1.2 how markets work Flashcards
what do consumers try and maximise
utility
what do firms try and maximise
revenue
what is demand
The quantity of a good or service that that consumers are willing and able to purchase at each and every price over a given time period.
What is marginal utility?
The satisfaction gained from consuming one extra unit of a good or service
Define diminishing marginal utility and how does this explain the shape of the demand curve
As one consumes more of a good, the satisfaction gained from each extra unit will fall. As marginal utility falls from each extra good consumed, it means consumers will only buy more of it if the price falls - hence the downward sloping curve.
what’s the substitute effect
As the price of a good falls, it appears cheaper in comparison to substitute goods. So it’s likely that people will switch to buying it.
What is PED?
The responsiveness of demand for a good or service to a change in its price.
What is the formula for PED?
percentage change quantity demanded ÷ percentage change price
What does PED > (-) 1 mean?
Demand is price elastic.
A small change in price leads to a greater change in demand
What does PED < (-) 1 mean?
Demand is price inelastic.
A change in price leads to a smaller change in demand
What does PED = (-) 1 mean? draw the curve
Demand has unit price elasticity
A percentage change in price leads to an equal percentage change in quantity demanded
What does PED = 0 mean?
Demand is perfectly inelastic
A change in price has no effect on the quantity demanded
What does PED = infinity mean?
Demand is perfectly elastic
A rise in price will cause demand to fall to zero
What factors affect PED?
- Availability of alternatives (more alternatives means PED more elastic as people will switch)
- Luxury vs Necessity goods (luxury’s have elastic PED as its not.needed)
- The proportion of income spent on good (if it’s small it becomes in elastic as small price)
- Addictive + habit forming goods (PED is elastic as can’t quit)
- Time period
- Brand image
- Breadth of definition
PED is significant when assessing burden of indirect taxation or incidence of subsidy - explain.
If the PED of a good/service is relatively inelastic, if the government puts and indirect tax on it, the consumer carries the majority of the tax burden and vice versa.
Likewise, if the demand for a g/s is inelastic, the consumer is going to receive majority of the subsidy.
What is YED?
responsiveness of demand to changes in real income
What is the formula for YED?
percentage change in quantity demanded ÷ percentage change in real income
What is the YED for normal goods?
Positive
0<y<1: Relatively income inelastic, necessity good
e.g. cars, books
1<y: Relatively income elastic, luxury good
e.g. chauffer driven car
A small increase in income leads to a bigger increase in quantity demanded.
N.B. Luxury and necessity goods are still types of normal good
What is the YED for inferior goods?
Negative
This is because people tend to demand higher-quality goods as their incomes rise, substituting them for lower-quality products
YED is significant to a firm when assessing the impact of income changes, why?
Knowing their income elasticity will allow them to plan for higher or lower profits if they can predict a rise or fall in incomes, such as knowing the economy is going into recession.
what is XED
The responsiveness of demand for one good to changes in prices of the other
What is the XED for substitutes?
POSITIVE, XED>0
e.g. tea and coffee
one good could replace the other, they are in competitive demand
What is the XED for compliments?
Negative, XED<0
What does XED = 0 mean?
The two goods are unrelated
XED is significant to a firm when the prices of related goods change, why?
Firms should monitor the prices of any substitutes if they have a positive XED. Predicting price changes of complements can help them force their future profits.
What is supply?
The quantity of a good or service that firms are willing and able to sell at each and every price over a given time period.
Why does the supply curve slope upward?
- As the price of a good rises, there is an incentive to supply more since the firm might achieve higher profits.
- As the price goes up, more firms are encouraged to enter the market
- As output increases in the short run, firms will have higher costs and will pass these onto consumers in the form of higher prices.
What is price elasticity of supply?
Supply is the amount of a certain good that a seller is willing and able to provide to buyers
What does PES > 1 mean?
supply is relatively price elastic.
The percentage change in supply is greater than the percentage change in price.
What does PES < 1 mean?
supply is relatively price inelastic.
The percentage change in supply is less that the percentage change in price.
Steep gradient.
What does PES = 1 mean?
supply is unit elastic.
Bisects the origin.
What does PES = 0 mean?
supply is perfectly inelastic.
A change in price has no effect on the quantity supplied.
Vertical line.
What does PES = infinity mean?
supply is perfectly elastic
What factors determine the size of PES ?
- Level of spare capacity
- State of the economy
- Level of stocks of finished goods in firm
- Perishability of the product
- Ease of entry to an industry
- Time period
What is difference between short and long run and how does this affect PES?
