1.2 how markets work

Question 1

what is economic welfare?

Answer 1

the level of well-being or prosperity of a group of individuals, such as a country

Question 2

what are one of the key assumptions made by neo-classical theory regarding decision making?

Answer 2

• that economic agents, such as individuals and firms, make decisions in a rational way
• a key element is that it is much easier to assume that all decisions are taken on the margin

Question 3

what does rational mean in an economic sense?

Answer 3

• economic agents are able to rank the order of different outcomes from an action in terms of their net benefits to them
• they then act in a way that will maximize these net benefits

Question 4

why/how are consumers assumed maximise their economic welfare or utility?

Answer 4

• because resources are scarce, they have to make rational decisions
• consumers are likely to spend their limited money on what will give them the greatest amount of satisfaction
• will purchase those items that give them the greatest marginal utility per pound and are affordable

Question 5

why/how do firms aim to maximise profits?

Answer 5

• neo-classical theory assumes that firms want to maximise their rewards from ownership
• ## profits are maximized when marginal revenue = marginal cost

Question 6

what does ‘at the margin’ mean?

Answer 6

at the next unit

Question 7

what is demand?

Answer 7

the quantity that purchasers are willing and able to buy at a given price in a given period of time

Question 8

what is the basic law of demand?

Answer 8

that the demand varies with price - the lower prices make products more affordable for consumers

Question 9

what causes movement along the demand curve?

Answer 9

• a higher price leads to a contraction of the quantity demanded
• a lower price leads to an expansion of the quantity demanded

Question 10

what is the income effect?

Answer 10

• a fall in price leads to an increase in purchasing power for consumers
• this allows people to buy more with a given budget
• for normal goods, demand increases with an increase in real income

Question 11

what is the substitution effect?

Answer 11

• a fall in the price of good x makes it relatively cheaper compared to substitutes
• some consumers will switch to good x leading to higher demand
• much depends on whether the products are close substitutes

Question 12

what are some causes of shifts in the demand curve?

Answer 12

1 - changing prices of a substitute good or service in competitive demand
2 - changing price of a complement
3 - changes in real income of consumers
4 - changes in the distribution of income
5 - effects of marketing and advertising
6 - other seasonal, social factors

Question 13

what happens to the demand for inferior goods when real income changes?

Answer 13

• when real income increases, our ability to purchase goods and services increases, leading to an outward shift in the demand curve
• when it falls, there will be a decrease in demand of normal goods but increased demand of inferior goods

Question 14

what is (total) utility?

Answer 14

the measure of the (total) satisfaction that we get from purchasing and consuming a good or service

Question 15

what is marginal utility?

Answer 15

the change in satisfaction from consuming an extra unit

Question 16

what is the law of diminishing returns?

Question 17

what explains the downwards sloping of the demand curve?

Answer 17

if the marginal utility is falling, then consumers will only be prepared to pay a lower price - law of diminishing returns

Question 18

what is derived demand?

Answer 18

the demand for a factor of production used to produce another good or service e.g. steel being strongly linked to the market demand for cars - relationships between markets

Question 19

what is composite demand?

Answer 19

exists where goods have more than one use - so an increase in the demand for one product leads to a fall in supply of the other e.g. milk is used for a variety of other dairy products

Question 20

what is price elasticity of demand?

Answer 20

the responsiveness of demand after a change in the good’s own price

Question 21

what is the equation for price elasticity of demand?

Answer 21

ped = % change in the quantity demanded / % change in price

Question 22

what does it mean to be price elastic or inelastic?

Answer 22

• elastic -> as the price changes the demand for it changes the same amount if not more - chnage in quantity > change in price
• inelastic -> as the price changes the demand doesn’t change as much - change in quantity < change in price

Question 23

what does income elasticity of demand (YED) measure?

Answer 23

the response of demand to a change in income

Question 23

what are the three different types of goods?

Answer 23

inferior good - any product with a negative income elasticity of demand
normal good - any product with a positive income elasticity of demand
luxury good - a product with a highly positive income elasticity of demand

Question 24

what is the relationship between income and demand?

Answer 24

• income and demand have a positive relationship for luxury goods so if your income increases then you are more likely to be encouraged to spend on more expensive luxury goods
• on the other hand, the relationship becomes negative for inferior goods because people tend to buy less cheap goods when they have more money to spend e.g. on shein

Question 25

what is the equation for YED?

Answer 25

% change in quantity demanded / % change in income

Question 26

what does cross elasticity of demand (XED) measure?

Answer 26

measures the responsiveness of quantity demanded for one good to a change in the price of another good

Question 27

what is the equation for XED?

Answer 27

% change in quantity demanded of good X / % change in price of good Y

Question 28

what are the three types of goods in XED?

Answer 28

• substitute goods: +ve XED
• complement goods: -ve XED
• unrelated goods: XED of 0

Question 29

what is market equilibrium?

Answer 29

when there is a state of balance between market demand and supply - there is no excess demand or supply

Question 30

what is price determination?

Answer 30

the process of how the forces of demand for goods and services and the supply of goods and services in a market interact to determine the price

Question 31

what causes an excess in supply or demand? what represents this on a supply/demand curve

Answer 31

• if the price of the good is above the market equilibrium, there will be an excess in supply
• if the price of the good is below the market equilibrium then, there will be an excess in demand
• area between demand and supply and above/below the equilibrium point represents the excess supply/demand respectively on a graph

Question 32

what do the market forces do to eliminate excess supply?

Answer 32

market forces will result in a contraction in supply and an extension in demand, causing a fall in price to the market equilibrium
- this shortage in demand will result in a decrease in the price of a good because firms will have to realize that they will have to lower their prices if they are to sell their goods.
- the fall in prices will lead to an increase in demand
contraction in supply + increase in demand = market reaches equilibrium

Question 33

what do the market forces do to eliminate excess demand?

Answer 33

market forces will result in an extension in supply and a contraction in demand, causing a rise in price to its market equilibrium
- this is because firms will spot this excess demand and recognise that they will have to increase prices in order to ration demand.
- as firms increase their prices, supplies will be willing to supply greater the good in greater quantities due to the profit motive.
both the contraction in demand an extension of supply will result in the market reaching equilibrium.