1.2 - How Markets Work? Flashcards
What is rational decision making an area of?
Behavioural economics
What are aims for consumers and firms when making economic decisions?
Consumers - maximise their utility
Firms - maximise profits
What is a customers utility?
The total satisfaction received from consuming a good or service
What is demand?
The quantity of a food or service that consumers are able and willing to buy at a given price during a given period of time
How does demand vary?
With price.
- the lower the price the more affordable the good thus consumer demand with increase
When does a leftshift in demand occur?
When the quantity of goods demanded decreases
When does a rightshift in demand occur?
When the quantity of goods demanded increases
what are the factors that shift the demand curve? (7)
- population
- income
- related goods
- advertising
- tastes and fashions
- expectations
- seasons
What are the 3 types of demand?
- derived
- composite
- joint
What is derived demand?
The demand for one good is linked tot the demand for a related good
What is composite demand?
When the good demanded has more than one use.
What is joint demand?
When goods are bought together, thus complementary
What is diminishing marginal utility?
- downward sloping demand curve, showing the inverse relationship between price and quantity
-an extra unit of the good is consumed decreasing consumer satisfaction
What does PED stand for?
Price Elasticity of demand
What is the price elasticity of demand?
Responsiveness of a change in demand to a change in price
What is the equation for PED?
PED = % change in quantity demanded/ %change in price
What does it mean if a product has price elastic demand? 3
- Very responsive to a change in price
- the change in price leads to an even bigger change in demand
- PED is >1
What does it mean if a good has price inelastic demand?
- Demand is relatively unresponsive to a change in price
- PED <1
What does it mean if a good has unitary elastic demand?
- PED = 1
- demand curve is a curve as for a 1% decrease in the price there is a 1%increase in the quantity demanded.
What does it mean if a good has perfectly inelastic demand?
- does not change when the price changes
- PED = 0
What does it mean when a good has perfectly elastic demand?
- Demand falls to 0 when price changes
- PED = infinite
What are the 6 factors that influence the PED?
- Necessity
- Substitutes
- addictiveness or habitual consumption
- proportion of income spent on the good
- Durability of the good
- Peak and off peak demand
What is a necessity? And how does it influence the PED?
- good such as bread or electricity
- has a relatively inelastic demand.
If one the price of bread or electricity were to change the demand would not change with it thus it is inelastic, this is because it is a necessity
What is a substitute and how does it affect the PED?
If a good as more substitutes then the demand is more price elastic.
- if the price of white bread increased the demand may change as there are many substitutes for white bread. However bread in general is more price inelastic as there aren’t many substitutes for bread as a whole
How is PED effected in the long run?
Consumers have time to respond and find a substitutes so demand becomes more price elastic
How is PED affected in the short run?
Consumers don’t have time to change their mind or think about their decision thus are more likely to be more impulsive, so demand is more inelastic
How does addictiveness or habitual consumption effect the PED of a good?
Consumers may feel loyal to a brand or be addicted to a product thus continue to demand the product even if the price increases. Therefore the product is price inelastic
How does the proportion of income spent on a good effect the PED?
- If the good only takes up a small proportion of income, such as a magazine which may only have a 50p price increase, the demand is likely to be relatively price inelastic
- if the good takes up a large proportion of income, such as a car which may increase by £5,000 then it is likely to have a more price elastic demand.
How does the durability of a good affect the PED?
A good that lasts a long time has like a washing machine or mattress it has a more elastic demand because consumers wait to buy another one.
How does peak and off peak demand effect the PED of a product?
During peak times such as 9am and 5pm for trains, the demand for train tickets is more likely to be price inelastic as it may be the only method of transport to reach home from work or school, or to reach work or school.
What curve does indirect tax shift?
Supply curve.
When is a firm likely to put most of the indirect tax burden on the consumer?and why?(3)
- When the good has an inelastic PED
- because a price increase wont cause demand to fall significantly.
- this is most effective for raising government revenue
When is a firm likely to take the tax burden upon themselves?
- if the good has an elastic demand
Otherwise the demand will decrease and they will receive a decrease in revenue
What is a subsidy?
A payment from the government to firms to encourage the production of a good and to lower their average costs
How is the benefit of a subsidy divided?
To a producer in the form of increased revenue
To the consumer In the form of lower prices
What is the equation for total revenue?
Total revenue = price x quantity demanded and supplied
How is revenue affected if PED is inelastic?
A firm can raise their price without quantity sold falling significantly thus will increase total revenue.
How is revenue affected if PED is elastic?
If the firm raises their prices quantity sold will full thus will reduce the total revenue
What is income elasticity of demand?
Responsiveness of a change in demand to a change in income.
What is the equation for the YED?
