1.2 How markets work Flashcards
Real Income
- Income that has been adjusted to account for inflation
6 Conditions of Demand
- Changes in Real Income
- Changes in taste/fashion
- Advertising/ branding
- Changes in the prices of substitute goods
- Changes in the prices of complementary goods
- Changes in population size/distribution
Rational economic behaviour (1)
- A decision-making process by individuals and firms in which they act to maximise their welfare
Effective Demand (3)
- The quantity of the good people are willing and able to buy
- At any given price
- Over a period of time
Supply (3)
- The quantity of the good firms are willing and able to offer for sale
- At any given price
- Over a period of time
DMU (3)
Diminishing Marginal Utility
- The idea that satisfaction recieved
- From each extra unit
- Consumed falls
Price elasticity of demand (PED) (3)
- A measure of the responsiveness of the quantity demanded of a product
- To a change in its price
- In percentage terms
Income Elasticity of Demand (YED) (3)
- A measure of the responsiveness of the quantity demanded of a product
- To a change in income
- In percentage terms
Factors that affect the PED
- Availability of substitutes
- Addictiveness of the product
- Price of product as a proportion of income
- Time period
Normal goods (3)
- Any goods for which demand increases when income increaes
- This means that is the YED is positive
- The term does not refer to the quality of the good
Inferior goods (3)
- These are goods for which demand decreases when income rises
- This means that the YED is negative
- Inferiority in this sense, is an observable fact rather than a statement about the quality of the good
Factors that affect YED
- During a recession wages usually fall and demand for inferior goods rises and luxury goods falls
- During a period of economic growth and rising wages, demand for luxury goods increases and demand for inferior goods decreases
- Other influences on income include minimum wage legislation, taxation, increased international trade
YED is influenced by any factors in an economy which change the wages of workers
Cross elasticity of demand (XED) (3)
- A measure of the responsiveness of the quantity demanded of a product
- To a change in the price of another product
- In percentage terms
Interpreting XED Values
If XED>1 : Demand between the goods is Price Elastic (Strongly Related)
If XED<1 : Demand between the goods is Price Inelastic (Weakly Related)
Why is knowledge of PED important to firms?
- If their product is price inelastic in demand, they should raise their prices
- If price elastic in demand, then they should lower their prices
- In this way firms can seek to maximise their revenue
Why is knowledge of PED important to governments?
- If they tax price inelastic in demand products, they can raise tax revenue without harming firms too much
- Consumers are less responsive to price changes so firms will pass on the tax to the consumer
- If they subsidies price elastic in demand products, there can be a greater than proportional increase in demand
Why is knowledge of XED important to firms?
They seek to maximise their revenue
- It can help them to adjust pricing strategies for substitute and complementary goods
- It can help them understand the likely impact of competitors’ pricing strategies on their sales
Why is knowledge of YED important to firms?
- Firms should consider providing more inferior goods in a recessionary environment
- Firms should consider providing more luxury products during periods of economic growth
They seek to maintain sales and maximise profits through periods of recession or economic growth
What is the Revenue Rule of PED?
The total revenue rule states that in order to maximise revenue, firms should increase the price of products that are inelastic in demand and decrease prices on products that are elastic in demand
Price elasticity of Supply (PES) (3)
- A measure of the responsiveness of the quantity supplied of a product
- To a change in its price
- In percentage terms
PES is Always Negative due to the Lw of sUPPLY
What is the Law of Demand?
- The law of demand captures this fundamental relationship between price and QD
- It states that there is an inverse relationship between price and QD
- When price rises the QD falls
- When prices fall the QD rises
This relationship partly explains why the demand curve is downward sloping
What are Conditions of Demand?
- Factors that will change the demand for a good/service, irrespective of the price level (Causing a shift in the entire demand curve)
For example, if a firm increases their Instagram advertising, there will be an increase in demand as more consumers become aware of the product . This is a shift in demand from D to D1. The price remains unchanged at £7 but the demand has increased from 15 to 25 units
State the 6 Conditions of Demand:
- Changes in Real Income
- Changes in taste/fashion
- Advertising/branding
- Changes in the prices of substitute goods
- Changes in the prices of complementary goods
- Changes in population size/distribution
Conditions of Demand
How can Changes in Real Income Shifts the Entire Demand
Curve at Every Price Level?
Income that has been adjusted to account for Inflation
Conditions of Demand
How can Changes in Taste/Fashion Shifts the Entire Demand
Curve at Every Price Level?
Conditions of Demand
How can Advertising/Branding Shifts the Entire Demand
Curve at Every Price Level?
Conditions of Demand
How can Changes in the price of Substitute Goods Shifts the Entire Demand Curve at Every Price Level?
