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Economics Theme 1 (micro) Old > 1.2 How Markets Work > Flashcards

1.2 How Markets Work Flashcards

1
Q

What 2 approaches can be followed to make assumptions about the behaviour of economic agents

A
  • deduction (start with hypothesis)

- induction (collect evidence)

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2
Q

Deductive schools of economics & famous economists

A
  • classical school (Adam smith)

- neoclassical school (Alfred Marshall)

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3
Q

Inductive school of economics & famous economists

A
  • behavioural school (Richard Thaler)

- Keynesian school (Joan Robinson)

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4
Q

Classical & neoclassical economics decision making

A
  • 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)

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5
Q

Utility

A

= the satisfaction or benefit derived from consuming a good

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6
Q

What do economic agents require to make rational decisions

A
  • time
  • information
  • ability to process information
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7
Q

Behavioural economics

A

Based on evidence & observations to develop assumptions

  • assumes individuals have bounded rationality
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8
Q

Bounded rationality

A

Individuals wish to maximise utility but are unable to do so due to:

  • lack of time
  • lack of information
  • inability to process information
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9
Q

What aspects of human behaviour prevent rational decision making?

A
  • habitual behaviour
  • consumer inertia (satisfied)
  • people influenced by the behaviour of others
  • consumer weakness of computation (don’t understand data)
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10
Q

Demand

A

The quantity of a good or service purchased at a given price over a given time period

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11
Q

Law of demand:

A

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)

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12
Q

Relationship between price & quantity on demand curve, distinction between movements & shifts in demand curve

A

Inverse relationship
Movement along curve = change in price
Shift in curve = conditions of demand change, outside factors

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13
Q

The conditions of demand: (cause shift in demand curve)

What influences demand

A
  • 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)
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14
Q

Substitute goods

A

Two alternative products that could be used for the same purpose

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15
Q

Complement goods

A

Products used together

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16
Q

Law of diminishing marginal utility

How did this influence shape of demand curve

A

= 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)

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17
Q

Revenue

A

Income a government / company receives

= price x quantity

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18
Q

Supply

A

Quantity of a good or service that firms are willing to sell at a given price over a given time period

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19
Q

Shape of supply curve & WHY

A

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)

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20
Q

Law of supply

A

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)
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21
Q

Raw material

A

Any material in its natural condition before it has been processed for use

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22
Q

Conditions of supply (causes shift in supply curve)

What influences supply

A
  • 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)
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23
Q

Excess demand

A

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

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24
Q

Excess supply

A

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

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25
Q

Equilibrium price (market clearing price)

A

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)

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26
Q

Direct tax

A

A tax levied directly on an individual or organisation

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27
Q

Indirect tax

A

A tax levied on a good or service

28
Q

Specific tax

A

Tax is the same fixed amount at all prices

  • causes parallel shift in supply curve

Eg. Fuel duty, beer duty

29
Q

Ad valorem tax

A

Tax increases as amount sold rises

  • causes non-parallel shift in supply curve

Eg. VAT (value added tax), import tariffs

30
Q

Why do government impose taxes

A
  • 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)

31
Q

Subsidy

A

Money given by the government to encourage production

32
Q

Why do government give subsidies to firms

A

To encourage production (electric cars, gym memberships)

causes right shift in supply curve

33
Q

Price elasticity of demand (PED)

PED equation

A

Measures the responsiveness of demand given a change in price

PED = percentage change in quantity demand
———————————————————
Percentage change in price

34
Q

Types of PED

A

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)

35
Q

Determinants (factors influencing) of PED

A

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)

36
Q

Price elastic of supply (PES)

PES equation

A

Measures responsiveness of supply given a change in price

PES = percentage change in quantity supplied
———————————————————
percentage change in price

37
Q

Types of PES

A

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)

38
Q

Determinants (factors influencing) of PES

A

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)

39
Q

How does PED & PES affect indirect taxes / subsidies

A

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

40
Q

Consumer surplus

A

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

41
Q

Producer surplus

A

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

42
Q

Consumer surplus & producer surplus diagram

A
43
Q

What is the incidence of indirect tax

What does it depend on

A

The distribution of tax between consumers & producers

Depends on elasticity of demand & supply

44
Q

How does elasticity of demand affect the incidence of indirect tax

A

Price elastic demand = burden of tax falls mostly on producers

Price inelastic demand = burden of tax falls mostly on consumers

45
Q

Incidence of subsidy

What does it depend on

A

How the gains of the subsidy are distributed between consumers & producers

Depends on elasticity of demand & supply

46
Q

How does elasticity of demand affect incidence of a subsidy

A

Price elastic demand = most gains of subsidy will go to producer
Price inelastic demand = most gains of subsidy will go to consumer

47
Q

How to calculate & draw tax revenue

A

Tax revenue = tax rate per unit x quantity sold

48
Q

How to calculate and draw government spending

A

Government spending = subsidy rate per unit x quantity sold

49
Q

Income effect

A

Assuming a fixed level of income, as price falls the amount consumers can afford increases, so demand increases

50
Q

Marginal utility

A

Utility or satisfaction obtained from consuming one extra unit of a good or service

51
Q

Diminishing marginal utility

A

As successive units of a good are consumed, marginal utility gained from each unit will fall

52
Q

Cross price elasticity of demand (XED) definition

A

Measures responsiveness of demand for one good given a change in price of another good

53
Q

XED equation

A

Percentage change in quantity demanded of product A
——————————————————————————
Percentage change in price of product B

54
Q

What goods have a +/- XED

A

Substitute goods = + XED
Complement goods = — XED
Unrelated goods = 0

55
Q

Income elasticity of demand (YED)

A

Measures responsiveness of demand to changes in income

56
Q

YED equation

A

Percentage change in quantity demanded
———————————————————
Percentage change in income

57
Q

What goods have a +/— YED

A

Normal goods = + YED

Inferior goods = — YED

58
Q

Income inelastic goods

A

= Normal goods that have a YED between 0 - 1

Tend to be necessities

59
Q

Income elastic goods

A

Normal goods with YED 1+

Often considered luxuries

60
Q

Functions of the price mechanism to allocate resources:

A
  • rationing
  • incentive
  • signalling
61
Q

Price mechanism

A

How prices allocate goods & services in a market based on levels of demand & supply

62
Q

Rationing price mechanism

A 
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
63
Q

Signalling price mechanism

A

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

64
Q

Incentive price mechanism

A

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

65
Q

How does PED determine how changes in price affects revenue

A

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

Economics Theme 1 (micro) Old (4 decks)

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