YED = %change in quantity demanded / % change in income
What is an inferior good?
- Those goods which see a fall in demand as income increases.
- As income increases consumers witch to branded goods
- YED<0
What is a a normal good?
Demand increases as income increases
YED>0
What is a luxury good?
- An increase in income causes a bigger increase of demand.
- YED>1
A luxury good is also a normal good as they have an elastic income.
What is the XED?
Cross elasticity of demand, responsiveness of a change in demand of one good to a change in price of another good
What is the formula for XED?
XED = %change in quantity demanded of X / %change in price of Y
How are complimentary goods affected by the XED? What happens in close and weak compliments? 4
- have a XED<0
- if one good becomes more expensive, the quantity demanded for both goods with fall
Close compliments: a small fall in the price of good X leads to a large increase in QD of Y
Weak compliments: a larger fall in the price of good X to only a small increase in QD of Y
How are substitutes affected by the XED? What happens in close and weak substitutes ? 2+2
- they can replace another good so the the demand curve is upward sloping
- XED>1
- if the price of one brand or TV increases, consumers might switch to another brand.
Close substitutes: a small increase in the price of good S leads to a large increase in QD of Y
Weak substitutes: a large increase in the price of good X leads to a smaller increase in QD of Y
How are unrelated goods effected by the XED?
They are unrelated thus have no effect on each other
Why are firms insterested in the XED?
It allows them to see how many competitors they have.
- less likely to be affected by price changes of other firms if they are selling complementary goods or substitutes
What is supply?
The quantity of a good or service that a producer is able and willing to supply at a given price during a given period of the time.
Why is the supply curve upward sloping?(3)
- if price increases, it is more profitable for firms to supply the good, so supply increases
- high prices encourage new firms to enter the market, because it seems profitable so supply increases
- with larger outputs, firms costs increase so they need to charge a higher price to cover the costs
What factors shift the supply curve?(7)
PINTSWC
- Productivity
- indirect taxes
- number of firms
- technology
- subsidies
- weather
- costs of production
How does productivity effect the supply curve?
Higher productivity causes an outward shift in supply, as average costs for firm fall
How does indirect taxes effect the supply curve?
Leftward shift in supply
How does the number of firms effect the supply curve?
More firms, larger supply
How does technology effect the supply curve?
More advanced causes a rightward shift in the supply curve
How do subsidies effect the supply curve?
Create an outward shift in supply as there is an increae
How does weather effect the supply curve?
Particularly for agricultural produce, favourable condition increase supply thus cause an outward shift in supply
How does the costs of production effect the supply curve?
- if they fall firms increase supply
- if they rise firms supply may decrease
How does a depreciation in exchange rates effect the supply curve?
Imports costs will increase causing inward shift in demand
- the purchasing power is decreased thus more expensive for firms to import raw materials
What is joint supply?
When increasing the supply of one good causes an increase or decrease in the supply of another good.
What does PES stand for?
Price elasticity of supply
What is the PES?
The responsiveness of a change in supply to a change in price
What is the formula for PES?
PES = %change in quantity supplied/ %change in price
What does it mean if the PES is elastic?
Firms can increase sup0y quickly at little cost
- PES >1
What does it mean if the PES is inelastic?
Increase in supply will be expensive for firms and take a long time
- PES <1
What does it mean if the PES is perfectly elastic?
PES = infinite
Any quantity demanded can be met without changing price
What does it mean if the PES is perfectly inelastic?
PES =0
Supply is fixed thus a change in demand means it can’t be met easily
What are the 5 factors that influence the PES?
- time scale
- spare capacity
- level of stocks
- how suitable factors of production are
- barriers to entry to the market
How does the time scale influence the PES?
- in the short run, supply is more price inelastic as it is difficult for producers to quickly increase supply
- in the long sun, supply is more price elastic
What is the long and short run?
Short run - period of time in which at least one factor of production is fixed
Long run - period of time in which all factors of production are variable.
How does spare capacity influence the PES?
- If a firm is operating at full capacity there is no space left to increase supply
- if there are spare resources supply can be increased quickly.
How does the level of stock influence the PES?
- if goods can be stored firms can stock them and increase market supply easily
- if goods are perishable, firms are unable to stock them for long so supply is more inelastic
How does the factors of production influence the PES?
If labour and capital are mobile, supply is more price elastic because resources can be allocated to where extra supply is needed.
How does the barriers to the entry market influence the PES?
High barriers to entry mean supply is more price inelastic as it is difficult for new firms to enter and supply the market
What is the Market equilibrium ?
When supply meets demand on the diagram
Price has no tendency to change thus known as the market clearing price.
WHat is excess demand?
When there is a shortage of supply in the market.
