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economics - theme 1 > 1.2 How Markets Work > Flashcards

1.2 How Markets Work Flashcards

1
Q

neo-classical theory

A

assumes that economic agents are rational

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2
Q

underlying assumptions of rational economic decision making

A
  • consumers aim to maximise utility (satisfaction gained from consuming a product)
  • firms aim to maximise profits (in order to keep shareholders and owners happy)
  • governments aim to maximise social welfare (they are voted in by and serve the public so should aim to maximise their satisfaction)
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3
Q

limitations to neo-classical theory and rational decision making

A

economic agents may not always act rationally due to;
- bounded rationality (rationality is limited to us due to our thinking capacity & the info available to us at the time)
- heuristics (people use rules of thumb to make quick, satisfactory decisions)
- habitual behaviour (default bias in choice)
- social norms (what’s accepted in society)
- herd behaviour (basing decisions on what people around us are doing)
- anchors (prices we’ve established as low / high in our minds as a guide for a price to pay)
- choice architecture (layout / range of choices can affect our decisions)

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4
Q

demand

A

the amount of a good / service that a consumer is willing and able to purchase at a given price in a given period of time

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5
Q

effective demand

A

when a consumer is both willing and able to purchase a good / service

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6
Q

movements along the demand curve

A

diagram 1
- caused by a change in the price of the good
- relies on income and substitution effects

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7
Q

the income effect

A

a rise in prices and a fall in real income reduces ‘purchasing power’ of people’s money, thus reducing the quantity demanded

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8
Q

the substitution effect

A

a rise in prices with the same income means people are likely to find cheaper alternatives / substitutes rather than paying for more expensive goods

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9
Q

shifts of the demand curve

A

diagram 2
- caused by a change in any of the factors which affect demand (conditions of demand)

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10
Q

conditions of demand

A
  • income
  • population
  • interest rates
  • quality
  • advertising
  • substitutes
  • complements
  • seasons / weather
  • expectations of future price increases
  • changes in income distribution
  • changes in taste / fashion
  • govt. legislation
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11
Q

conditions of demand - income

A

an increase in disposable income enables consumers to be able to afford more goods, so it usually leads to an increase in demand

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12
Q

conditions of demand - population

A

a rising population means more people in the country, so there will be more people demanding goods, therefore leading to an increase in demand

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13
Q

conditions of demand - interest rates

A

if interest rates are low, it’s cheaper to borrow money, so consumers can be encouraged to buy expensive items on credit, e.g. cars, holidays, etc. thus increasing demand

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14
Q

conditions of demand - quality

A

an increase in the quality of goods encourages people to buy them, so demand increases

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15
Q

conditions of demand - advertising

A

a successful advertising campaign can gain more consumers and increase demand

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16
Q

conditions of demand - substitutes

A

an increase in price of an item can increase demand for a substitute, e.g. a rise in prices of apple phones may lead to a rise in demand for samsung phones

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17
Q

conditions of demand - complements

A

a decrease in price of complements (goods with extra add-ons) can increase demand, e.g. a decrease in price of the PS4 can increase demand for PS4 compatible games

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18
Q

conditions of demand - seasons / weather

A

some goods may see fluctuations in output and sales related to the season of the year, e.g. fans have an increased demand during summer

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19
Q

conditions of demand - future expectations

A

if people expect a shortage of something, or that the price may rise in the future, demand for the good will increase, and vice versa if they expect the price will fall in the future

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20
Q

conditions of demand - changes in income distribution

A

a more equal distribution of income can increase total demand in an economy, as the poor tend to spend most of their income on necessities

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21
Q

conditions of demand - changes in taste / fashion

A

if something becomes more fashionable, we expect demand to increase

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22
Q

conditions of demand - govt. legislation

A

if a govt. make something a legal requirement, demand may increase, e.g. demand for children’s car seats rose after the govt. made it a legal requirement

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23
Q

utility

A

a measure of the satisfaction we get from purchasing and consuming a good / service

