1.2 - How markets work Flashcards
What is diminishing marginal utility?
The marginal utility of extra units decline as more is consumed
Marginal utility - the change in satisfaction from consuming an extra unit
Assumptions of rational economic decision making
- Consumers are utility maximisers
- Firms are profit maximisers
What is demand?
The quantity of a good or service that you are willing and able to buy at a given price in a given time period
What is derived demand?
The demand for a factor of production used to produce another good or service (e.g. steel)
What is the Law of Demand?
Inverse relationship between the price of a good and demand
As price fall, we see an extension of demand
As price increase, we see a contraction of demand
Why is more demanded when price falls (2)
- Income effect
- Substitute effect
What causes shifts in demand (PASIFIC)
Population
Advertisment
Substitutes
Income
Fashion
Income tax
Complements
What is the price elasticity of demand (PED)
Measures the responsiveness of quantity demanded after a change in price
% change in QD / % change in P
PED = 0
Price is perfectly inelastic
PED = between 0 and 1
Price inelastic
PED = -1
Unitary elastic
PED = between -1 and infinite
Elastic
PED = infinite
Pefectly elastic
Factors affecting PED (SPLAT)
Substitutes
Proportion of income
Luxury vs necessity goods
Addictiveness
Time
What is the income elasticity of demand (YED)
The responsiveness in the quantity demanded to a change in income
YED = % change in Qd / % change in Y
Inferior goods - negative YED
Necessity goods - between 0 and 1 YED
Luxury goods - above 1 YED
What is cross elasticity of demand (XED)
The responsiveness in the quantity demanded of good A to a change in price of good B
XED = % change in Qd (Good A) / % change in P (Good B)
Complements - negative XED
Substitutes - positive XED
What is supply?
The quantity of goods and services that firms are willing and able to sell at a given price level
What is the law of supply?
As the price of a good / service increases, the quantity of a good / service increases (positive relationship between price of good and supply)
Why is more
What causes supply to shift (PINTSWC)
Productivity
Indirect taxes
Number of firms
Technology
Subsidy
Weather
Cost of production
What is the price elasticity of supply (PES)
The responsiveness of quantity supplied to a change in price
PES = % change in Qs / % change in P
What causes PES to shift (TRIBES)
Time period
Raw materials
Inventory
Barriers to entry
Ease of substitutes
Spare capacity
Value of PES (perfectly and relatively elastic, and perfectly and relatively inelastic)
Elastic - greater than 1
Perfectly elastic - infinity
Relatively elastic - greater than 1
Inelastic - below 1
Perfectly inelastic - 0
Relatively inelastic - between 0 and 1
What is the equilibrium
When the demand meets the supply
It can also be called the market clearing price
What are the 3 functions of the price mechanism?
- Rationing
- Incentivising
- Signalling
Explain rationing function
It allocates scarce resources among competing uses
When demand exceeds supply, prices rise, discouraging some consumers from buying
It ensures that goods are allocated to those consumers who are willing to pay the highest price
E.g. natural disaster - those in most urgent need are willing to pay more - resources are effectively allocated to those who need it the most
Explain incentive function
It provides incentive for producers to allocate scarce resources effectively
Higher prices = higher demand therefore motivating producers to produce more goods / services
Lower prices = lower demand therefore encouraging producers to reallocate resources
E.g. if the price of crude oil rises significantly, oil-producing countries have a greater incentive to increase production as they can earn higher revenue (leads to an increase in supply of the market)
Explain signalling function
Prices convey information about changing market conditions - allows consumers and producers to make informed decisions
Higher prices may signal potential shortage -> consumers conserve consumption and producers to increase supply
Lower prices may signal potential surplus -> consumers are prompted to buy more and producers to cut back on production
e.g. the fluctuations of gasoline prices can signal changes in global oil markets - if prices rise, then consumers may resort to public transport and producers to invest more in exploration and production
Difference between local, national and global markets
Local - supply and demand is determined within a specific geographic area
National - supply and demand is determined covers a country
Global - involves international trade of other economies
Factors influencing local markets (2)
Local factors:
- Weather
- Local preferences
E.g. the price of fresh produce at a local farm market may vary from seasonal changes and local supply
Factors influencing national markets
National policies and regulation
- Taxes
- Trade policies
E.g. the national housing market can be influence by government policies related to interest rates and mortgage regulation
Factors influencing global markets
- Currency exchange rates
- Global supply chains
- Geopolitical events
E.g. the price of oil in global market affects fuel prices around the world (impacting consumers and industries)
Definition of consumer surplus
The difference between what a consumer wants to pay for a good / service and how much they actually pay for it
Definition of producer surplus
The difference between what a producer wants to sell a good / service and how much they actually sell it for
What happens to consumer and producer surplus if demand increases
Consumer surplus increases as more people are willing to buy the good at a higher price
Producer surplus increases as they are able to charge at a higher price
What is the difference between Ad valorem and specific indirect tax
Specific indirect tax - a tax on production of every unit per output
Ad valorem - a tax on production
Definition of indirect tax
A tax imposed by the government to increase the supply cost of producers
Definition of subsidy
A grant by the government to boost production by reducing supply cost
Diagram for subsidy
Diagram for indirect tax (ad valorem and specific)
3 reasons why consumers behave irrationally
- Herd behaviour - consumers are influenced by the actions and behaviour of others (e.g. social norms, peer pressure - play significant role in decision making) - this is seen in fashion trends
- Habitual behaviour - consumers rely on habits and routines in decision making - this leads to suboptimal choices if they don’t re-evaluate their options - e.g. same brand of toothpaste, may not be the best
- Weak at computation - consumers struggle at complex calculations / lack access to information needed to make perfectly rational decision - limited cognitive abilities / information leads to suboptimal choices - e.g. comparing the cost per unit of different sized products