Prices get pushed up causing firms to increase supply, thus price will increase causing demand to contract.
It will then reach equilibrium again
What is excess supply?
When there is a surplus in demand thus prices will fall as firms lower their prices to sell there goods
What occurs if there’s a shift in supply or demand curve?
A new market equilibrium
What is the price mechanisms purpose
To determine the market price
How does the price mechanism effect a free market economy?
Used to allocate Scarce resource to where they are demanded and where there is a shortage as well as removing them if there is a surplus
What are the three main functions of the price mechanism to allocate resources?
Rationing
Incentive
Signalling
What is rationing in allocation of resources?
When there are scarce resources prices increase due to excess demand, discouraging demand thus creating a ration in resources.
What is incentive in allocation of resources?
Encouraging a change in behaviour of consumers or producers.
What is signalling in allocation of resources?
When the price acts as a signal to consumers and new firms entering the marker.
Changes show where resources are required in the market.
- a high price signals firms to enter the market because it is profitable.
What is consumer surplus?
The difference between the price the consumer is willing and able to pay and the price they actually pay.
- based on what the consumer perceived their private benefit will be consuming from the food
Where is consumer shown on the supply demand curve?
The area above the market price and below the demand curve
What is the relationship between consumer spending and diminishing marginal utility?
Consumer surplus generally declines with each extra unit consumed
- this is because the extra unit generates less utility than the one already consumed, thus consumers are willing to pay less for extra units.
What is the relationship between the PED and the consumer surplus?
An inelastic demand curve gives a larger consumer surplus
- consumers are willing to pay a much higher price to consume the good.
What is the producer surplus?
The difference between the price the producer is willing to charge and the price they actually charge.
- the private benefit gained by the producer that covers their costs - measured by profit
What is economic welfare?
The total benefit society receives from an economic transaction
How is economic welfare calculated?
By the area of consumer and producer surplus added together.
What is the sum of consumer surplus and producer surplus called?
Community surplus
What are indirect taxes?
Taxes imposed by the government that increase production costs for producers,
- causing producers to supply less
- increasing the market price
- causing demand to contract
What are the 2 types of indirect taxes?
Ad valorem
Specific taxes - excise duties
How is the indirect tax shown diagrammatically?
By the vertical distance between two supply curves
Where does the burden of tax fall with different PED’s?
- If demand is relatively elastic, the tax will mainly fall on the supplier
- if the demand is relatively inelastic, the incidence of the tax will fall mainly on the consumer
What are Ad Valorem taxes?
Taxes a Percentage such as VAT
- vat currently 20%in the UK
What are excise duties?
Taxes set per unit of a product to decrease incentive of purchase by increasing the prices
- e.g. fuel, alcohol, cigarettes
What effect does advolem taxes have on the supply curve?
Causes them to pivot leftwards
What is a subsidy?
A payment from the government to a producer to lower their costs of production and encourage them to produce more
How are subsides shown diagrammatically?
Shift the supply curve to the right, lowering market price
Verticals distance between the supply curves shows the output
How is government spending on subsidies shown?
By the value of the subsidy per unit times the output
What is the effect of subsidies on consumer?
Increase output thus lower prices for consumers, helping families on low or fixed incomes
What is the effect of subsidies on employment rates?
Increase the employment rate, by making workers more skilled through apprenticeship schemes and lowering the cost of employing workers
What is the effect of subsidies on inflation?
Could help to control a sustained increase in the general price level by keeping production costs low
What is the effect of subsidies on merit goods?
Encourage consumption of merit goods, creating positive externalities
How are subsidies effected by the PED?
- if inelastic, greater effect on equilibrium price providing greater consumer gain
- if elastic, larger effect on quantity thus benefit producer more
What is a consumer subsidy?
Encourages consumers to purchase more of a good or service
- effect demand not shifting in supply curve
What is a producer subsidy?
Lower the cost of production shifting the supply curve.
What does it mean to act rationally?
Making a decision that results in the most optimal level of utility or benefit for the consumer
What factors effect the rationality of your decisions ?(3)
- The influence of other peoples behaviour
- Importance of habitual behaviour
- consumer weakness at computation
How does other peoples behaviour influence ones rationality of a decision?
Other peoples behaviour creates a bias within the consumer.
Social pressure; encourages consumers to do things they would not usually even if it is harmful, and consumers become unwilling to change, whether it benefits them or not as it conforms to the norms of their society
How does rational behaviour effect consumer behaviour?
- reduce the amount of time it takes to do something as consumers don’t have to consciously think about their actions
- consumers may find it hard to give up habits such as smoking
How does consumer weakness at computation?
Consumers are unable to exercise self control with some decisions.
Due to the law of diminishing marginal utility.
