1.2 How Markets Work

Question 1

What is meant by rational decision making ?

Answer 1

when making economic decisions it is assumed that:

• consumers aim to maximise utility (satisfaction/benefit) using a limited budget
• firms aim to maximise profits

Question 2

What is demand ?

Answer 2

• the quantity of a good/service that consumers are willing and able to buy at a given price in a given time period

Question 3

What are the three different types of demand ?

Answer 3

• Effective demand: when a desire for a product is backed up by willingness and ability to buy
• Latent demand: (potential demand) where there is a desire to buy a product but consumers lack purchasing power ➡️ highly affective by advertising
• Derived demand: demand for product X is linked to demand for product Y eg. the demand for steel is strongly linked to the demand for new vehicles

Question 4

What causes a movement on the demand curve ?

Answer 4

• price
• refers to a change along the curve, the movement denotes a change in demand and price (as price decreases demand increases)

Question 5

What causes shifts of the demand curve ?

Answer 5

🔔 non-price factors

• real incomes (the more £ the more we buy)
• changes in price of substitutes (competitive demand) or complements (joint demand)
• inflation reate
• employment rate
• trends (products become more/less desirable)
• advertisement (influences people to buy)
• changes in interest rates (increased charge = decrease demand)
• seasonal factors
• changes in population (increase population = increase demand)

Question 6

What are laws of demand ?

Answer 6

1. as prices fall, demand increases
2. as prices rise, demand decrease

Question 7

What is the concept of diminishing marginal utility ?

Answer 7

• can help to explain the inverse relationship between price and quantity demanded
• as more of a good is consumed, the additional utility (satisfaction) from each extra unit will fall ➡️ because consumers are assumed to be rational, they will not pay more for a good than the additional utility unit provides therefore price and qnty demanded are inversely related

Question 8

What are substitute goods ?

Answer 8

• substitute goods are two goods that could be used for the same purpose ➡️ if the price of one good increases, then demand for the substitute is likely to rise

Question 9

What are complementary goods ?

Answer 9

• complementary goods are good which are bought + used together ➡️ if demand for one rises then demand for the other will rise to eg.tennis balls and tennis rackets

Question 10

What is supply ?

Answer 10

• the quantity of a good/service that firms are willing and able to produce at a given price in a given time period

Question 11

What are the laws of supply ?

Answer 11

1. as price rises, quantity supplied rises
2. as price falls, quantity supplied falls

🔔 assumptions: firms are motivated by profits (increased price= increased profits) + cost of producing a unit increases as output increases (marginal costs)

Question 12

What causes a movement along the supply curve ?

Answer 12

• price
• as price increases quantity supplied increases (vice versa)

Question 13

What causes shifts of the supply curve ?

Answer 13

• cost of production: decreased costs = increase in supply ➡️ can produce more at the same price eg. price of raw materials, exchange rates, wages
• new technologies: can decrease cost of production ➡️ more efficient + lower prices for consumers
• price of other goods: if other goods are cheaper to make then may make them instead
• govt: laws/taxes/subsidies/regulations ➡️ making it easier/harder/cheaper to make
• the climate: favourable weather = increase in supply
• no. of producers in the market: more producers = greater supply

Question 14

What is meant by market equilibrium ?

Answer 14

• a state of equality/balance between market demand and supply ➡️ there is no excess supply/demand
• know as ‘fair market price’ OR ‘market clearing price’

Question 15

Why is equilibrium constantly changing ?

Answer 15

• equilibrium never stays the same as demand and supply are constantly changing therefore moving equilibrium upwards/downwards

Question 16

What is excess supply (disequilibrium) ?

Answer 16

• when supply is greater than demand and there are unsold goods in the market (waste)
• the surplus puts a downward pressure on the market price ➡️ producers are forced to lower their price bcs of waste, until it reaches equilibrium

Question 17

What is excess demand (disequilibrium) ?

Answer 17

• when quantity demand exceeds supply ➡️ happens when the current market price is set below equilibrium, results in an upward pressure on price until it reaches equilibrium
• higher prices (in theory) stimulates an expansion in supply as producers respond to higher prices

Question 18

What is the price mechanism ?

Answer 18

• describes how decisions taken by consumers and businesses interact to determine the allocation of scarce resources between competing uses
• invisible hand operates through self-interest and allocates resources in society’s best interest

Question 19

What are the three functions of price mechanism to allocate resources ?

Answer 19

• rationing: resources are scarce, thus will runout if everyone could have them (stops people from having everything)
• incentive to firms: higher prices encourages and allows firms to produce more (greater output = increased profits)
• signalling: changes in price shows changes in s&d which acts as a signal to producers and consumers of surpluses and scarcities of resources ➡️ prices adjust to show where resources are required eg. excess supply: the price mechanism will help to eliminate a surplus of goods by allowing the market price to fall

Question 20

What is consumer surplus ?

Answer 20

• the difference between what a consumer would pay for a product and what they actually pay (rises and falls as market price for a good/service changes)
• a measure of the welfare people gain from consuming goods/services ➡️ on a S&D diagram area under demand curve and above the market price

Question 21

What is producer surplus ?

Answer 21

• the difference between what producers are willing and able to supply for and the price they actually receive
• shown by area above supply curve and below the price

Question 22

Why may individuals not act in a rational way ?

Answer 22

• limited ability to calculate
• importance of social networks
• emotions overtakes logic
• altruism vs pure self interest
• desire for instant rewards/satisfaction + lack of self control
• habits/default choices

Question 23

Examples of social norms/customs that influence our behaviour ?

Answer 23

• seat belt laws
• queuing behaviour in shops
• smoking bans in public places
• buying a round of drinks at the pub

Question 24

What is habitual behaviour ?

Answer 24

• people carry on behaving as they have always done
• repeat choices/purchases become automatic as they don’t require effort
• to CHANGE behaviour requires compelling incentives

eg. broadband/energy provider, breakfast cereal

Question 25

What is herd behaviour ?

Answer 25

• we often make decisions based on who is around us and the choices they make eg. choosing food at a restaurant

Question 26

What are indirect taxes and how does PED effect this ?

Answer 26

• tax imposed by govt that increases the supply costs for producers reducing the quantity demanded (movement on the demand curve)
• elastic PED: most of tax will be absorbed by supplier
• inelastic PED: most of tax can be passed on the consumer

Question 27

What are subsidies and how can it be seen on a supply diagram ?

Answer 27

• any form of govt support (eg. financial) offered to producers and occasionally consumers ➡️ causes outward shift of supply leading to lower equilibrium price and increase in quantity (LOWERS PRODUCTION COSTS)
• total shaded area = total govt spending on sub
• consumer on bottom and producer on top