1.2 How markets work Flashcards
Inductive statement
Collect evidence
Deductive statement
Start with a hypothesis
Rational choice
involves weighing up costs and benefits and trying to maximise surplus of benefits over costs
Utility
measure of satisfaction that we get from purchasing and consuming a G/S
Consumer durables
Products that give steady flow of utility over their working life
Consumer non-durables
Products that are used up in the act of consumption
Demand
Quantity of a G/S that consumers are willing and able to buy at a given price at a given time period
Diminishing marginal utility
Marginal utility is change in satisfaction from consuming an extra unit of a G/S. Beyond a point, marginal utility may start to fall
As more of a good is consumed, the additional utility (satisfaction) from each extra unit consumed will fall. Because consumers are assumed to be rational, they will not pay more for a good than the additional utility it provides. Therefore, price and quantity demanded are inversely related.
Complement goods
Products used together - joint demand
Derived demand
demand that comes from demand for something else. Demand for machinery derived from demand for consumer goods
PED
Price elasticity of demand - responsiveness of demand for a product following a change in price
Substitute goods
Two alternative products that could be used for the same purpose
Competitive supply
Alternative products that a firm can produce with its resources. E.g. potatoes OR carrots
Supply
quantity of a G/S that a producer is willing and able to supply onto the market at a given price at a given time period
PES
Price elasticity of supply - responsiveness of supply of a product following a change in price
Equilibrium
situation where there is no tendency for change
Price mechanism
Decisions of consumers and firms interact to determine allocation of resources. Does not ensure equitable distribution of resources and can lead to market failure
Consumer surplus
difference between the total amount that consumers are willing and able to pay for a good or service
Producer surplus
difference between what producers are willing and able to supply a good for and the price they actually receive
Direct tax
tax levied directly on an individual or organisation
Indirect tax
tax levied on a good or service
Specific tax
Set tax per unit. Parallel shift in supply curve.
Ad Valorem tax
Percentage of sales price tax. Non-parallel shift
Subsidy
payments by government to suppliers to reduce COP.
Effect: increase supply, decrease market equilibrium price
Computational weakness
When consumers find it difficult to calculate probability of something happening when they make purchasing decisions.
Habitual consumption
Strong default choices. Repeat choices become automatic as they do not involve much mental effort.
Rational choice model
independent choice
consistent tastes and preferences
complete info
optimal choice
Continue consuming until marginal benefit = marginal cost
Bounded rationality
When consumers have limited attention, knowledge and ability to understand complex decisions
Info gaps
Consumers have insufficient knowledge to make optimal decision
Explain shape of demand curve
Income Effect: When the price of a good falls, the consumer can maintain the same consumption for less spending. Provided that the good is normal, some of the increase in real income is used to buy more
Substitution Effect: When the price of a good falls, ceteris paribus, the product is now relatively cheaper than an alternative and some consumers will switch their spending from an alternative good or service. The more substitutes there are in the market and the lower the cost and inconvenience of switching, the bigger the substitution effect is likely to be.
Joint demand
demand for one product is positively related to demand for a related good or service - complements
XED = negative
Composite demand
Product has more than one use
Demand increase leads to supply decrease
Determinants of PED
No of substitutes: more substitutes - more price elastic
Cost of switching: expense in switching - inelastic
Necessity = inelastic
Luxury = elastic
Higher proportion of income = more elastic
More time to respond to price change = more elastic
Habitual = inelastic
Broad definition of G/S = inelastic
Explaining upwards slope of supply
Profit motive: When market price rises following an increase in demand, it then becomes more profitable for businesses to increase their output
Production and costs: When output expands, a firm’s production costs tend to rise; therefore, a higher price is needed to cover these extra costs. This may be due to diminishing returns as more factors of production are added to production, but each extra input is less productive than the one before
New entrants into the market: Higher prices create an incentive for other businesses to enter the market leading to an expansion of supply
Substitute in production
two or more goods that can be produced using the same resources
Producing one good prevents sellers from using resources to produce another. Produce one or produce the other, but not both.
Joint supply
Joint supply is where an increase or decrease in the supply of one good leads to an increase or decrease in supply of a by-product.
cows can be utilized for milk, beef, and hide
PES determinants
Spare capacity
Stock of finished products/components
Factor mobility (flexible labour market)
Time period and production speed
Increase in demand
Excess demand at existing market price
SR rise in price and fall in available stock - signal to producer
Profit incentive leads to movement along supply curve
Excess demand
Market price below EQ price
Results in queuing for G/S and upward pressure on price
Higher prices rations demand to those w effective demand
Stimulates expansion of supply to respond to high profit
Causes of shifts in demand curve
Changes in price of substitutes/complements
Changes in real income
Changes in distribution of income
Changes in consumer tastes or preferences
Interest rates
Changes in size and age structure of population
Seasonal factors
Normal goods (necessities and luxury)
Positive income elasticity of demand
Necessity: between 0 and 1, income inelastic
Luxury: >1
Inferior goods
Negative income elasticity of demand
Cross price elasticity of demand for substitutes and complements
Substitutes: positive
Complements: negative
Price mechanism functions
Signalling: adjusts to demonstrate where resources are required. If prices rising due to high demand, it is a signal to expand production to meet rising demand. If there is excess supply, price mechanism will eliminate surplus allowing market price to fall.
Incentives: Higher prices act as incentive to raise output due to changing nature of needs and wants. Demand weaker in recession, supply contracts as producers cut back on output.
Rationing: when demand outstrips supply. Shortage, prices are big up and only those who are willing and able to pay will buy.
Impact of indirect tax on consumers and suppliers
PED > 1, indirect tax absorbed mostly by supplier
PED < 1, indirect tax absorbed mostly by consumer
Rational decisions require?
Time
Info
Ability to process info
Bounded rationality
Due to lack of time, info and ability to process info.
habitual behaviour/consumer inertia
people influenced by behaviour of others
consumer weakness at computation
Determinants of demand
Changes in age structure
Changes in income
Advertising
Changes in tastes/preferences
XED
Cross elasticity of demand
Responsiveness of demand for one good to changes in price of another good.
Substitutes have positive XED.
Complements have negative XED.
