1.2 How Markets Work Flashcards
What is a market?
A place where buyers and sellers meet to exchange goods
What is a demand curve?
A curve that shows the relationship between the price of a product and the quantity of the product demanded
What is effective demand?
An individual can afford to pay for the good and service
What is market demand?
Sum of each individual demand curve for a particular good or service
What influences the shape of the demand curve?
As price falls, people are more willing to buy a good
What causes a movement along the demand curve
A change in price of the good
What causes a shift in the demand curve?
A change in any of the factors which affect demand, EXCEPT price
What are the conditions of demand?
- income
- taste - advertising, branding
- fashion
- price of substitutes (e.g. adidas and Nike)
- price of complementaries ( e.g. cheese and crackers)
- population increase/decrease, ageing population
- availability of credit (e.g. loans)
When does extension occur?
When the quantity demanded rises due to decrease in price
When does contraction occur?
When the quantity demanded falls due to an increase in price
What happens to the demand curve if demand decrease?
Shifts to the left
What happens to the demand curve when demand increases?
Shifts to the right
How does population affect demand?
- size of population rises - more people want the good - increase in demand for all products — rightward shift
- ageing population - people at different ages demand different things — goods that affect ageing population will be more in demand -> rightward shift
How does income affect demand?
- higher income levels - more disposable income so people can afford more goods - demand increases
- rightward shift
What is a normal good?
- where the quantity demand increases in response to an increase in consumer income
- e.g. holidays, branded items
What is an inferior good?
- where the quantity demanded decreases in response to an increase in consumer incomes
- canned food vs fresh, bus vs taxi
How do related goods affect demand? (Substitutes)
- an increase in price of X —> leads to contraction of demand for X, but increase in demand for Y
- a decrease in price of X —> people switch away for substitutes and demand more of X
How do related goods affect demand? (Complements)
- if price or X decreases —> extension of demand for X and an increase in demand for Y - rightward shift
- if the price of X increases —> contraction of demand for X and a decrease in demand for Y - leftward shift
How does advertising affect demand?
- if a firm advertises well demand will increase - rightward shift
- if a rival advertises this can lead to a decrease in demand - leftward shift
How does expectation affect demand?
- if people expect a shortage of X —> greater demand - rightward shift
- if people expect a fall in price of X —> lower demand - leftward shift
What is real income?
- income adjusted for inflation
- cuts in income tax could lead to an increase in disposable income
Impact of real income on demand
- increase in disposable income —> increase demand for normal goods
- fall in demand for inferior goods
What does price elasticity of demand measure?
PED measures the responsiveness of demand to a change in the price of a good
What is the formula for PED?
% change in quantity demanded/ % change in price
Why are most values of PED negative?
A rise in price leads to a fall in quantity demanded
What is unitary elastic PED?
- When PED = 1
- quantity demanded changes by exactly the same percentage as price
What is relatively elastic PED?
- PED > 1
- quantity demanded changes by a larger percentage than price so demand is relatively responsive to price
- shallow gradient
What is relatively inelastic PED?
- PED < 1
- quantity demanded changes by a smaller percentage than price so demand is relatively unresponsive to price
- steep gradient
What is perfectly elastic PED?
- PED = infinity
- a change in price means that quantity demanded falls to 0 and demand is very responsive to price
- horizontal line
What is perfectly inelastic PED?
- PED = 0
- a change in price has no effect on output so demand is completely unresponsive to price
- vertical line
Factors that affect PED
- availability of substitutes
- % of income spent on product
- necessity or luxury
- habit forming
- number of uses
- time
How does availability of substitutes affect PED?
- if there are lots of substitutes, people will switch to other products when prices rises —> elastic PED
- if no substitutes, people have to still buy that good as there are no alternatives —> inelastic PED
How does time influence PED?
- the longer the time, the easier it will be for a person to find an alternative supplier of the product —> more elastic PED
- short run goods tend to be more inelastic
How do necessities influence PED?
- inelastic PED if you need something you’re still going to buy it if prices rise
- e.g. petrol
How does % of income spent influence PED?
