1.2 - How markets work Flashcards
How do firms use utility theory to guide their rational decision making?
Firms gain most of their utility through maximising profits
Reasons for wanting to maximise profit include:
- Survival
- To reinvest profits
- To offer managers and staff members better rewards
How does the government use utility theory to guide their rational decision making?
Governments should act in ways that best serve the population and, try to maximise overall welfare.
This includes:
- Achieving economic growth.
- Reducing inflation.
- Reducing unemployment.
- Achieving a balance between payments in and payments out (equilibrium)
How do consumers use utility theory to guide their rational decision making?
- Consumers are said to act rationally and maximise utility within the limits of their income.
- Different consumers will have different interpretations of utility
- Consumers may also want to maximise their work-life balance - Consumers act as workers when they do this
What does the demand curve illustrate?
Why is it downward sloping?
- The demand curve illustrates the relationship between quantity demanded and price
- Price is what the buyer pays for a specific good or service.
- Quantity demanded is the total number of units purchased at that price.
- The demand curve is downward sloping and shows the relationship between price and quantity - the higher the price is, the lower demand is
What is the distinction between the willingness and the ability to pay?
Willingness to pay: the desire to pay based on tastes and preferences.
Ability to pay - factors in a person’s income, and whether they can afford the good or service
What is the distinction between complement goods and substitute goods?
- Substitute goods: an increase in the price of one good will increase the quantity demanded of the other, e.g Persil and Ariel washing pods.
- Complement goods: an increase in the price of one good will cause a decrease in the quantity demanded of the other, e.g flights to Spain and suncream
Which two theories explain the relationship between price and quantity demanded?
- Income effect: when prices fall, consumers can afford a greater quantity of goods and services (assuming income is fixed). So demand for these G&S increases.
- Substitution effect: when the price of one good falls, consumers will buy more of the cheaper good or service and less of the more costly good or service. So demand for the cheaper good will increase
How does a change in demand cause a shift in the demand curve?
- The demand curve will shift right when there is an increase in demand for the good at each price level, e.g. if a product were to suddenly become more popular, the demand curve would shift right.
- The demand curve will shift left when there is a decrease in demand for the good at each price level
How does a change in income shift the demand curve?
- The effect of a change in income depends on the type of good.
- For a normal good, increased income will lead to an increase in quantity demanded, e.g new cars.
- For an inferior good, increased income may lead to a reduction in quantity demanded, e.g rice
What does a change in price do to the demand curve?
- Changes in prices cause a move along the curve
- A rise in price will lead to a demand contraction.
- A fall in price will lead to a demand expansion/extension
What is the law of diminishing marginal returns and how does it explain why the demand curve is downward sloping?
- Diminishing marginal returns: the more of something you add, the lower the impact of each additional unit, assuming all else is fixed.
- The law of diminishing marginal returns can explains why demand curve slopes downwards - as the quantity purchased rises, the price that consumers are willing to pay falls.
- Consumers may be willing to pay a lower price for a higher volume because they gain less utility (or satisfaction) from each extra unit.
What is the law of diminishing marginal utility?
- Marginal utility is the extra benefit to an individual of consuming a good or service.
- The law of diminishing marginal utility states that the more an individual consumes (ceteris paribus) the utility of the good/service decreases with every additional unit consumed
What factors cause a shift in the demand curve?
P.A.S.I.F.I.C
Population: the larger the population, the higher the demand - age distribution also affects demand
Advertising: will increase consumer loyalty to the good and increase demand
Substitutes: if the price of the substitute rises, quantity demanded for the original good will rise
Income: if consumers have more disposable income, they are able to afford more goods, so demand increases
Fashion trends: demand curve will change if consumer tastes change
Interest rates: if they’re high people will save more and spend less so quantity demanded decreases
Complements: an increase in the price of one good will cause a decrease in the quantity demanded of the other e.g. butter and bread
What is PED and what is its formula?
Price elasticity of demand is the responsiveness of a change in demand to a change in price
% Change in quantity demanded / % change in price
What are the 5 types of PED?
Price elastic goods are very responsive to a change in price - PED>1
Price inelastic goods are relatively unresponsive to a change in price - PED<1
Unitary elastic goods have a change in demand which is equal to the change in price - PED=1
Perfectly inelastic goods have a demand which doesn’t change when price changes - PED=0
Perfectly elastic goods have a demand which falls to zero when price changes - PED=infinity