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24
Q

marginal utility

A

the additional utility (satisfaction) gained from consuming an extra product

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25
Q

total utility

A

the total satisfaction from a given level of consumption, so this continues to increase even while marginal utility is decreasing

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26
Q

law of diminishing marginal utility

A

states that the marginal utility of extra units declines as more is consumed (i.e. the utility gained from the next unit is lower than the utility gained from the previous unit)

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27
Q

effect of diminishing marginal utility on demand curve

A
  • explains why the demand curve slopes downwards
  • if more of a good is consumed, there is less satisfaction derived from the good
  • this means consumers are less willing to pay high prices at high quantities, as they’re gaining less satisfaction
  • lowering the price makes it more attractive for consumers to keep consuming extra units
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28
Q

elasticity of demand

A

an attempt to measure the responsiveness of quantity demanded to changes in other variables

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29
Q

price elasticity of demand (PED)

A
  • the responsiveness of demand to a change in the price of a good
  • % change in quantity demanded / % change in price
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30
Q

percentage change calculation

A

(new value - old value) / old value x100

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31
Q

numerical values of PED

A
  • diagram 3
  • PED=0; perfectly inelastic; price change has no effect on output so demand is completely unresponsive to price
  • PED<1; relatively inelastic; QD changes by a smaller % than price so demand is relatively unresponsive to price
  • PED=1; unitary elastic; QD changes by the exact same % as price, and this would be shown as a reciprocal curve
  • PED>1; relatively elastic; QD changes by a larger % than price so demand is relatively responsive to price, and curve will be more sloping
  • PED=infinity; perfectly elastic; a price change means quantity falls to 0 and demand is very responsive to price, and this would be shown by a horizontal line
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32
Q

factors influencing PED

A
  • availability of substitutes; good availability of substitutes results in a higher PED value (elastic demand) as people will switch to other products when prices rise, but if there are no alternatives, people will have to buy that good and demand will be inelastic
  • time; in the short term, PED is low (inelastic demand) as consumers are less responsive to price increases, but in the long term, PED is higher (elastic) as consumers can find substitutes
  • addictiveness; demand is inelastic for addictive goods, because no matter how high prices are, people will still buy the good to fulfil their addiction
  • price of the product as a proportion of income; the lower the proportion of income the price represents, the lower the PED value, as a price increase will only have a relatively small impact on them, so demand is inelastic
  • necessity; if an item is a necessity, PED will be low (inelastic) because you’ll still buy it even if the price rises
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33
Q

significance of PED

A
  • knowledge of PED is important to firms seeking to maximise their revenue;
  • PED inelastic; firms should raise prices
  • PED elastic; firms should lower prices
  • indirect taxation; diagram 4
  • inelastic demand; large rise in price but low decrease in demand (higher incidence on consumer)
  • elastic demand; small rise in price but large decrease in demand (higher incidence on producer)
  • subsidies; diagram 5
  • inelastic demand; large fall in price but small increase in demand (high consumer gain)
  • elastic demand; small fall in price but large increase in demand (high producer gain)
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34
Q

PED and total revenue

A
  • diagram 5.5
  • elastic demand; firms should decrease price to maximise revenue
  • inelastic demand; firms should increase price to maximise revenue
  • unitary elastic demand; a change in price doesn’t affect total revenue
  • calculations;
  • total revenue = price x quantity
  • PED = %changeQD / %changeP
  • %change = (new-old) / old x 100
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35
Q

income elasticity of demand (YED)

