1.2 - How markets work Flashcards
How do consumers act rationally?
By aiming to maximise utility.
How do producers act rationally?
By aiming to maximise profits.
What is demand?
How much is demanded at a given price over a certain time period.
What is the shape of the demand curve?
Downward sloping.
What does the shape of the demand curve indicate?
Demonstrates how a fall in price will cause an increase in the quantity demanded.
What effects cause the shape of the demand curve?
Substitution effect - when there is a rise in price, the consumer tends to buy more of a relatively lower priced good and less of a higher priced one.
Income effect - when price rises, purchasing power decreases, this leads to a decrease in demand.
What causes movement along a demand curve?
A change in price.
What factors cause a shift in the demand curve? (Think PASIFIC)
Population
Advertising
Substitutes
Incomes
Fashion and Trends
Interest Rates
Complements
What is total utility?
Amount of satisfaction a person gets from the total amount of product consumed.
What is marginal utility?
The change in total utility from consuming an extra unit of a product.
What is the law of diminishing marginal utility?
With each consumption of a product, utility increases but at a decreasing rate.
What is price elasticity of demand (PED)?
A measure of the responsiveness of quantity demanded of a product to a change in its price.
What is the PED equation?
percentage change in quantity demanded / percentage change in price
Why is PED always a negative value?
As price increases, demand decreases.
What does a PED of 0 mean?
Perfectly inelastic demand.
What does a PED of between 0 and -1 mean?
Inelastic demand.
What does a PED of -1 mean?
Unitary elastic demand.
What does a PED of between -1 and negative infinity mean?
Elastic demand.
What does a PED of negative infinity mean?
Perfectly elastic demand.
What does HEVI stand for?
Horizontal-Elastic Vertical-Inelastic.
Name 3 factors influencing PED.
Availability of substitutes - the more substitutes there are the more of an incentive there is to switch consumption.
Proportion of income - the greater the percentage of income, the more elastic
Nature of product - if the product is addictive is it is more likely to be inelastic.
When demand is perfectly inelastic, a change in price causes total revenue to…
Change in the same direction by the same proportion.
When demand is inelastic, a change in price causes total revenue to…
Change in the same direction.
When demand is unitary elastic, a change in price causes total revenue to…
Remain unchanged.
When demand is elastic, a change in price causes total revenue to…
Change in the opposite direction.
When demand is perfectly elastic, a rise in price causes total revenue to…
Fall to 0.
What is the significance of PED for firms?
If firms know if a product is price elastic or inelastic, they can change price accordingly.
What is the significance of PED for government?
If government wishes to maximise its tax revenue it will place indirect taxes in inelastic products.
What is cross elasticity of demand (XED)?
A measure of responsiveness of quantity demanded for one product to a change in price of another.
What is the XED equation?
Percentage change in quantity demanded for one product / percentage change in price of another.
What does a positive XED suggest?
Products are substitutes - as the price of one product rises the demand for another product will also rise.
What does a negative XED suggest?
Products are complements - as the price of one product rises the demand for the other one falls.
What is the significance of XED for firms?
If a firm is selling products that are complements or substitutes, they will be able to price there products accordingly to make maximum profit.
What is income elasticity of demand (YED)?
A measure of responsiveness of quantity demanded of a product to a change in real income.
What is the YED equation?
Percentage change in quantity demanded / percentage change in real income
What does a positive YED indicate?
Normal good - as real incomes rise, demand for the good also rises.
What does a negative YED indicate?
Inferior good - as real incomes rise, demand for the good falls.
What is the significance of YED for firms?
If firms know the demand for a product is income elastic then they know that demand and total revenue will increase significantly during periods of economic growth.
What is the significance of YED for government?
If the government wish to maximise tax revenue during an economic boom it place indirect taxes on those products whose demand is income elastic.
What is supply?
How much is supplied at a given price level over a certain period of time.
What is the shape of the supply curve?
Upwards sloping.
What does the shape of the supply curve indicate?
As price increases so does supply.
What causes the shape of the supply curve?
