumers are prepared to pay for a good or services above what they actually pay
= utility or satisfaction gained from a good or service in excess of the amount paid for it
Producer surplus
Extra amount of money paid to producers above what they are willing to accept to supply a good or service
= extra earning obtained by a producer above minimum required to supply the good or service
Consumer surplus & producer surplus diagram
What is the incidence of indirect tax
What does it depend on
The distribution of tax between consumers & producers
Depends on elasticity of demand & supply
How does elasticity of demand affect the incidence of indirect tax
Price elastic demand = burden of tax falls mostly on producers
Price inelastic demand = burden of tax falls mostly on consumers
Incidence of subsidy
What does it depend on
How the gains of the subsidy are distributed between consumers & producers
Depends on elasticity of demand & supply
How does elasticity of demand affect incidence of a subsidy
Price elastic demand = most gains of subsidy will go to producer
Price inelastic demand = most gains of subsidy will go to consumer
How to calculate & draw tax revenue
Tax revenue = tax rate per unit x quantity sold
How to calculate and draw government spending
Government spending = subsidy rate per unit x quantity sold
Income effect
Assuming a fixed level of income, as price falls the amount consumers can afford increases, so demand increases
Marginal utility
Utility or satisfaction obtained from consuming one extra unit of a good or service
Diminishing marginal utility
As successive units of a good are consumed, marginal utility gained from each unit will fall
Cross price elasticity of demand (XED) definition
Measures responsiveness of demand for one good given a change in price of another good
XED equation
Percentage change in quantity demanded of product A
——————————————————————————
Percentage change in price of product B
What goods have a +/- XED
Substitute goods = + XED
Complement goods = — XED
Unrelated goods = 0
Income elasticity of demand (YED)
Measures responsiveness of demand to changes in income
YED equation
Percentage change in quantity demanded
———————————————————
Percentage change in income
What goods have a +/— YED
Normal goods = + YED
Inferior goods = — YED
Income inelastic goods
= Normal goods that have a YED between 0 - 1
Tend to be necessities
Income elastic goods
Normal goods with YED 1+
Often considered luxuries
Functions of the price mechanism to allocate resources:
- rationing
- incentive
- signalling
Price mechanism
How prices allocate goods & services in a market based on levels of demand & supply
Rationing price mechanism
Scarce resources (excess demand) creates upward pressure on prices = firms increase prices = fewer consumers willing/able to pay = contraction in demand = consequently rations resources = market at equilibrium
Signalling price mechanism
Encourages change in behaviour of consumer/producer by price signals
Falling prices in market = signals consumers to increase demand & producers to leave market due to lower profits
Rising prices in market = signals consumers to decrease demand & producers to enter a market or increased production of that good/service
= market moves towards equilibrium
Incentive price mechanism
Higher prices incentivises producers to increase supply to increase profits
Rational producers will increase supply to maximise profit
= Extension in supply, reduces excess demand = market moves to equilibrium
How does PED determine how changes in price affects revenue
Price inelastic PED:
Price increase = increase in total revenue
Price decrease = decrease in total revenue
Price elastic PED:
Price increase = decrease in total revenue
Price decrease = increase in total revenue