Two goods that could be used for the same purpose by the consumer
Conditions of Demand
How can Changes in the prices of complementary goods Shifts the Entire Demand Curve at Every Price Level?
Two goods that the consumer use together
Conditions of Demand
How can Changes in the population size/distribution Shifts the Entire Demand Curve at Every Price Level?
Define Marginal Utility:
- Marginal utility is the additional utility (satisfaction) gained from the consumption of an additional unit of a product
- The utility gained from consuming the first unit is usually higher than the utility gained from consuming the next unit
To calculate total utility, the marginal utility of each unit consumed is added together
This means that total utility keeps increasing even while marginal utility is decreasing
Factors that influence the PES
The factors that determine the responsiveness are called the determinants of PES
- Mobility of the factors of production
- Availability of raw materials
- Ability to store goods
- Spare capacity
- Time period
A diagram that demonstrates the share of a specific tax paid by the consumer (A) and the producer (B)
- The government places a specific tax on a demerit good
- The supply curve shifts left from S1→S2 by the amount of the tax
- The price the consumer pays has increased from P1 before the tax, to P2 after the tax
- The price the producer receives has decreased from P1 before the tax to P3 after the tax
- The government receives tax revenue = (P2-P3) x Q2
- The consumer incidence (share) of the tax is equal to area A - (P2-P1) x Q2
- The producer incidence (share) of the tax is equal to area B - (P1-P3) x Q2
- The QD in this market has decreased from Q1→Q2
- If the decrease in QD is significant enough, it may force producers to lay off some workers
Specific Tax - A fixed tax per unit of output
Demerit Good - Goods which have harmful impacts on consumers/societies
What is Equilibrium in a market?
- Equilibrium in a market occurs when demand = supply
- At this point the price is called the market clearing price
- This is the price at which sellers are clearing their stock at an acceptable rate
- Any price above or below P creates disequilibrium in this market
- Disequilibrium occurs whenever there is excess demand or supply in a market
Diagram and Explanation
Disequilibrium - Excess Demand
- At a price of P1, the quantity demanded of electric scooters (Qd) is greater than the quantity supplied (Qs)
- There is a shortage in the market equivalent to QsQd
- This market is in disequilibrium
- Sellers are frustrated that products are selling so quickly at a price that is obviously too low
- Some buyers are frustrated as they will not be able to purchase the product
- Sellers realise they can increase prices and generate more revenue and profits
- Sellers gradually raise prices
- This causes a contraction in QD as some buyers no longer desire the good/service at a higher price
- This causes an extension in QS as sellers are more incentivised to supply at higher prices
- In time, the market will have cleared the excess demand and arrive at a position of equilibrium (PeQe)
Different markets take different lengths of time to resolve disequilibrium. For example, retail clothing can do so in a few days. Whereas the housing market may take several months
When the supply is greater than the demand
Disequilibrium - Excess Supply
Face Mask Example
- At a price of P1, the quantity supplied of face masks (Qs) is greater than the quantity demanded (Qd)
- There is a surplus in the market equivalent to QdQs
- This market is in disequilibrium
- Sellers are frustrated that the masks are not selling and that the price is obviously too high
- Some buyers are frustrated as they want to purchase the masks but are not willing to pay the high price
- Sellers will gradually lower prices in order to generate more revenue
- This causes a contraction in QS as some sellers no longer desire to supply masks
- This causes an extension in QD as buyers are more willing to purchase masks at lower prices
- In time, the market will have cleared the excess supply and arrive at a position of equilibrium (PeQe)
Real World Example: Changes to Demand That Increase Price
During lock downs associated with the Covid-19 pandemic, furniture retailers experienced unexpectedly high demand for their products (especially desks and sofas)
- Due to the Covid mandated change of working from home, consumers experienced a temporary change in taste as they sought to set up comfortable home offices
- This led to an increase in demand for desks from D1→D2
- At the original market clearing price of P1, a condition of excess demand now exists
- The demand for desks is greater than the supply
- In response, suppliers raise prices
This causes a contraction of demand and an extension of supply leading to a new market equilibrium at P2Q2 - Both the equilibrium price (P2) and the equilibrium quantity (Q2) are higher than before
Real World Example: Changes to Supply That Increase Price
Ukraine is one of the world’s largest producers of wheat. During the Russian-Ukrainian war, exports of wheat have been halted India imported 13% of the nation’s wheat requirements from the Ukraine
- Due to the war in the Ukraine, India is experiencing a supply shock in its wheat market
- This causes a decrease in supply of S1→S2