A
  • responsiveness of demand to a change in income
  • % change in quantity demanded / % change in income
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36
Q

numerical values of YED

A
  • YED<0; inferior good; negative income elasticity; a rise in income leads to a fall in demand for the good
  • YED=0-1; normal good; positive income elasticity; a rise in income leads to a rise in demand for the good
  • YED>1; luxury good; highly income elastic; a type of normal good, but a rise in income leads to a bigger percentage increase in demand for the good
37
Q

factors influencing YED

A
  • depends on whether goods are;
  • inferior; cheaper goods, e.g. supermarket own-brand value products
  • normal; necessities, e.g. milk
  • luxury; higher-end goods, e.g. HD TVs
  • influenced by factors in an economy that change the wages of workers;
  • recession; wages tend to fall; demand for inferior goods rises & luxury goods falls
  • economic growth; rising wages; demand for luxury goods rises & inferior goods falls
  • other influences on income, e.g. minimum wage legislation, taxation, increased global trade
38
Q

significance of YED

A
  • important for businesses to know how their sales will be affected by changes in the income of the population, so they can maximise sales and profits through periods of recession or economic growth
  • it may have an impact on the type of goods that a firm produces, e.g. during a recession, firms may produce more inferior goods and less luxury goods
39
Q

cross price elasticity of demand (XED)

A
  • the responsiveness of demand for one good (A) to a change in price of another good (B)
  • % change in quantity demanded of A / % change in price of good B
40
Q

numerical values of XED

A

XED<0; complementary goods; a decrease in price of good B will increase demand for good A, e.g. a printer and ink cartridges
XED=0; unrelated goods; a change in price of good B has no impact on demand for good A
XED>0; substitutes; an increase in price of good B will increase demand for good A

41
Q

factors influencing XED

A
  • depends on whether the goods are;
  • substitutes (goods in competitive demand)
  • complements (goods in joint demand)
  • unrelated (goods with no relationship)
42
Q

significance of XED

A
  • firms need to be aware of their competition and those producing complementary goods so they know how price changes by other firms will impact them, so they can take appropriate action
  • it can help them to adjust pricing strategies for substitutes and complementary goods, and understand the likely impact of competitors’ pricing strategies on their sales
43
Q

movement along the supply curve

A
  • diagram 6
  • caused by a change in the price of a good
44
Q

shift of the supply curve

A
  • diagram 6
  • caused by a change in any factors affecting supply (conditions of supply)
45
Q

conditions of supply

A
  • costs of production
  • price of other goods
  • weather
  • indirect taxes
  • subsidies
  • technology
  • change in the number of firms in the industry
  • goals of the supplier
  • govt. legislation
  • producer cartels
46
Q

conditions of supply - costs of production

A
  • an increase in costs of production will lead to a firm increasing their prices, to avoid making a loss, so the supply curve will shift to the left, so less is supplied at each price
  • if costs decrease, it’ll shift to the right
47
Q

conditions of supply - price of other goods

A
  • joint supply is when the production of one good automatically causes the production of another good
  • e.g. production of beef automatically produces leather, so if the price of beef rises, farmers will slaughter their cows, and will get more leather, causing a shift to the right and an increase in supply
  • competitive supply is when the production of one good prevents the supply of another
  • e.g. if a farmer kills his cows, he can’t produce milk, so a rise in the price of beef may cause a decrease in supply of milk and a shift to the left
48
Q

conditions of supply - weather

A
  • supply may be dependent on weather, e.g. for agricultural goods
  • if weather is good, more wheat will be produced so the supply curve will shift to the right & vice versa
49
Q

conditions of supply - indirect taxes

A
  • if an indirect tax increases, costs of production for the firm increase, so the supply curve shifts to the left
  • if a tax decreases, costs of production decrease, and the supply curve shifts to the right
50
Q

conditions of supply - subsidies

A
  • if a subsidy increases, costs of production for the firm decrease, so the supply curve shifts to the right
  • if a subsidy decreases, costs of production increase and the supply curve shifts to the left
51
Q

conditions of supply - technology

A
  • new technology increases productivity and lowers costs of production, so firms can produce more goods for the same price, so the curve shifts to the right
  • ageing technology will have the opposite effect
52
Q

conditions of supply - change in the number of firms in the industry

A
  • if the no. of firms in an industry increase, the supply will increase so the curve will shift to the right
  • if no. of firms decrease, it’ll shift to the left
53
Q

conditions of supply - goals of the supplier

A
  • if the supplier is motivated by helping society and providing a service, they may increase supply even when it doesn’t provide extra profit
54
Q

conditions of supply - govt. regulation

A
  • high levels of regulation may increase costs for a firm, which can decrease supply so the curve will shift to the left
55
Q

conditions of supply - producer cartels

A
  • some firms / countries come together to decrease supply and increase the price of their good to increase profits
56
Q

price elasticity of supply (PES)