- if a good/service represents a very small percentage of a person’s total income expenditure, an increase in price will have relatively small impact on whether they buy that product - inelastic
- but if it is a large percentage of their income they will be less inclined to keep buying after a price increase - elastic
How does habit forming influence PED?
- if a product is addictive then it’s inelastic
- no matter how high prices rise people will still buy to fulfil their addiction
- e.g. cigarettes, alcohol
How does number of uses influence PED?
- if there are lots of uses then PED will be more inelastic
- e.g. electricity
What happens to revenue with an elastic demand curve?
- decrease in price —> increase in revenue
- increase in price —> decrease in revenue
What happens to revenue with an inelastic demand curve?
- decrease in price —> decrease in revenue
- increase in price —> increase in revenue
What happens to revenue with a unitary demand curve?
A change in price doesn’t affect total revenue because a change in price is met with a proportionate change in demand
What is income elasticity of demand?
Measure the responsiveness of demand to a change in income
Formula for YED
% change in quantity demanded / % change in income
What happens when YED is negative + income rises
- it is an inferior good
- a rise in income will lead to a fall in demand for a good
What happens when the YED is positive
- it is a normal good
- a rise in income will lead to a rise in demand for the good
- e.g. fresh fruit
What is YED > 1
- income elastic
- luxuries
What is YED < 1
- income inelastic
- necessities
What happens to income when the economy is in recession?
Average incomes are falling
What happens to incomes when the economy is booming?
Average incomes are rising
What is cross elasticity of demand?
Measure the responsiveness for good A following a change in the price of another product, good B
Formula for XED
% change in quantity demanded of good X / % change in price of good Y
What happens when XED is positive?
- goods are substitutes
- an increase in price of B will increase demand of A
What happens when XED is negative?
- the goods are complementary
- an increase in price of B will decrease demand for A
- e.g. DVDs and DVD players
What happens when XED = 0?
- goods are unrelated
- a change in price of good B has no impact on good A
What does the size of the integer represent in XED?
- represents the strength of the relationship
- the larger the number, the stronger the relationship between the two goods
What is the significance of XED?
- firms need to be aware of their competition and those producing complementary goods
- they need to know how price changes by other firms will impact them so they can take appropriate action
What is supply?
Supply is the ability and the willingness to provide a good or service at a particular price at a given moment in time
What causes a movement along the supply curve?
A change in the price of the good
What causes a shift in the supply curve?
A change in the factors which affect supply (conditions of supply)
When does contraction of supply occur?
When quantity supplied falls, due to a decrease in price
When does extension of supply occur?
When quantity supplied rises due to an increase in price
What happens to the supply curve when there is a decrease in supply
- leftward shift
What happens to the supply curve when there is an increase in supply?
Rightward shift
Conditions of supply?
- cost of production
- advances in technology
- weather
- taxes + subsidies
- transport costs
How does cost of production affect supply?
- if a business has an increase in their costs but selling price remains same, they make less money on what they sell
- increasing the price —> avoids making a loss so less is supplied at each price - leftward shift
- decrease in price —> rightward shift
How does weather affect supply?
- agricultural goods are reliant of weather
- weather is good = more supply - rightward shift
- weather is bad = less supply - leftward shift
How does technology affect supply
- new technology causes a fall in production costs due to higher productive efficiency
- provides incentives for firms to lower prices or produce more goods at the same price —> rightward shift
- during war, firms use less efficient technology —> leftward shift
How do taxes and subsidies affect supply?
- tax decreases supply
- subsidy increases supply as it reduces both production cost + price of the commodity - therefore more affordable to produce
How does joint supply affect supply?
- increase or decrease in the supply of one good leads to the increase or decrease in supply of a by - product
- e.g. cows can be used for milk, beef and hide
- if the supply of cows increases, so will the supply of dairy + beef product
What is price elasticity of supply?
Measures the responsiveness of supply to a change in price
Formula for PES
% change in quantity supplied / % change in price
Why is the supply curve upwards facing?
- profit motive
- at higher prices, producers have an incentive to supply more as they will get more profit
When is PES relatively elastic?
- PES > 1
- starts at Y axis
- quantity supplied changes by a larger percentage than price so supply is relatively responsive to price
When is PES relatively inelastic?
