1.2 - How Markets Work Flashcards
What is the income effect
when prices fall, consumers can afford a greater quantity of goods and services (assuming income is fixed), so demand for these goods and services increases
What is the 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 and demand for the costlier good decreases
What happens to demand for normal and inferior goods when income increase
Normal - demand increases
Inferior- demand decreases
What is marginal utility
marginal utility is the extra benefit to an individual of consuming a good or service
What does elasticity measure
the responsiveness of one variable to the change in another variable
Formula for PED
% change in quantity demanded / % change in price
Formula for Income elasticity of demand (YED)
% change in quantity demanded / % change in income
Formula for cross price elasticity of demand (XED)
% change in quantity demanded of good A / % change in price of good B
What does it mean when PED is greater than 1, less than 1, equals infinity, equals 0, equals 1
PED > 1- elastic demand
PED < 1- inelastic demand
PED = infinity- perfectly elastic
PED = 0-perfectly inelastic
PED = 1- unitary elastic
What type of good has YED: greater than 0, greater than 1, less than 1
YED > 0 = normal goods
YED > 1 = luxury goods
YED < 0 = inferior goods
When is XED positive, negative, and close to 0
XED > 0 = substitute goods
XED < 0 = complement goods
XED = 0 = unrelated goods
What affects elasticity of demand (5)
Availability of substitute goods /services
Types of good
Impact of indirect taxes
Impact of subsidies
Percentage of income and time
What does it mean for elasticity of decreasing price increases total revenue
Elastic demand
What does it mean for elasticity if increasing price increases total revenue
Inelastic demand
Why do firms aim for high elasticity of supply
So they can react rapidly to changes in price and demand
How do firms increase supply elasticity
Improve tech
Introduce flexible working patterns
Have excess production capacity
What is the formula for price elasticity of supply (PED)
% change in quantity supplied / % change in price
When is supply elastic
PES > 1
When is supply inelastic
1 > PES > 0
When is supply unitary elastic
PES = 1
What factors effect PES (3)
Perishable goods
Recessionary period (increases)
Agility
What is the difference between the quantity demanded and quantity supplied
Excess supply
What happens when quantity demanded excess quantity supplied
There is excess demand
What does the price mechanism use to achieve an efficient allocation of resources
The invisible hand
Why is the price mechanism free from bias
Is it governed by lots of agents interacting rather than an individual
What are the 3 functions of the price mechanism
Incentive function
Signalling function
Rationing function
What is the consumer and producer surplus
the benefit that goes to different economic agents as a result of buying and selling goods in the market
What is the total surplus
total benefit to society of economic agents buying and selling a particular good or service (producer + consumer surplus)
What are indirect taxes
Taxes on consumption
What does it mean if a tax is imposed with inelastic demand
Lots of the tax is passed onto the consumer and little absorbed
What happens if a tax is imposed on perfectly elastic demand
Producers bear the whole burden of the tax
What do traditional economists assume
Economic agents act perfectly rationally to maximise utility
What are theories of irrationality (3)
Asymmetric information
Limits on time
Computational weakness
What is availability bias
We assume things that happen in the past are more likely to occur again