A
  • the responsiveness of supply to a change in price of the good
  • % change in quantity supplied / % change in price
  • % change = (new - old) / old x 100
57
Q

numerical values of PES

A
  • PES=0; perfectly inelastic; change in price has no effect on output (vertical line)
  • PES<1; inelastic; QS changes by a smaller percentage than the change in price (more steep)
  • PES=1; unitary elastic; QS changes by the exact same percentage as price
  • PES>1; elastic; QS changes by a larger percentage than the change in price (more sloping)
  • PES=infinity; perfectly elastic; change in price means QS falls to 0 (horizontal line)
58
Q

factors influencing PES

A
  • time; in the short-run, it will be harder for producers to respond to price increases as it takes time to produce the product, so supply is inelastic, but in the long-run they can change any of their FOP and supply will be more elastic
  • product stock; if a business has a stockpile of goods, when price rises, they can use up their stock so supply will be more elastic
  • spare capacity; if a business is working below full capacity, and there’s a price increase, they can easily respond by producing to their full capacity so the supply curve will be more elastic
  • availability of raw materials; if they’re scarce, PES will be low (inelastic) and if they’re abundant, it’ll be higher (elastic)
  • availability of factors of production; for example, labour may need specific skills / training so can’t be instantly increased, e.g. if doctors’ wages rose significantly, it’d take years before an increase in the no. of doctors, so it’s inelastic
  • ease of entry into the market; large costs of start-up equipment can make it harder to increase supply, which makes it inelastic, and trade unions can restrict entry
  • availability of substitutes; if a product has many substitutes within the firm, it’ll have high elasticity as producers can easily switch between them and alter supply patterns depending on if price rises or falls (e.g. different IPhone models)
59
Q

difference between short-run and long-run

A
  • short-run; any period of time in which at least one factor of production is fixed, and this is a limiting factor
  • long-run; any period of time in which all factors of production are variable, so producers are able to vary all of their resources to respond to changing market conditions
60
Q

price determination

A
  • in a free market economy, prices are determined by the interaction of supply and demand in a market
61
Q

equilibrium

A
  • where supply is equal to demand
  • aka market clearing price as there’s no surplus or shortage
  • any point above the equilibrium creates disequilibrium in the market - occurs when there’s excess demand or supply
62
Q

excess demand

A
  • diagram 7
  • when demand is greater than supply
  • occurs when prices are too low or when demand is so high that supply can’t keep up
63
Q

market response to excess demand

A
  • diagram 7
  • sellers are frustrated that products are selling too quickly at a price too low
  • some buyers are frustrated as they can’t purchase the product
  • sellers realise they can raise prices and generate more revenue and profits
  • this causes a contraction in QD (as some buyers no longer desire the product at a higher price) and an extension in QS (as sellers are more incentivised to supply when prices are higher)
  • in time, the market will have cleared the excess demand and arrive at a position of equilibrium
  • different markets take different lengths of time to resolve disequilibrium, e.g. retail clothing can do so in a few days whereas the housing market may take several months
64
Q

excess supply

A
  • diagram 8
  • when supply is greater than demand
  • occurs when prices are too high or when demand falls unexpectedly
  • e.g. during the later stages of the pandemic, the market for facemasks was in disequilibrium due to excess supply
65
Q

