1.2 How Markets Work Flashcards
How are assumptions made when creating economic models
Deduction - start with a hypothesis
Induction - collect evidence
Deductive Assumption Schools
Classical school - Adam Smith
Neo-classical school - Alfred Marshall
Inductive Assumption Schools
Behavioural school - Richard Thaler
Keynesian school - Joan Robinson
Utility
The satisfaction or benefit derived from consuming a good
What are decision makers in classical and neoclassical economics
Rational
How do consumers act rationally
Buying products that maximise utility
How do firms act rationally
Maximising utility though profit
Maximising profit is achieved through producing as efficiently as possible and making things that consumers both want and can afford
What is needed to make rational decision
Time
Information
Ability to process information
Behavioural Economics
School of economic thought based on evidence and observations to develop assumptions of economic decision making
Uses inductive approach
Assumes individuals have bounded rationality (individuals wish to maximise utility but cannot)
What can prevent rational decision making
Habitual behaviour/consumer inertia
People are influenced by the behaviour of others
Consumer weakness at computation
What are the two types of economy consolidation
Nationalisation and privatisation
Nationalisation
Process of bringing economic activity under state control
Industry would be run by public sector instead of private sector
Privitisation
Process of transferring economic activity from state to market
Industry run by private sector instead of public sector
How can we explain changes in prices of goods and services
Develop a model that beings together the two fundamental economic agents that determine the price of a good (consumers and producers)
Demand
The quantity of a good or service purchased at a given price over a given time period
How is contraction shown on a demand curve
Movement along the demand curve to the top left
How is extension shown on a demand curve
Movement on the curve in a top bottom direction
Law of Demand
Ceteris Paribus, as the price of a good increases, quantity demanded decreases
Conversely, as the price of a good decrease, quantity demanded increases
What causes a contraction on a demand curve
An increase in price
What causes an extension on a demand curve
A decrease in price
What does an inward shift on a demand curve show
A decrease in demand
What does an outward shift on a demand curve show
An increase in demand
Conditions of Demand
Population size Price of substitute goods Price of complement goods Population structure Incomes Advertising Tastes/preferences
Substitute Good
A good which can be an alternative product which could be used for the same purpose
Complement Goods
Products that are used together
Revenue
Income that a government or company receives
Raw Materials
Materials before being processed for use
How is extension shown on a supply curve
Movement along the curve in a top right direction
How is contraction shown on a supply curve
Movement on the curve in a bottom left direction
Total Revenue
Price * Quantity
Who supplies good and services
Firms in a market
Supply
Quantity of a good or service that firms are willing to sell at a given price over a given time period
Law of Supply
Ceteris Paribus, as the price of a good increases, quantity supplied increases
Conversely, as the price of a good decreases, quantity supplied decreases
What does extension on a supply curve show
An increase in price
What does contraction on a supply curve mean
A decrease in price
What does a supply curve assume
Firms are motivated to produce by profit
The cost of producing a unit increases as output increases
What does an inward shift on a supply curve mean
A decrease in supply
What does an outward shift on a supply curve mean
An increase in supply
Conditions of Supply
Changes in production costs Improvements in technology/innovation Number of firms in the market Changes in the price of related goods Weather conditions Firms’ expectations about future prices
Market
Anywhere buyers and sellers meet to exchange money for goods
Excess Demand
What the demand of a product is greater than its supply
Excess Supply
When the supply of a product is greater than its demand
Price Equilibrium
When demand and supply are equal
What is the equilibrium price also known as and why
Market clearing price
All products are cleared off the market
Direct Tax
A tax levied directly on an individual or organisation
Indirect Tax
A tax levied on a good or service
Specific Tax
Parallel shift in the supply curve
Same fixed amount at all prices
Ad Valorem Tax
Non-parallel shift in the supply curve
Tax increases as the amount sold rises
Law of Diminishing Marginal Utility
The satisfaction derived from the consumption of an additional unit of a good will decrease as more of a good is consumed
Why do governments impose taxes
Raise government revenue
Decrease certain economic activities
Subsidy
Money given by the government to encourage production
Shared Economic Incidence
When the government increases indirect tax, suppliers need to be able to maintain profit and sales thus them increasing the price of the product by only 50% of the tax. This means the consumer pays 50% of that indirect tax and the supplier pays the other 50%
What effect do subsidies have on a supply and demand curve
Subsidies lead to increased production leading to increased supply. This means there is an outward shift for supply
Price Elasticity of Demand
A measure of the responsiveness of demand given a change in price
When is demand price elastic
When a change in price causes a proportionately larger change in demand
When is demand price inelastic
When a change in price causes a proportionately smaller change in demand
Price Elasticity of Demand Determinants
Number of substitutes Necessity/luxury Addictiveness Time Proportion of income spent on the product
How does number of substitutes affect price elasticity of demand
