1.2) how markets work

Question 1

what are the economic objectives of the various agents?

Answer 1

• producers: maximise profit; survival, reinvestment, share
• consumers: maximize utility and/or income
• government: maximizes welfare; growth, full employment

Question 2

how does behavioural economics challenge traditional economic theory?

Answer 2

• suggests that it is not realistic to assume EA are rational and utility maximisers
• they assess the social, psychological, and emotional factors on decision-making

Question 3

what is demand?

Answer 3

the quantity of a good/service that consumers are willing and able to buy at a given price, at a particular time
- downward sloping curve; higher the price, lower the QD = law of diminishing marginal utility
- increase in price = contraction, decrease in price = extension
any movement along the demand curve is cause by changes in price

Question 4

when may the demand curve shift?

Answer 4

• left = decrease in amount demanded at every price, right = increase in amount demanded at every price

Question 5

what factors may cause a shift in demand?

Answer 5

• changes in tastes and fashion // seasons
• changes to real income - the amount they can afford to purchase with their income - diff types of goods
• price of substitute, complementary (joint demand) goods
• derived demand - demand for a good used in making another

Question 6

what are the different types of goods?

Answer 6

• normal - people demand more if their real income increases, right shift = more bought
• inferior - people demand less of if their real income rises, as they switch to more expensive goods
• luxury goods - an equal distribution of income would mean that more people could buy these

Question 7

what is price elasticity of demand?

Answer 7

how the quantity demanded of a good responds to a change in its price
- PED = % change in QD / % change in price

Question 8

what are different values of PED?

Answer 8

if PED:
- >1 = relatively elastic. %c in P will cause a larger %c in QD. HIGHER the value, more elastic
- perfectly elastic = infinity. any increase in price means demand will fall to 0
- 0 < x < 1 = relatively inelastic. %c in P will cause a smaller %c in QD. SMALLER the value, more inelastic
- perfectly inelastic = 0. any change in price has no effect on QD
- unitary PED = 1. %c in P = %c in QD

Question 9

what is income elasticity of demand?

Answer 9

how much the demand for a good changes with a change in real income
- YED = %c in QD / %C in P

Question 10

what are the different values of YED?

Answer 10

• YED > 1 = income elastic -> demand increases more than income does
• YED < 1 = income inelastic -> demand increases less than income does
• YED = 0 = perfectly inelastic -> income increase has no effect on demand

Question 11

what is cross elasticity of demand? and what are the values for XED?

Answer 11

how the quantity demanded of a good responds to the change in price of another good
- XED = %c of QD of good A / %c of P in good B

if substitutes -> POSITIVE - a fall in the price of one substitute will reduce the demand for another. the closer the sub, the higher the XED
if complementary -> NEGATIVE - an increase in the price of a good will reduce the demand for its complements
- unrelated goods have XED = 0

Question 12

what are the factors influencing PED?

Answer 12

• SUBSTITUTES - more subs a good has, the more price elastic it is because they can easily switch
• TYPE OF GOOD - essential? addictive? immediate services? multi-functional commodities?
• % of INCOME SPENT - anything that takes a large proportion of income is more likely to be price elastic because they are more likely to find the bests price for it e.g. a fridge
• TIME - in the LR demand becomes more elastic as it becomes easier to change to alternatives + change in habits and loyalties

Question 13

how are revenue and PED linked?

Answer 13

total revenue is maximised when PED = 1
if demand is elastic:
- reduction in P = increased revenue. increase in P = decreased revenue
if demand is inelastic:
- reduction P = reduction in revenue, increase in P = increase in revenue

Question 14

how is YED different for different types of goods?

Answer 14

• normal goods have a +IVE YED (0 < x <1). as incomes rise, demand increases
• luxury goods have YED > 1 - elastic
• inferior goods have -IVE YED. as incomes rise, demand falls. the inferior good is replaced with one deemed to be of higher quality

Question 15

what is supply?

Answer 15

the quantity of a good or service that producers supply to the market at a given price, at a particular time
- supply curve shows price and QS
- increase in price = extension in supply. decrease in price = contraction in supply
movement along the supply curve is caused by changes in price

Question 16

why does the supply curve slope upwards?

Answer 16

• the higher the price charged, the higher the quantity supplied
• this is because producers and sellers aim to maximise their profits so essentially, the higher the price, the higher the profit. gives them incentive to expand production
• BUT profit can only be made and firms will only produce more if the price increases more than the costs

Question 17

when may the supply curve shift?

Answer 17

• left shift - decrease in the amount supplied at every price, right shift = increase in the amount supplied at every price

Question 18

what factors may cause a shift in supply?

Answer 18

anything that affects the FoP
- increase in the cost of production decreases producers’profits. left shift
- improvements in tech, reduced CoP, right shift
- changes to the productivity of FoP, more output from a factor, right shift
- indirect taxes and subsidies, increases CoP, left shift
- change to the price of other goods (alternatives)??
- number of suppliers in the market will increase supply to the market, right shift

Question 19

what is price elasticity of supply (PES)?

Answer 19

how the quantity supplied of a good responds to a change in its price
- PES = %c in quantity supplied / %c in price
- generally positive, the higher the price,, the greater the supply

Question 20

what are the different values of PES?