market response to excess supply

A
  • diagram 8
  • sellers are frustrated that the products aren’t selling and the price is too high
  • some buyers are frustrated as they want to purchase the product but aren’t willing to pay the high price
  • sellers will gradually lower prices to generate more revenue
  • this causes a contraction in QS (as some sellers no longer desire to supply the product) and an extension in QD (as buyers are more willing to purchase the product at lower prices)
  • in time, the market will have cleared the excess supply and arrive at a position of equilibrium
66
Q

shift in demand - real world example

A
  • diagram 9
  • due to the increased amount of people working from home during lockdowns in the Covid-19 pandemic, consumers experienced a temporary change in taste as they sought to set up home offices
  • furniture retailers experienced unexpectedly high demand for their products, e.g. desks
  • this led to an increase in demand and a right shift of the demand curve, increasing output
  • at the original price of p1, excess demand would’ve existed as demand would’ve been higher than supply
  • so in response, suppliers raise prices, leading to a new, higher market equilibrium and the excess demand has been cleared
67
Q

shift in supply - real world example

A
  • diagram 10
  • India imported much of its wheat from Ukraine (one of the largest producers of wheat) and during the Russian-Ukraine war, exports of wheat have been halted
  • due to the war, India is experiencing a supply-shock in its wheat market
  • this led to a decrease in supply and a left shift of the supply curve, decreasing output
  • at the original price of p1, excess demand exists as demand is greater than supply
  • so in response, sellers in India raise prices, leading to a contraction in demand and an extension in supply
  • this leads to a new, higher market equilibrium and the excess demand has been cleared
68
Q

the price mechanism

A
  • price is determined by the interactions of demand and supply (consumers and producers), which also determines the allocation of resources
  • e.g. price rises when demand is higher than supply, encouraging suppliers to sell more to make a higher profit
  • the price mechanism has 3 functions to allocate resources, which are built on self-interest;
  • rationing
  • signalling
  • incentive
  • adam smith referred to the functions of the price mechanism as the ‘mystery of the invisible hand’
69
Q

the price mechanism - rationing

A
  • prices allocate (ration) scarce resources
  • when prices are rising, fewer consumers are willing and able to demand at higher prices, so the limited resources are rationed and allocated to those who can afford them and those who value them most highly
70
Q

the price mechanism - signalling

A
  • it acts as a signal for where resources should be used
  • when prices rise, producers move resources into the manufacture of that product
  • when prices fall, resources are moved away from that product
  • the change in price indicates that the market conditions have changed, so consumers and producers adjust their consumption and production, so when price equilibrium moves, output equilibrium moves with it
71
Q

the price mechanism - incentive

A
  • rising prices incentivises producers to reallocate resources to production of that good so they can make more money, and it incentivises consumers to work hard, as the more money they earn, the more they can buy
  • falling prices acts as an incentive for reallocation of resources to new markets, but incentivises consumers to buy more of a good
72
Q

the price mechanism in the context of local markets

A
  • the Covid-19 pandemic disrupted supply chains as many countries blocked imports to prevent the spread of the virus, e.g. in Britain, less imports from other countries means fewer goods on supermarket shelves, so supply is low but demand is still high, so the price of food rises to ration off the excess demand, so that only the consumers who value food the most highly buy them (rationing function)
73
Q

the price mechanism in the context of national markets

A
  • the price of housing differs across the UK, from being high in the south and low in the north, perhaps because London (capital, financial centre, high tourism) has a high population relative to the rest of the UK, so house prices will rise to ration off excess demand and only provide houses to those who value them the most (rationing function)
  • high house prices in london also offers an incentive for firms to allocate resources to the production of more houses, as there’s profit to be made in this industry (incentive function)
74
Q

the price mechanism in the context of global markets

A
  • in 1973, the OPEC proclaimed an oil embargo (restriction) which led to oil prices soaring as oil was an invaluable resource to countries, so the high prices left the market open only to those consumers who valued oil highly (state of disequilibrium)
75
Q

