1.2 How markets work Flashcards
Neoclassical assumptions
-Consumers act rationally by aiming to maximise utility/economic welfare
-firms act rationally by aiming to maximise profits -governments act rationally by aims to maximise social welfare
Utility
Refers to the level of satisfaction of consumer issues from the consumption of a product/service
Demand
The quantity of goods or services that will be bought at any given price over a period of time.
Changes in price/quantity causes…
Contractions and extensions
Demand curve slopes downwards because…
-substitution effect - price increase incomes stays the same = quantity decreases or buys lower price good.
-Income effect- rise in price = purchasing power/disposable income decreases
Graph: extension
Always moves right
Graph: contraction
Always moves left
Factors causing shifts in demand curve
PIRATES L
P
Polpulation
I
Income
R
Relates/substitutes
A
Advertisement
T
Tastes and trends
E
Expectation
S
Seasons
L
legislation
Total Utility
-represents the total satisfaction gained from the total amount of a product consumed
Marginal Utility
-represents the change in utility from consuming an additional unit of the product
The law of diminishing marginal utility
-as consumption of a product is increased the consumers utility increases but as a either decreasing or diminishing rate
e.g if money assign to marginal utility then a rational consumer would pay less for each additional unit = quantity demanded increases as prices falls
PED (Price elasticities of demand)
-is a measure of the responsiveness of quantity demanded of a product to change in its prices.
PED equation
% change in QD/ % change in P
about PED
-PED always have a negative value (downward sloping)
0
Perfectly inelastic
0 to 1
Relatively inelastic
1
Unitary elastic
1 to Infinity
Relatively elastic
Infinity
Perfectly elastic
Factors influencing PED
-Availability of substitutes
-proportion of income spent on a product
-nature of the product
-durability of the product
-length of time under consideration (demand more price elastic in long-run than short)
Total revenue
The value of goods sold by firm and is calculated by multiplying price by quantity sold
when demand is inelastic, as price increases, TR …
increases
when demand is elastic, as price increases, TR …
decreases
when demand is unit elastic, as price changes, TR …
Remains unchanged
Significance of PED for firms
-if PED inelastic they can increase TR by increasing price
-if PED elastic they can increase TR by reducing price
Significance of PED for consumers
-If PED is Inelastic firms may raise prices reducing PP of consumers
Significance of PED for government
-if government wants to maximise tax revenue it will place indirect taxes on products which PED is inelastic
-the government may tax products which demand is price elastic so producers bear a higher proportion of tax burden E.G to reduce negative externalities
XED (Cross elasticities of demand)
Is the responsiveness of demand for one product to change in the price of another product
XED Equation
% change in QD of Y/ %change in price of X
XED positive sign means
Products or substitutes- they are competitive in demand E.G price increase for one product might lead to rise in demand for another product
XED negative sign means
Products are complements- demand increase for one product increases demand for another product
Significance of XED for firms
-Knowledge of XED is useful for setting prices as firms which product is a substitute can decrease its price to increase TR firms
- complimentary goods can command high prices and offer product bundles to increase TR
(YED) Income elasticities of demand
-Measure of the responsiveness of the quantity demanded of a product to change in real income
YED equation
% change in quantity demanded/ % change in real income
YED positive sign means
Product is a normal good: rise in real income= increase in demand
YED negative sign means
Product is an inferior good: rise in real income = fall in demand
Relationships between income and demand
-Normal good = positive relationship
-inferior goods = negative relationship
Significations of YED for firms
-If firms no demand is income elastic then demand and see our will increase during economic growth but fall during recessions
-important for firms when making investment decisions
Significance of YED for government
-if government wants to maximise tax revenue during boom it will place indirect taxes on products which demand is income elastic
-knowledge of YED helps call estimating tax revenues
Supply
The quantity of a good or service that firms are willing to sell at a given price over a given period of time.
Supply is upward sloping because
More will be supplied as price increases
- firms motivated by profit to maximise TR
-firms reduce output/exit market when fall in price
Movements along supply curve..
by Q and P
Factors that cause shift in the supply curve
-Costs of production
-productivity of workforce
-indirect taxes
-subsidies
-technology
- discoveries of raw materials
CPISTD
PES (price elasticities of supply)
Responsiveness of quantity supplied for a product to change in its price
PES equation
% change in QS/ % change in P
PES always has a positive value because
Supply curve upward sloping
Factors influencing PES
PSSSTB
PES - P
Production lag - supply more inelastic if takes time to produce
PES - S
Stocks - if there is a large stocks supply is elastic as able to respond quickly to price changes
PES - S (2)
Spare capacity - if under utilised machinery/workers it’s possible to increase this and supply is more elastic
PES - S (3)
Substitutability- if resources of FOP easy to reallocate it’s more elastic
PES - T
Time- dependent on short or long run if short run supply more inelastic however in the long run may be more elastic
PES - B
Barriers - high barriers such as tax = more inelastic
Short run
Period of time in which at least one factor of production is fixed
Long run
Period of time in which all factors of production is variable
Equilibrium - when QD=QS
-Is determined by the interaction of the supply and demand curve
- equilibrium price and quantity would not change unless there is a change in conditions of demand/supply
Excess supply occurs when
-If the price is above the equilibrium price then QD> QS therefore surplus.