In the short run at least one factor of production is fixed. New firms cannot join as they are unable to gather all the FOP needed to produce the goods. New firms will join the market in the long run.
PES will probably be inelastic in the short run and elastic in the long run. This is because firms will find it harder to adjust to a change in price in the short run.
Define equilibrium
The price where the quantity demanded equals the quantity supplied for a good or service in a market. This is the market clearing price.
What is the price mechanism?
The use of market forces to allocate resources in order to solve the economic problem of what, how and for whom to produce
Explain the ‘signalling’ function of the price mechanism.
- Price changes send contrasting messages to consumers and producers about whether to enter or leave a market.
*Indicates changes in the conditions of demand or supply
e.g. an increase in price signals that demand is high and that firms should increase production
Explain the ‘incentive’ function of the price mechanism.
- An incentive is something that motivates a producer or consumer to enter or leave a market.
- Higher prices -> incentive for process to supply more because of the possibility of greater revenue and therefore profits. Also acts as an incentive for new firms to enter the market
*Likewise, if prices fall, firms will be motivated to leave
What is a tax?
A compulsory charge made by the government, on goods, services, incomes or capital
Define indirect taxes.
Taxes imposed on goods or services supplied by businesses.
What are the 2 types of indirect taxes? Define both and draw the diagrams
Specific tax: Flat rate taxes that are charged as a fixed amount per unit of good
e.g. excise tax, duty on alcohol
Ad valorem tax: Tax is a percentage of the unit cost of supplying the product. The size of the tax varies at each and every price point.
e.g. VAT 20% (0% on children’s clothing, 5% on utilities)
Define direct taxes
Taxes levied on income and wealth
e.g. income tax, inheritance tax, pay as you earn. They cause a shift left in demand
What does the introduction of indirect taxes do to costs? Which curve will shift?
Indirect taxes increase costs of production at each an every price point. Price per unit increases to pass costs onto consumers. There is shown by a parallel shift left in supply for specific taxes and a rotation upwards about the intercept with the vertical axis for ad valorem taxes. The market price increases causing a contraction in demand.
How does elasticity affect the incidence of tax?
If demand is more price inelastic or supply is more price elastic, the consumer bears most of the tax burden.
Define subsidy.
A government grant given to firms, which reduces costs of production and encourages an increase in output
How does elasticity affect the effectiveness of subsidies
If supply is more elastic, the quantity won’t increase by much but the consumer will have a higher proportion of the subsidy.
If demand is more elastic, quantity will increase a lot more, and the producer will receive a higher proportion of the subsidy.
Explain habitual behaviour as a reason why consumers may not always act rationally?
- Habits may represent short cuts in decision making. e.g. using a rule of thumb saves time and effort even though it doesn’t give an exact answer when making a decision, it is sufficiently accurate to justify using it.
- Consumers may feel like it’s not worth the time and effort to get 100% of the information needed.
- Lack of self-control over addiction: alcohol, food
Explain other people’s influence as a reason why consumers may not always act rationally?
- Consumers may not pick the most efficient good for maximising their utility because other people have given bad reviews or because they wish to buy the same good as everyone else
- Choices which are influenced by social norms
- The desire to fit in may make people buy more expensive items
- Peer-pressure
Explain computational weakness as a reason why consumers may not always act rationally?
- People may not have all the information readily available to them in order to make rational and well-informed decisions.
- Prices and offers are often presented in ways where consumers find it difficult to do the mathematics required for a comparison. Some firms deliberately exploit this difficulty by presenting information in a disjointed way
- Some calculations take too much mental effort, while some people may not be capable to do some mentally
- Humans are unable to rationalise large amounts of information and may take ‘mental shortcuts instead of calculating the best option precisely
What do governements maximise
Social welfare
Voted in by public and serve the public
What causes the demand curve to shift
Less demand or more demand which differs by the conditions of demand (PIRATES)
Population
Income
Related goods
Advertising
Taste or fashion
Expectations
Seasons
More/less good demanded for a higher/lower price
What causes a movement along the demand curve
A change in the price of good
What is total utility
Represents the satisfaction gained by a customer as the result of their overall consumption
What happens when PED is elastic inelastic or unitary elastic
Elastic is when a decrease in price leads to an increase in revenue
Inelastic is when an increase in price leads to an increase in revenue
Unitary elastic is when price doesn’t effect revenue