Answer 20

if PES > 1:
- the supply of the good is relatively elastic, meaning that a larger %c in price will cause a larger %c in QS
- the higher the value, the more elastic supply is for the good

if PES = infinity: perfectly elastic supply, any fall in price will mean that QS will be reduced to 0

if 0 < PES < 1:
- the good is relatively inelastic, change in price will cause a smaller change in QS.
- smaller the value of PES, the more inelastic a good is

if PES = 0: supply is perfectly inelastic, change in price has no effect on thr QS supplied

Question 21

why is supply price elastic in the short run but not in the long run?

Answer 21

• in the short run, a firm’s capacity is fixed (+ one fixed FOP) like capital. it takes time to increase production the SR, so it is inelastic
• however, in the LR all FOP are variable so the firm is able to increase its capacity so supply is more elastic in the LR because firms have longer to react to changes in price and demand

Question 22

What are the main factors affecting PES?

Answer 22

TEASS
- state of the economy at the time: during period of unemployment, it is easy to attract new workers
- availability of FOP: mentioned above
- spare capacity: if they have this, a firm can quickly increase the supply of a good without an increase in costs (e.g. building new infrastructure)
- stockpiles: high stock is more elastic supply because they’re able increase supply quickly
- perishability: e.g. fresh fruits and flowers are inelastic in supply because they cannot be stored for long

Question 23

What is equilibrium price and quantity and how can these be determined?

Answer 23

• at equilibrium, price and output are stable as supply is equal to demand. all products presented for sale are sold and the market is CLEARED
• equilibrium point can be found where the supply and demand curves meet.
• when they arent equal, the market is in disequilibrium, leading to excess supply or demand

Question 24

how do the market forces in a free market act to remove excess supply?

Answer 24

• excess supply is when the QS > QD.
• if the price is set above the eq. price there would be an excess SUPPLY (surplus)
• this would cause the price to be forced down, supply to contract and demand to extend until the eq. price is reached

Question 25

how do the market forces in a free market act to remove excess supply?

Answer 25

• excess demand is when the QD > QS.
• if the price is set above the eq. price there would be an excess demand (shortage)
• this would cause the price to be forced up, supply to extend, and demand to contract until the eq. price is reached

Question 26

How is it assumed that consumers and producers act rationally in a competitive market?

Answer 26

• consumers aim to maximise their own welfare + utility by buying goods/services that improve their quality of life
• producers compete to provide consumers with what they want, at the lowest price possible - so that they can maximise profit

Question 27

What are the three functions of the price mechanism?

Answer 27

Allocates goods and service by the forces of supply and demand - the ‘invisible hand’
- acts as an INCENTIVE - higher prices to encourage production, by providing other profits
- SIGNALLING - changes in price show change in supply and demand and act a signal to producers to produce more or less
- acts as a RATION of scare resources - if there is a high demand for a good, it supply will be limited and its price high so it can be restricted to those that can afford it

• also used to allocate capital goods, as well as consumer goods

Question 28

What are the advantages and disadvantages of the price mechanism?

Answer 28

+ resources will be allocated efficiently to satisfy consumers wants and needs
+ can operate without the cost of employing people to regulate it
+ what is produced is in the hands of the consumer
+ prices minimised as resources are used as efficiently as possible

• inequality in wealth and income
• under-provision of merit goods and vice versa, as the production of these wont be at the socially optimum level
• public goods not produced as there is no profit in making them
• people with limited skills will suffer unemployment or low wages

Question 29

What are consumer and producer surplus?

Answer 29

• consumer surplus is the difference between what they are willing to pay and what they actually pay (eq. Price) for a food or service
• usually top triangle of an ME diagram
• producer surplus is the difference between the price that a producer is willing to supply and the price they actually receive the g/s at (eq. Price)
• usually bottom triangle

Question 30

what is a subsidy?

Answer 30

• a subsidy money paid by the government to the producer of a good to make it cheaper than it would be otherwise
• sometimes provided to encourage the demand for a merit good e.g. gym memberships as the subsidy lowers the market price

Question 31

what is the purpose of a tax?

Answer 31

• governments can place indirect taxes on demerit goods to reduce its demand
• the presence of a tax aims to discourage people from buying it as the tax raises the market price

Question 32

how does a subsidy benefit both the consumer and the producer?

Answer 32

• subsidies encourage increased production and a fall in price, which leads to an increase in demand. so, a subsidy shifts the supply curve to the RIGHT
• if the demand is inelastic, consumer gain is greater => consumer gain is that by paying less than the good than they would’ve without the subsidy
• if the demand is elastic, producer gain is greater => that gained by receiving extra revenue from the government that they can keep

Question 33

how do taxes affect both consumers and producers?

Answer 33

• taxes increases the price of a good, causing demand to reduce. so, the supply curve shifts to the left
• relative proportion borne by the producers and consumers is depend on elasticity
• if the demand is inelastic, consumer burden is greater => they lose out by paying more for the good than if the tax wasn’t in place
  if the demand is elastic, producer burden is greater =>lose out by paying some of the revenue to the govt