The more substitute goods a product has, the greater the degree of consumer switching when there is a price change
More substitute goods => more elastic
How does being a necessity/luxury affect price elasticity of demand
If a product is a necessity, people will require the product no matter what
Necessity => Price Inelastic
If a product is a luxury, people will not necessarily need it
Luxury => Price Elastic
How does addictiveness affect the price elasticity of demand
More addictive => more price inelastic
How does time affect the price elasticity of demand
Time gives consumers the opportunity to find alternatives
Greater time period => more elastic
How does proportion of income spent on the product affect the price elasticity of demand
Greater proportion of income spent on product then the less able consumers will be able to afford after price increases
Greater proportion of income spent => more price elastic
How to calculate price elasticity of demand
Percentage change in quantity demand
/
Percentage change in price
PED Value for elastic
Greater than 1
PED Value for inelastic
Between 0 and 1
PED Value for unitary elastic
= 1
PED Value for perfectly elastic
0
Price Elasticity of Demand Diagrams
Price Elastic - Close to horizontal (-)
Price Inelastic - Close to vertical ()
Price Elasticity of Supply
A measure of the responsiveness of supply given a change in price
Price Elasticity of Supply Determinants
Time required to produce the product Level of spare capacity Number of stocks/finished goods available Time Perishability of the product
How does time required to produce the product affect the price elasticity of supply
Greater time required to produce => more price inelastic
Less time required to produce product, firms will be able to respond to changes in price fast
Short production time => price elastic
How does level of spare capacity affect the price elasticity of supply
Greater spare capacity => more price elastic
Factors of production available to be used in production so firms will be able to respond to change in price quickly
How does number of stock/finished goods available affect the price elasticity of supply
More finished goods => more price elastic
Firms able to respond to price rise by releasing more products on to the market
How does time affect the price elasticity of supply
Greater time period => more price elastic
Time gives firms opportunity to expand/reduce production
How does perishability of produce affect the price elasticity of supply
More perishable => more price inelastic
More perishable a product is, harder it is to build up stock
When is supply price elastic
When a change in price causes a proportionately larger change in supply
When is supply price inelastic
When a change in price causes a proportionately smaller change in supply
How to calculate price elasticity of supply
Percentage change in quantity supplied
/
Percentage change in price
PES Value for Price Elastic
Greater than 1
PES Value for price inelastic
Between 0 and 1
PES Value for unitary elastic
1
PES Value for perfectly elastic
0
Consumer Surplus
Extra amount of money consumers are prepared to pay for a good or service above what they actually pay
It is the utility or satisfaction gained from a good or service in excess to 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
It is the extra earning obtained by a producer above the minimum required for them to supply the good or service
Incidence of Indirect Tax
Distribution of the tax between consumers and producers
Depends on the elasticity of both demand and supply
When demand is price elastic, the burden of the tax will fall mostly on producers
When demand is price inelastic, the burden of tax will fall mostly on consumers
Incidence of Subsidy
How the gains of the subsidy are distributed between consumers and producers
Depends on the elasticity of both demand and supply
When demand is price elastic, most of the gain goes to producers
When demand is price inelastic, most of the gain goes to consumers
Income Effect
Assuming a fixed level of income, the income effect means that as price falls the amount that consumers can afford increases and so demand increases
Diminishing Marginal Utility
As successive units of a good are consumed, the utility gained from each unit will fall
Cross Price Elasticity of Demand (XED)
Measures the responsiveness of demand for one good to changes in the price of another good
Substitute goods have a positive XED
Complement goods have a negative XED
The XED of unrelated goods is zero
Income Elasticity of Demand (YED)
Measures the responsiveness of demand to changes in income
Inferior goods have a negative YED
Normal goods have a positive YED
Normal goods that have a YED between 0 and 1 are classed as income inelastic goods. They tend to be necessities.
Normal goods that have a YED larger than 1 are classed as income elastic goods. These goods are often considered luxuries
Functions of Price Mechanism
Signalling
Incentive
Rationing
Signalling
Price mechanism acts as a signal where resources should be used
When prices rise, producers move resources into the manufacture of that product
The change in price indicates to suppliers and consumers that market conditions have changed so they should change the quantity bought and sold
Rationing
The price system is a way of rationing goods because when price increases, some people will no longer be able to afford to buy the products and others may no longer have the desire to buy the good
Limited resources can be rationed and allocated to the people who are able to afford them and those who value them most highly
Incentive
Acts as an incentive for people to work hard
Buyers realise that the more money they have, they are able to buy more products
Suppliers realise that if they produce more of the goods, they will make more money
Also low prices act as an incentive to consumers to buy more of a good and higher prices act as an incentive to sell more of a good
