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Economics Theme 1 - Micro > 1.2 How Markets Work > Flashcards

1.2 How Markets Work Flashcards

1
Q

Underlying assumptions of rational economic decision making

A
  • consumers aim to maximise utility (satisfaction or benefit derived from consuming a good)
  • firms aim to maximise profits (efficient production & matching consumers demands)
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2
Q

Two approaches of decision making (school of economics & economists linked)

A

Deduction (start with hypothesis)

  • classical school (Adam Smith)
  • neoclassical school (Alfred Marshall)

Induction (collect evidence)

  • behavioural school (Richard Thaler)
  • Keynesian school (Joan Robinson)
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3
Q

What does classical and neoclassical economics think about decision making

A

Decision makers (economic agents) are assumed to be rational (maximise utility/profit)

They require:

  • time
  • information
  • ability to process information
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4
Q

What does behavioural economics believe about decision making

A

Assume decision makers (economic agents) have bounded rationality = 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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5
Q

Reasons why consumers may not behave rationally

A
  • influence of other peoples behaviour (individuals influenced by social norms / friends)
    Eg. stock markets, cigarettes
  • habitual behaviour / consumer inertia (habits, satisfied, prevent consumers considering an alternative, addictions)
    Eg. cigarettes, alcohol, drugs
  • consumer weakness at computation (aren’t willing or able to make comparisons, no self-control, don’t look at long term effects)
    Eg. saving up for pension/house
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6
Q

Demand (definition)

A

= the quantity of a good or service consumers are willing and able to buy at a given price over a given time period

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7
Q

Distinction between movements along the demand curve and shifts of a demand curve

A

Movements along demand curve caused by change in price

  • Decrease in price = extension/expansion in demand
  • Increase in price = contraction in demand

Shifts of demand curve caused by non-price factors affecting demand

  • right shift = increase in demand
  • left shift = decrease in demand
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8
Q

The conditions of demand (factors that cause shift in demand curve)

A
  • changes in age and size distribution of population
  • changes in real incomes
  • advertising
  • changes in taste & fashions
  • changes in price of substitutes & complementary goods
  • weather
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9
Q

Concept of diminishing marginal utility, how does this influence the shape of the demand curve

A

Marginal utility = additional utility (benefit) gained from the consumption of each additional unit

the marginal utility from each additional unit declines as consumption increases

As quantity of good/service consumed increases = marginal utility gained will decrease = price consumers willing to pay decreases = demand decreases (rational consumer will maximise utility & consume up to the point where the marginal cost/price of the product is equal to the marginal utility)

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10
Q

Substitute vs complement goods

A

Substitute goods = two alternative products that can be used for the same purpose

Complement goods = products that are used together

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11
Q

Price elasticity of demand (PED)

Definition & formula

A

= measures the responsiveness of quantity demanded given a change in price

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12
Q

Types of PED and their numerical values

A

Perfectly inelastic PED = change in price causes no change in demand, demand is unresponsive to price (PED=0, vertical curve)

Relatively inelastic PED = change in price causes a proportionately smaller change in demand (PED<1, steep curve)

Unitary elastic PED = change in price causes a proportionately equal change in demand (PED=1, straight proportionate curve)

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)

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13
Q

Factors influencing PED (determinants)

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)

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14
Q

Significance of PED to firms & governments (indirect taxes, & graph)

A

Determines effects of imposition of indirect taxes & subsidies

  • more inelastic PED = higher incidence of tax on consumer (tax ineffective at reducing output), but consumer demand less responsive (higher tax revenue for gov) = larger consumer burden (G1)
  • more elastic PED = lower incidence of tax on consumer (small increase in price) = firms/producers cover most of tax = larger producer burden (G2)
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15
Q

Significance of PED to firms & governments (indirect subsidies, & graph)

A
  • more inelastic PED = higher fall in price for consumer, less extra revenue for firms/producer (ineffective at increasing output as only small increase in output but cheaper for gov as have to pay on less goods) = larger consumer gain (G1)
  • more elastic PED = smaller fall in price for consumer, more extra revenue for firms/producer (effective as large increase in output) = larger producer gain (G2)
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16
Q

Income elasticity of demand (YED) Definition & formula

A

= measures responsiveness of quantity demanded given a change in income

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17
Q

Types of YED and their numerical values

A

Inferior good = as income rises, demand falls (YED < 0) Normal good = as income rises, demand rises (YED > 0) - Elastic YED = Luxury good (normal good when YED > 1) - Inelastic YED = Necessity (normal good when YED 0-1)

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18
Q

Significance of YED to firms & governments

A
  • firms selling luxury goods have elastic YED so increase in real income has big increase on demand - firms selling inferior goods have inelastic YED so increase in real income causes fall in demand Firms do well in different periods of economy (recession, boom), important to understand their YED to predict & plan
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19
Q