- At the original market clearing price of P1, a condition of excess demand now exists (shortage)
- The demand for wheat is greater than the supply
- In response, sellers in India raise prices
- This causes a contraction of demand and an extension of supply leading to a new market equilibrium at P2Q2
- The equilibrium price (P2) is higher and the equilibrium quantity (Q2) is lower than before
Supply Shock - An unexpected event that suddenly changes the supply of a product
Real World Example: Changes to Demand That Decrease Price
Example : Demand for lobsters in Maine, USA has been falling steadily in recent months
This has resulted in a price fall from $12.35 /pound on the 1st April to $9.35 /pound on the 1st May
- In recent months the USA has been experiencing an increasing rate of inflation
- Inflation lowers the purchasing power of money in a consumer’s pocket and so effectively reduces their real income
- With reduced real income fewer luxuries are consumed
- This led to a decrease in demand for lobsters from D1→D2
- At the original market clearing price of P1, a condition of excess supply now exists
- The demand for lobsters is less than the supply
- In response, suppliers gradually reduce prices
- This causes a contraction of supply and an extension of demand leading to a new market equilibrium in P2Q2
- Both the equilibrium price (P2) and the equilibrium quantity (Q2) are lower than before
Real World Example: Changes to Supply That Decrease Price
Example : In order to help meet their climate targets and to lower energy costs for households, the EU is providing subsidies for solar panels
- To help meet its climate change targets and lower household energy bills the EU has provided a subsidy to solar panel retailers
- This causes an increase in supply of S1→S2
- At the original market clearing price of P1, a condition of excess supply now exists (surplus)
- The supply of solar panels is greater than the demand
- In response, sellers in the EU lower prices
- This causes an extension of demand and a contraction of supply leading to a new market equilibrium at P2Q2
- The equilibrium price (P2) is lower and the equilibrium quantity (Q2) is higher than before
Price Mechanism in a Local Market
Increase in Honey Consumption
- Due to a change in one of the conditions of demand (most likely change in tastes), the demand for honey in the local market has increased from D1→D2 and the price has increased from $15 to $18
- The higher price serves to ration a valuable product. Those consumers who can afford to purchase it at $18, receive it
- The higher price incentivises producers to allocate more factors of production to producing honey and this is evident from the extension in supply from Q1 to Q2
- The shift in demand signals to other producers that demand for honey is strong and they should consider entering the market
Price Mechanism in a National Market
The T-Shirt market in the UK is highly competitive. In 2018 the price of cotton fell
- Due to a change in one of the conditions of supply (a decrease in costs of production), the supply of T-shirts in the UK has increased from S1→S2 and the price has fallen from P1 to P2
- The lower price increases the number of consumers who can access this product. It is rationed more widely as there is an excess in supply
- The lower price incentivises consumers to purchase more T-shirts and this is evident from the increase in demand from Q1 to Q2
- The shift in supply signals to other producers that there is excess supply and they should consider leaving the market
Price Mechanism in a Global Market
- Cash crops such as wheat, oats, barley, soy, corn, sunflowers etc. can be grown using the same factors of production
- Many countries export excess crops into the world market
- Producers use world prices to guide their production decisions
- Farmers in France have been producing corn for many years and the market price is $2/kg. The price of potatoes in global markets has until recently been steady at $2/kg
- Due to a change in one of the conditions of demand (possibly an increase in global population), the demand for potatoes has increased from D1→D2 and the price has increased from $2/kg to $3/kg
- The higher price serves to ration the potatoes. Those consumers who can afford to purchase it for $3, receive it
- The higher price incentivises producers to allocate more factors of production to producing potatoes and this is evident from the extension in supply from Q1 to Q2
- The shift in global demand signals to producers in France that demand for potatoes is strong and they should consider switching some of their production from corn to potatoes
PMechanism at work in two related global markets, corn and potatoes
Interpreting PED Values
Interpreting YED Values
Market Equilibrium Diagram:
Excess Demand Diagram:
Excess Supply Diagram:
PED (Perfectly Elastic Diagram)
PED (Perfectly Inelastic Diagram)
PED (Unitary Elasticity Diagram)
PES : The responsiveness of Qs Given a change in Price
Elastic Supply Diagram:
PES > 1
PES > 1
* High Stock, Factory has Spare Capacity, Unemployment - Workers are readily available - Long Run (Factory could expand)
PES : The responsiveness of Qs Given a change in Price
Inelastic Supply Diagram:
PES < 1
PES : The responsiveness of Qs Given a change in Price
Perfectly Inelastic Supply Diagram:
PES = 0
PES : The responsiveness of Qs Given a change in Price
Perfectly Elastic Supply Diagram:
PES = ∞
