1.2 How Markets Work Flashcards
What does the word rational mean?
Economic agents are able to consider the outcome of their choices and recognise the net benefits (pros and cons)
How do consumers, producers, workers and the government act rationally?
Maximising their utility
Maximise profits
Balancing welfare consideration of both pay and benefits
Placing the interests of the people they serve first in order to maximise their welfare
How is rational decision making flawed?
Consumers are often more influenced by emotional purchasing decisions than rational of net benefits
What is demand?
The amount of a good or service that a consumer is willing and able to purchase at a give price at a given time period.
What causes a movement on the demand curve?
Change in price
What is the law of demand?
There is an inverse relationship between price and QD
What causes a shift in the demand curve?
Conditions of demand
- change in real income
- changes in taste or fashion
- advertising or branding
- changes in the prices of substitutes
- changes in the prices of complementary good
- changes in population size/distribution
What is marginal utility?
The additional utility (satisfaction) gained from the consumption of an additional product
How do u calculate total utility?
The marginal utility of each unit consumed is added together
What is the law of diminishing marginal utility?
The additional products consumed, the utility gained from the next unit is lower than the utility from the previous unit
How does the law of diminishing marginal utility help explain the reason why the demand curve is downward sloping?
First unit purchased the utility is high and consumers are willing to pay high price
The more they purchase there is less utility and willingness to pay the initial price
Lowering the price makes it more attractive so consumers keep consuming
What is the price elasticity of demand?
How responsive the change in quantity demanded is to a change in price
How do you calculate PED?
% change in QD
————————-
% change in price
How do you calculate % change?
New - old
—————- *100
Old
“How do we know how elastic a good is?
If PED = 0 it is perfectly inelastic
If PED is between 0-1 it is relatively inelastic
If PED = 1 it is unitary elasticity
If PED > 1 it is relatively elastic
If PED is infinite it is perfectly elastic
What factors influence/ determinants of PED?
Elastic:
- availability of substitutes
- time period
- proportion of income
- nature of product (addictive)
What is income elasticity of demand?
How responsive the change in quantity demanded is to a change in income
How to calculate YED?
% change in QD
————————
% change in income
What does negative and positive YED mean?
Negative YED: a rise in income will lead to a fall in quantity sold
Positive YED: a rise in income will lead to an increase in the quantity sold
YED 0<1 what is the type of good
YED >1 what is the type of good
YED <0 what is the type of good
Necessity
Luxury
Inferior
What are the factors that influence YED?
. During a recession wages usually fall and demand for inferior rises and luxury goods fall
. During economic growth, wages increase, demand for inferior goods fall and luxury rise
.Influences on income: minimum wage, taxation
What is cross price elasticity of demand (XED)?
Changes in the prices of complementary goods and substitutes affect the demand
how responsive the change in quantity demanded for good A is to a change in price of good B
How to work out XED?
% change in QD of good A
————————————
% change in P of good B
XED<0 What is the good?
XED>0 What is the good?
XED=0 What is the good?
Complementary goods
Substitutes
Unrelated goods
Why is PED significant to firms?
. Important to firms seeking to maximise their revenue
- product inelastic=raise prices
-elastic = lower prices
Why is PED significant to governments?
. Important to governments with regard to taxation and subsidies
- taxing inelastic = raise tan revenue without harming firms
- consumers are less responsive so tax with be passed to consumers
-
. If they subsidies price elastic there can be a greater than proportional increase
Why is XED significant to firms?
. Important to firms as they seek to maximise their revenue
- help them adjust pricing strategies for substitutes and complementary
. Helps understand the likely impact of competitors price strategies
What is supply?
The amount of a good/service that a producer is willing and able to supply at a given price in a given time period
Why is supply upward sloping?
Positive relationship between price and quantity supplied
What are the factors effecting supply?
. Cost of production
. Indirect taxes
. Subsidies
. New technology
. Change in the number of firms in the industry
Explain how the factors of supply effects the supply curve.
COP increases, less revenue/profit, less investment, less supply, supply curve shits left
Indirect taxes increase, supply curve shifts left
Subsidies increases, supply curve shifts right
New technology increases, shifts right
Increase number of firms, shifts right
What is price elasticity of supply?
How responsive the change in quantity supplied is to a change in price
How to calculate PES?
%changeinQS
PES = ———————-
%changeinprice
What are determinants of PES?
- availability of raw materials
- ability to store goods
- spare capacity
- time period
What is short run?
Any period of time which at least 1 factor of production is fixed
What is long run?
Period of time which all the factors do production are variable
What is a market?
Any place that brings buyers and sellers together
When does equilibrium occur in a market?
Demand = supply
When does disequilibrium occur?
excess demand (when demand is greater than supply) - can occur when prices are too low or when demand it so high
Excess supply (when supply is greater)- can occur when prices are two high or when demand falls unexpectedly
What is price mechanism?
The interaction of demand and supply in a free market
What are the three price mechanisms?