consumer surplus

A
  • diagram 11
  • the difference between the price a consumer is willing to pay and the price they actually pay
  • the more inelastic the demand curve, the higher consumer surplus is likely to be
  • consumer surplus falls as price increases and rise as prices decrease
76
Q

producer surplus

A
  • diagram 11
  • the difference between the price a producer is willing to sell a product for and the price they actually do sell it for
  • the more inelastic the supply, the higher producer surplus is likely to be
  • producer surplus rises as price increases and falls as price decreases
77
Q

community / social surplus

A
  • diagram 11
  • consumer surplus + producer surplus
  • the point of allocative efficiency
  • it’s maximised at free market equilibrium price
  • any disequilibrium reduces community surplus
  • apart from a shift in supply / demand, no other price and output combination can increase community surplus
78
Q

how changes in supply / demand might affect consumer / producer surplus

A
  • diagram 12
  • a decrease in supply or demand leads to a fall in consumer and producer surplus
  • an increase in supply or demand leads to an rise in consumer and producer surplus
79
Q

indirect taxes

A
  • a tax on expenditure, levied by the govt. on producers, who pass the tax onto consumers
  • usually imposed on demerit goods to reduce consumption, thus production of the good, and to raise govt. revenue
  • 2 types of indirect tax;
  • specific tax; fixed tax per unit of output, e.g. excise duties on alcohol, tobacco, petrol, etc.
  • ad valorem tax; a percentage of the price of the good, so it increases in proportion to the value of the good, e.g. VAT
80
Q

impacts of an indirect tax

A
  • diagram 13
81
Q

incidence of indirect taxes

A
  • the more inelastic the demand curve (PED), the higher the incidence (share) of tax on the consumer - QD decreases by a much smaller proportion than the increase in price
  • the more elastic the demand curve, the lower the incidence of tax on the consumer - QD decreases by a larger proportion than the increase in price
82
Q

subsidies

A
  • a grant given by the govt. to firms
  • aims to encourage production, thus consumption of a merit good
83
Q

impacts of subsidies

A
  • diagram 14
84
Q

incidence of subsidies

A
  • the more inelastic the demand curve (PED), the higher the consumer gain as the decrease in price will be more than proportional to the increase in QD
  • the more elastic the demand curve, the higher the producer gain as the increase in QD will be more than proportional to the decrease in price
85
Q

alternative views of consumer behaviour

A
  • free markets are built on the assumptions of rational decision making; consumers aim to maximise utility, firms aim to maximise profits, and govts. aim to maximise welfare of citizens
  • however, people don’t always behave rationally, due to;
  • the influence of other people’s behaviour
  • the importance of habitual behaviour
  • consumer weakness at computation
86
Q

the influence of other people’s behaviour

A
  • individuals often make choices influenced by social norms, e.g. buying something to ‘fit in’
  • consumers become unwilling to change this bias, even if doing so will benefit them, just so they don’t go against the social norms
  • e.g. they could buy a cheaper alternative of a product but will choose to buy the more expensive one if everyone else has it
87
Q

the importance of habitual behaviour

A
  • consumers make so many purchasing decisions that they often rely on habits to speed up the process
  • however, these habits prevent consumers from considering alternatives, so consumer inertia often develops as convenience is prioritised
  • firms exploit habitual patterns, i.e. by placing products at checkouts to benefit from impulse purchasing, e.g. of chewing gum
  • habits involve addictions, e.g. alcohol, tobacco, food, etc. and people lack self-control to give this up, which leads to them making decisions that won’t maximise benefit
88
Q

consumer weakness at computation

A
  • the wider the range of choice, the harder it is for consumers to gather info and compute which one offers the highest net benefits
  • consumers often lack the time or ability to compare prices, so they’ll buy more expensive goods than needed
  • some sellers exploit this weakness, e.g. by selling multipacks as consumers will assume they’re cheaper, when in reality, the individual products work out cheaper

economics - theme 1 (4 decks)

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