Cross price elasticity of demand (XED) Definition & formula

A

= measures responsiveness of quantity demanded for good X given change in price of good Y

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20
Q

Types of XED and their numerical values

A
  • substitute goods = increase in price of good Y causes increase in demand of good X (XED > 0) - complement goods = increase in price of good Y causes decrease in demand of good X (XED < 0) - unrelated goods = change in price of good Y has no impact on demand of good X (XED = 0)
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21
Q

Significance of XED to firms & governments

A
  • if elastic XED, change in price of substitute & complement goods have big effect on demand of their goods - important if firms have many substitute / complement goods to plan, adjust, prepare - aware of competition or firms producing complement goods to predict how price changes will impact their revenue
22
Q

Relationship between PED and total revenue (revenue formula)

A

Revenue = Price x Quantity

23
Q

Supply

A

= the quantity of a good or service firms are willing to sell at a given price over a given time period

24
Q

Movements along supply curve vs shift of supply curve

A

Increase in price = extension in supply
Decrease in price = contraction in supply
Changes in cost of production for firms = shift in supply

25
Q

Conditions of supply (factors that cause shift in supply curve

A
  • changes in production costs (subsidies / indirect taxes)
  • 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)
  • exchange rates (increase in value of currency = reduction in price of imports = increase in supply)
26
Q

Explain the shape of the supply curve

A

price increases = quantity of goods / services firms willing to supply increases (positive relationship)
Profit motive: as price increases the profit gained by firms will increase = rational profit maximising firms supply more
As firms increase output they need to charge a higher price to cover increased costs involved with higher output
Decrease in the price of goods / services = decrease in good/services supplied (less incentive for firms to provide same quantity of the good/services)

27
Q

Price elasticity of supply (PES) Definition & formula

A

= measures responsiveness of quantity supplied given a change in price

28
Q

Types of PES and their numerical values

A

Perfectly inelastic PES = change in price causes no change in supply, supply is unresponsive to price (PES=0, vertical curve)
Relatively inelastic PES = change in price causes a proportionately smaller change in supply (PES<1, steep curve, start on quantity axis)
Unitary elastic PES = change in price causes a proportionately equal change in supply (PES=1, straight proportionate curve)
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)

29
Q

Factors influencing PES (determinants)

A

Time required to produce the product (production lag) — 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)
Short run vs long — short run = PES more inelastic (at least 1 factor of production fixed = hard to increase supply)

30
Q

Distinction between short run & long run, significance for PES

A

Short run = inelastic PES (difficult to adjust supply production, at least one factor of production fixed eg. labour)
Long run = elastic PES (all factors of production variable, firms can increase supply more easily)

31
Q

Equilibrium price (definition & graph)

A

Determined by forces of supply & demand
Equilibrium price = where supply is equal to demand (demand & supply curve cross)
Also called market clearing price (all products supplied to market are bought & cleared)

32
Q

Excess supply (definition, diagram, operation of market forces to eliminate it)

A

= price of good above equilibrium price

(firms have unsold goods = have to lower prices = contraction in supply, demand increases as more affordable = extension in demand = back to equilibrium)

33
Q

Excess demand

A

= price of good below equilibrium price

(shortage in market, firms can increase prices = extension in supply & contraction in demand bringing it back to equilibrium)

34
Q

How shift in demand curve causes equilibrium price & quantity to change in real world situations

A

decrease in demand = decrease in quantity (Q to Q1) & reduction in price (P to P1). If firm keeps same price = excess supply. Therefore by reducing the price it encourages firms to produce less quantity = market reaches equilibrium
increase in demand = increase in price (P to P2) & increase in quantity (Q to Q2). if price stayed the same = excess demand. Therefore by increasing the price it helps to ration demand & incentivises suppliers to increase quantity

35
Q

How shift in supply curve causes equilibrium price & quantity to change in real world situation

A

decrease in supply = increase in price & decrease in quantity, If price stays same = excess demand But price increase = rations excess demand = encourages suppliers to increase quantity = market reaches equilibrium
increase in supply = decrease in price (P to P1) & increase in quantity supplied (Q to Q1). If price stays same = excess supply from Q to Q1. Therefore by reducing the price it encourages firms to produce less & incentivising consumers to increase quantity

36
Q

Functions of the price mechanism (the invisible hand) to allocate resources

A

Rationing = changes in price rations goods (when price increases, some people cant afford good, removes excess demand, limited resources can be rationed & allocated to those whose can afford higher prices)

Signalling = signals where resources should be used (rise in price = producers use more resources for that product, indicates it consumers/producers to change quantity sold/bought as market conditions have changed)