Rationing, signalling, incentive
What is price mechanism rationing?
Prices allocate scarce resources
Prices rise when resource becomes more scarce
What is price mechanism signalling?
Prices provide information to producers and consumers where resources are required
What is price mechanism incentive?
When prices rise it incentivises producers to reallocate resources from a less profitable market to this market in order to maximise their profits
What is consumer surplus?
The difference between the amount the consumer is willing to pay for a product and the price they have actually paid
What is producer surplus?
The difference between the amount that the producer is willing to sell a product for and the price they actually do
What area is consumer surplus on the supply and demand diagram?
Area between the equilibrium price and demand - underneath the demand curve
What are the underlying assumptions of rational economic decision-making for consumers and firms?
Consumers aim to maximise utility: Consumers allocate their resources to maximise their satisfaction or happiness from the consumption of goods and services.
Firms aim to maximise profits: Firms aim to produce and sell goods/services to achieve the highest possible difference between revenue and costs.
What is the difference between movements along a demand curve and shifts of the demand curve?
Movement along the demand curve occurs when the price of the good itself changes, leading to a change in quantity demanded (extension or contraction).
Shifts of the demand curve happen when non-price factors (conditions of demand) change, such as income, preferences, or prices of related goods, leading to an increase or decrease in demand.
List factors that can cause a shift in the demand curve.
Changes in income (normal and inferior goods)
Changes in consumer preferences or trends
Prices of substitutes and complements
Expectations about future prices
Population size and demographics
How does diminishing marginal utility affect the shape of the demand curve?
Diminishing marginal utility states that as more units of a good are consumed, the additional satisfaction (utility) from each additional unit decreases.
This results in consumers being willing to pay less for additional units, leading to a downward-sloping demand curve.
What are the formulae for calculating price, income, and cross elasticities of demand?
Price elasticity of demand (PED):
PED = %ΔQd / %ΔP
Income elasticity of demand (YED):
YED = %ΔQd / %ΔY
Cross elasticity of demand (XED):
XED = %ΔQd(A) / %ΔP(B)
Define the numerical interpretations of PED values.
Perfectly elastic: PED = ∞
Relatively elastic: PED > 1
Unitary elastic: PED = 1
Relatively inelastic: PED < 1
Perfectly inelastic: PED = 0
What factors influence price elasticity of demand?
Availability of substitutes
Necessity vs. luxury
Proportion of income spent on the good
Time period for adjustment
Why is the price elasticity of demand significant to firms and governments?
Firms: PED helps in pricing strategies and predicting the impact on revenue when prices change.
Government: Helps assess the impact of taxes and subsidies, and predict how consumers will respond to changes in indirect taxes or income.
Explain the relationship between PED and total revenue.
If demand is inelastic, increasing price increases total revenue.
If demand is elastic, increasing price decreases total revenue.
If demand is unitary elastic, changes in price do not affect total revenue.
What causes movements along the supply curve and shifts of the supply curve?
Movements along the supply curve: Caused by changes in the price of the good.
Shifts of the supply curve: Caused by changes in non-price factors such as production costs, technology, taxes, subsidies, or expectations.
Define price elasticity of supply and provide its formula.
Definition: The responsiveness of quantity supplied to a change in price.
Formula:
PES = %ΔQs / %ΔP
What factors influence price elasticity of supply?
Time period (short-run vs. long-run)
Spare production capacity
Availability of stocks
Flexibility of production
How is equilibrium price and quantity determined?
At equilibrium, the quantity demanded equals the quantity supplied.
This occurs where the demand and supply curves intersect.
What happens if there is excess demand or excess supply in a market?
Excess demand: Prices rise, causing a contraction in demand and an extension in supply.
Excess supply: Prices fall, causing an extension in demand and a contraction in supply.
What are the three functions of the price mechanism?
Rationing: Allocates scarce resources when demand exceeds supply.
Incentive: Higher prices encourage producers to supply more.
Signalling: Indicates where resources are needed based on price changes.
Define consumer surplus and producer surplus.
Consumer surplus: The difference between what consumers are willing to pay and what they actually pay.
Producer surplus: The difference between the price producers receive and the minimum they are willing to accept.
How do changes in supply and demand affect consumer and producer surplus?
Increase in demand: Increases both consumer and producer surplus.
Increase in supply: Increases consumer surplus but may reduce producer surplus per unit.
What is the incidence of indirect taxes on consumers and producers?
If demand is inelastic, consumers bear a larger share of the tax burden.
If supply is inelastic, producers bear a larger share of the tax burden.
How do subsidies benefit consumers and producers?
Subsidies reduce costs for producers, encouraging greater supply.
Consumers benefit from lower prices and increased availability of goods.
Why might consumers not behave rationally?
Influence of others: Peer pressure or social norms.
Habitual behaviour: Consumers stick to routines, even if suboptimal.
Weakness at computation: Difficulty in calculating the best choices.