-market forces will cause price to fall to the equilibrium leading to extension of demand/contraction of supply eliminating surplus.
Excess demand occurs when
-Price is below the equilibrium price then QD>QS thefore excess Demand
-market forces will cause price to rise to equilibrium leading to an extension of supply/contraction of demand eliminating excess demand
Price mechanism
The use of market forces to allocate resources in order to solve the economic problem of what, how, and for whom to produce.
The interaction of demand and supply to determine the market clearing price.
Factors causing change the equilibrium price
Change in conditions of demand (shift) change in conditions of supply (shift)
Functions of the price mechanism in a free market economy
RISC
Price mechanism - R
Rationing device - market forces ensure QD=QS
Price Mechanism - I
Incentive -profit acts as incentive for firms produce G/S
Price Mechanism- S
Signalling device - signals producers to increase/decrease QS
-encourages firms to enter markets when price increased to increase competition and decreases price
Price mechanism- C
Changes in wants - change in demand reflected by changing price
The invisible hand in price mechanism
-Theory that coveys in free/competitive market without any intervention if all individuals in the economy act in the best self interest this automatically is in the best interest of the economy
-Adam Smith
- self interest of individuals operate through system of mutual independence
-independence incentivises producers to make what is socially necessary
Market
Refers to all those buyers and sellers of a product/service involved in making exchanges with each other and who helped to determine its price
different type of markets
-local/national/global/internet
consumer surplus
Measures the difference between how much consumers are willing to pay and what they actually pay for a product (graphically it is the area under the demand curve but above the price)
-therefore receiving some benefit/surplus
Producer surplus
-measures the difference between the price the producers receive and the cost of supply in other words represents profit (graphically is the area between the supply curve and the market price)
-therefore receiving some benefit /surplus
SAD-U
Supply Above Demand Under
-Producers surplus relates to suppliers and so area above supply curve/below equilibrium price =. producer
-don’t assume fall in price will increase consumer surplus dependent on reason
factors affecting consumer surplus
-gradient of demand curve
-changes in the conditions of demand
factors affecting producer surplus
-gradient of supply curve
-changes in condition of supply
Indirect taxes
-Taxes on expenditure and include taxes such as VAT.
-cause an increase in cost of supply so supply curve shift lefts
Ad valorem
-tax that is imposed as a percentage of the price of the product or service
-supply curve shift lefts & becomes steeper
-e.g VAT levied 20% in Uk
Specific tax
-set amount of tax on each unit of the product
-supply curve shifts left parallel to og supply curve
Incidence of tax
How the burden of tax is distributed between different groups E.G producers and consumers
-demand is INELASTIC CONSUMERS bears a much larger proportion of the tax burden
-demand is ELASTIC PRODUCERS bears a much larger proportion on the tax burden
total tax revenue =
producer tax burden + consumer tax burden
Subsidy
Is a grant from the government has effect of reducing costs of production
-shift supply curve right
advantages of subsidies
-increase output and lower prices for consumers
-helps firms to be more competitive/regulates market
-can improve employment rate - more skilled workers via apprenticeships
-help boost demand during recessions control inflation
disadvantages of subsidies
-gov revenue could be better spent elsewhere
-excess demand and supply
-environmental risks
-economic scarcity
rational economics
-consumers act rationally in aims to maximise utility/economic welfare
-firms act rationally in aims to maximise profits
-governments act rationally in aims to maximise social welfare
reasons why consumers may not behave rationally
-herding
-habitual behaviour/inertia
-consumer weakness at computation
herding
-influence on others of how to behave
-subconsciously learns from the behaviours of others
-e.g social norms/trends
-habitual behaviour/inertia
-routine of behaviours/short-cut decisions
-past affects current which can be difficult to change
-not maximising economic welfare as routine behaviour rather than analysing cost
-Inertia - people are loss adverse - more effort into preventing a loss than winning a gain
consumer weakness at computation
-consumers not always willing/able to seek out extra information and therefore not maximising utility/welfare
-consumers find it difficult in calculating probability
-influence of how choice is presented e.g firms make it difficult so consumers choose more expensive option