It is more profitable for producers to supply at higher prices, increasing the incentive to produce.
What causes movement along the supply curve?
A change in price.
What factors cause a shift in the supply curve? (Think PINTSWC)
Productivity
Indirect Taxes
Number of Firms
Technology
Subsidies
Weather
Costs of Production
What is price elasticity of supply (PES)?
A measure of the responsiveness of quantity supplied for a product to a change in its price.
What is the equation for PES?
Percentage change in quantity supplied / percentage change in price
What does a PES of 0 mean?
Perfectly inelastic supply.
What does a PES of between 0 and 1 mean?
Inelastic supply.
What does a PES of 1 mean?
Unitary elasticity of supply.
What does a PES of between 1 and infinity mean?
Elastic supply.
What does a PES of infinity mean?
Perfect elastic supply.
Why is PES always a positive value?
As price increases, so does quantity supplied.
Name 3 factors influencing PES.
Time - in the short run, it is difficult to change supply quickly so it tends to be more inelastic.
Spare capacity - if firms have unused machinery or underemployed workers then supply is more likely to be elastic.
Ability to switch resources from one use to another - if firms are able to switch workers and machinery between tasks quickly and efficiently supply is likely to elastic.
Where can the equilibrium price and quantity be found?
The point of intersection between the demand and supply curves.
When is there excess supply in an economy?
When the price is above the equilibrium price.
When is there excess demand in an economy?
When the price is below the equilibrium price.
What causes a change in equilibrium price?
A change in demand and/or supply.
What are the 3 key functions of the price mechanism?
Rationing device - market forces ensure that the amount demanded is exactly equal to amount supplied.
Incentive - the prospect of making a profit acts as an incentive for firms to produce goods and services.
Signalling device - to producers to increase or decrease amount supplied.
What is consumer surplus?
The difference between how much consumers are willing to pay and what they actually pay for a product.
Where can consumer surplus be found on a demand-supply diagram?
Below the demand curve but above the equilibrium line.
What are the 2 factors affecting consumer surplus?
Gradient of demand curve - the steeper it is the greater the consumer surplus.
Movement of demand curve - an increase in demand leads to an increase in consumer surplus.
What is producer surplus?
The difference between the minimum price a producer will sell a product for and what they actually sell it for.
Where can producer surplus be found on a demand-supply diagram?
Above the supply curve but below the equilibrium line.
What are the 2 factors affecting producer surplus?
Gradient of the supply curve - the steeper it is the greater the producer surplus.
Movement of supply curve - an increase in supply leads to and increase in producer surplus.
What is an indirect tax?
A tax on expenditure.
What are the 2 types of indirect tax?
Ad valorem taxes.
Specific taxes.
What is an ad valorem tax?
A percentage of the price of a product, e.g. VAT.
What is a specific tax?
A set amount per unit of a product, e.g. tax on cigarettes.
What direction do taxes cause the supply curve to move to?
To the left.
What is the consumer incidence of tax?
Relates to the burden of the tax that falls onto consumers.
What is the producer incidence of tax?
Relates to the burden of the tax that falls onto producers.
Where can the consumer incidence of tax be seen on a graph?
Above the equilibrium line.
Where can the producer incidence of tax be seen on a graph?
Below the equilibrium line.
What does consumer incidence of tax + producer incidence of tax equal?
Total revenue earned by the government.
What is a subsidy?
A grant from the government that is designed to reduce the costs of producer.
What direction do subsidies cause the supply curve to move to?
To the right.
Where can the consumer gain of a subsidy be viewed on a graph?
Below the equilibrium line.
Where can the producer gain of a subsidy be viewed on a graph?
Above the equilibrium line.
What does consumer gain + producer gain equal?
Total amount of spending by government.
What are the 3 main ways consumers don’t act rationally?
Herd mentality - this following what the majority or ‘relevant’ do, instead of maximising utility.
Habitual behaviour - this the tendency to stick with the current situation due to comfort. This is often linked to ‘playing safe’.
Computational weakness - some consumers may be unable or unwilling to make comparisons between prices.