- PES < 1
- starts at X axis, steep
- quantity supplied changes by a smaller percentage than price so supply is relatively unresponsive to price
When is PES unitary?
- PES = 1
- starts from origin
- quantity supplied changes by exactly the same percentage as price
Factors affecting price elasticity of supply?
- time
- long run
- level of sparse capacity
- stocks/ inventories
- ease + cost of factor substitutability
- speed of production
How does time affect PES?
- more elastic in long run as this gives producers more time to increase resources
How does the long run affect PES?
- all factors of production are variable (land, labour, capital, enterprise)
How does level of sparse capacity affect PES?
- more space to increase supply = more elastic
How does stock affect PES?
- higher stock = more to supply - more elastic
How does ease + cost of substitutability affect PES?
- can machines + labour switch easy to making the products
- e.g. ventilators in coronavirus epidemic
How does speed of production affect PES?
- longer it takes to produce the good = the more inelastic
- e.g. malt whiskey - brewing, housing - planning permission
What is perfectly inelastic PES?
- PES = 0
- a change in price has no effect on output so demand is completely unresponsive to price
- shown by vertical line
What is perfectly elastic PES?
- PES = infinity
- horizontal line
- a change in price means that quantity supplied falls to 0 and supply is very responsive to price
What is the equilibrium point?
- where there are no more forces bringing about change
What is price equilibrium?
When supply is equal to demand (where the curve crosses)
Why is it also known as the market clearing price?
All the products supplied to the market are cleared (bought) as no buyers are unable to buy the good
When is price set below the equilibrium?
When there is excess demand
What impact does excess demand have?
There’s a shortage in the market
What do firms do when there is excess demand?
- theyre increase prices and still sell their goods
- extension in supply
- higher price -> contraction in demand -> now at equilibrium
What happens when price is set higher than equilibrium?
There is excess supply
What impact does excess supply have on the market?
Firms have unsold goods
What do firms do when there is excess supply?
- put sales on to sell these excess goods
- contraction in supply
- lower price —> extension in demand
- now at equilibrium
Functions of price mechanisms to shortages
- shortages signal producers to increase price
- incentive to supply more to increase profit
- rationing of demand -> contraction of demand
- equilibrium restored
- price mechanism self corrects
Function of price mechanism for excess supply?
- signal to lower price -> leads to extension of demand
- contraction of supply - less incentive to produce as profits are lower
- equilibrium is restored
- price mechanism self corrects
What is consumer surplus?
- area below demand curve + above price level
- shows the difference between what customers are willing to pay + market price
What is producer surplus?
- area above supply curve + below price level
- shows the difference between the price the supplier is willing to produce their product at + market price
Are consumers rational?
Traditional economic theory has assumed consumers are perfectly rational and make choices to maximise happiness
What are the two types of thinking?
- automatic and intuitive
- reflective and rational
Describe the automatic system
It’s your gut reaction
Describe the reflective system
It’s your conscious thought
What helps us make choices?
- relying on rules of thumb
- this is because we cannot spend hours analysing all our decisions
- information is often too complex to make assessments of everything
What suggests that consumers are irrational?
Behavioural biases
Reasons why consumers may not behave rationally?
- consideration of influence of other people’s behaviour
- habitual behaviour
- consumer weakness + computation
- choice overload
- information failure or asymmetric information
How does the influence of other effect decisions?
- herding behaviour - if we see someone else doing something we are more likely to do so too
- we are influenced by what other people do when making decisions
How does habitual behaviour affect decisions?
- status quo - individuals tend to stick with their current situation
- this may be because they want to play it safe and not risk a change as it may make them worse off (loss aversion)
- this can lead to consumers losing out on possible utility gain + not maximising their utility
How does choice overload affect decisions?
- if there’s too many options to choose from, it’s difficult for the consumer to work out the benefits of each one + is too much information to process
- so they may not reach a rational decision to maximise utility
Information failure/ asymmetric informations affect on decisions
- there may not be enough info on a rational decision
- or other buyer know more than the seller so their decision isn’t always rational and may reflect onto self interest
