1.2 How Markets Work Flashcards
What are the assumptions of rational economic decision making?
Consumers aim to maximise utility and firms aim to maximise profits
Factors causing a shift in demand
P - Population
I - Income
R - Related goods
A - Advertising
T - Tastes and Fashions
E - Expectations
S - Seasons
What is the concept of diminishing marginal utility
The law of diminishing marginal utility states that as an extra unit of the good is
consumed, the marginal utility, i.e. the benefit derived from consuming the good,
falls. Therefore, consumers are willing to pay less for the good.
Why is demand curve downward sloping?
Shows inverse relationship between price and quantity
Formula for PED
% change in Price / % change in QD
PED for an elastic good
PED>1
PED for an inelastic good
PED<1
Value of unitary elastic good
1
Value of perfectly inelastic good
0
Factors influencing elasticity of demand
P - Proportion of Income
L - Loyalty (Brand)
A - Addictiveness
N - Necessity
T - Time
S - Substitutes
Why is the demand curve downward sloping?
Shows the inverse relationship between price and quantity
Formula for price elasticity of demand
% change in Price/ % change in QD
Factors influencing PED
P - Proportion of income
L - Loyalty
A - Addictiveness
N - Necessity
T - Time (durability)
S - Substitutes
PED of elastic good
PED>1
PED of inelastic good
PED<1
PED of unitary elastic good
1
PED of perfectly inelastic good
0
Tax on an inelastic good
If the good is inelastic, burden will fall mostly on consumer. Tax most effective on goods with inelastic demand
Tax on an elastic good
Burden will fall mostly on producers. Tax won’t raise as much revenue however it will be effective in lowering demand on a product.
PED and Revenue: If firm increases price of good
Inelastic good - revenue will increase
Elastic good - revenue will fall
Formula for YED
% change in income / % change in quantity demanded
YED of inferior goods
YED<0
YED of normal goods
YED>0
Luxury goods
YED>!
Cross Elasticity of Demand Formula
% Change in QD good A / % Change in QD good B
XED of Complementary goods
Negative
XED of Substitute goods
Positive
What type of goods will firms increase more of when the economy is prospering?
Luxury
Factors that shift supply curve
P - Productivity
I - Indirect Taxes
N - Number of firms
T - Technology
S - Subsidies
W - Weather
C - Cost of production
Formula for PES
% change in price / % change in QS
PES of elastic supply
PES>1
PES of inelastic supply
PES<1
PES of perfectly inelastic supply
0
PES of perfectly elastic supply
Infinity
Factors influencing elasticity of supply
B - Barriers to entry
R - Raw Material availability
I - Inventories (stock levels)
T - Time
S - Spare capacity
How does time affect elasticity of supply?
In short run, supply may be less elastic as it takes firms time to adjust to production capacity. In long run, supply may be more elastic as firms can make capital investments to expand capacity.
What is the market clearing price?
The price at which supply meets demand
What is a surplus?
Where there is more supply than demand
What is a shortage?
Where there is more demand than supply.
What are the functions of the price mechanism?
Rationing - Allocating correct amount of resources due to scarcity
Signalling - Shows where resources are needed in a market. High price signals to firms to enter market and for consumers to lead the market.
Incentive - Encourages firms to join market if price is high.
What is consumer surplus?
Difference between the price and the price consumers are willing to pay, (Above market price and below demand curve
Producer surplus
Difference between price producer is willing to charge and the price they actually charge
How does an increase in demand affect consumer surplus?
It would increase consumer surplus
How does an increase in supply affect consumer surplus?
Reduces consumer surplus
How does an increase in supply affect producer surplus?
Increase producer surplus
How does an increase in demand affect Producer surplus?
Reduces consumer surplus
What are the two types of indirect taxes?
Ad valorem (%) or Specific taxes (fixed amount)
If demand is elastic, who will the burden of an indirect tax fall on?
Incidence will fall on supplier
If demand is inelastic, who will the burden of an indirect tax fall on?
Incidence will fall on consumer
Negatives of ad valorem taxes
Tax could be inflationary
Tax could be regressive
Benefits of ad valorem tax
Inelastic demand can lead to large government revenue (e.g petrol,tobacco)
What is a subsidy?
A subsidy is a payment from the government to a producer to lower their costs of
production and encourage them to produce more.
Effects of subsidies on consumers
Lower prices, reduce inequality, encourage consumption of merit goods.
Taxpayer pays for subsidy but may not benefit
Effects of subsidy on firms
Lower costs of production, more skilled workers (if subsidy encourages),increase in LRAS
Effects of subsidy on government
Boost demand in economic decline, gov failure if subsidy inefficient, opportunity cost
Subsidy on elastic demand curve
Benefits consumers more
Subsidy on inelastic demand curve
Benefits producers more
Reasons people may not act rationally
Other peoples actions (Herd Mentality)
Habitual behaviour
Computational weakness