Incentives = incentive for people to work hard (consumers realise more money = more goods they can buy, producers realise more production of goods = make more profit, low prices incentivises consumers to buy more & high prices incentivises producers to sell more)

37
Q

The price mechanism in the context of different types of markets (local, national, global)

A

Local: coronavirus disrupted supply chains & reduced imports = British supermarkets rise price of food to ration of excess demand (rationing function)
National: price of housing differs across UK, as population in London is high relative, house prices rise through rationing function to reduce excess demand & firms allocate more resources to house production in London as higher house prices (incentive function)
Global: restricted supply of oil globally (geopolitical factor with USA & Middle East, trade wars, non-renewable resource) = very high oil prices everywhere (over reliance so very high demand) deterred consumers who value oil less and it returns to price equilibrium (rationing function)

38
Q

In what markets might the price mechanism not work as well?

A

Bigger market = harder for market to work at equilibrium
Government intervention in the market can sometimes distort price signals & prevent price mechanism from working

39
Q

Consumer surplus

A

= Difference between what consumers are willing & able to pay for a good / service and what they actually pay for the good / service (set by the price mechanism)

40
Q

Producer surplus

A

= difference between what producers are willing & able to sell a good / service for and what they actually sell the good / service for (set by the price mechanism)

41
Q

How consumer & producer surplus is illustrated on a supply & demand diagram

A

Consumer surplus = top triangle above equilibrium
(as price increases, consumer surplus area gets narrower as fewer consumers willing to pay higher price)
Producer surplus = bottom triangle below equilibrium
(as price decreases, producer surplus area gets narrower as fewer producers willing to supply at the lower price, only most efficient will still supply at a profit)

42
Q

How changes in supply affect consumer & producer surplus (with graph)

A

Decrease in supply (S1 to S2) = fall in consumer surplus & producer surplus
Increase in supply (S2 to S1) = increase in consumer surplus & producer surplus

43
Q

How changes in demand affect consumer & producer surplus (with graph)

A

Decrease in demand (D1 to D2) = fall in consumer surplus & producer surplus
Increase in demand (D2 to D1) = increase in consumer surplus & producer surplus

44
Q

Indirect taxes (vs direct tax)

A

Indirect tax = tax levied on the consumption of goods & services (paid by consumers indirectly)
Direct tax = tax levied on an individual (income tax/corporation tax - increased from 19% to 25% in April 2023)

45
Q

Types of indirect tax

A

Ad valorem tax = tax increases in proportion to value of good
Eg. VAT (non-parallel shift in supply curve)
Specific tax = set amount of tax on unit of good
Eg. Alcohol tax, fuel duty, sugar tax, carbon tax, cigarette duty (parallel shift in supply curve)

46
Q

Impact of indirect tax (specific tax) on consumers, producers, government

A
  • Increased production costs for firms = supply decreases (left shift from S1 to S2)
    = rise in price (P1 to P2) and fall in output (Q1 to Q2)
  • higher consumer prices, consumer tax burden above equilibrium
  • higher producer costs & fall in output, producer tax burden below equilibrium
  • gov gains tax revenue (consumer burden + producer burden) = AB x Q2, tax per unit = AB
47
Q

Impact of indirect tax (how does ad valorem tax differ) on consumers, producers, government

A
  • rise in costs of production = non-parallel left shift of supply curve (decrease in supply)
  • tax amount (tax per unit) grows as price of good increases
  • size of government revenue increases more if price is increased more
48
Q

Incidence (tax burden on taxpayers) of indirect taxes on consumers & producers

A
  • if PED perfectly elastic / PES perfectly inelastic, producer pays all tax
  • if PED perfectly inelastic / PES perfectly elastic, consumers pays all tax
    More elastic PED / inelastic PES = lower incidence of tax on consumers, higher incidence of tax on producers
    More inelastic PED / elastic PES = higher incidence of tax on consumers, lower incidence of tax on producers
    More inelastic PED = higher government revenue (smaller fall in demand due to tax)
49
Q

Subsidy definition (+ UK examples)

A

= money given by the government to encourage production and consumption of a good or service by reducing prices

Eg. Solar panels, electric cars (but reduced recently), R&D, public transport in UK
Eg. Fuel/gas/rice in India to improve affordability for poorer citizens
Eg. Vaccinations in Hong Kong to increase consumptions

50
Q

Impact of subsidies on consumer, producers, government

A
  • fall in production costs = increase in supply (right shift from S1 to S2)
    = fall in price (P1 to P2) and rise in output (Q1 to Q2)
  • consumer gain/subsidy below equilibrium
  • producer gain/subsidy above equilibrium
  • government spending = (producer gain + consumer gain) = AB x Q2, subsidy per unit = AB

Economics Theme 1 - Micro (4 decks)

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