1.2 how markets work Flashcards
rationality
economic assumption that:
- individuals (consumers) aim to maximise utility (satisfaction)
- firms aim to maximise profit
demand
the quantity of good or service that consumers are willing and able to buy at any given price in a given period of time
law of demand
as price of a good increases, the quantity demanded of a good decreases
what causes contractions and extensions?
price
what causes shift lefts/rights?
factors other than price
factors that affect demand
- price
- consumer incomes
- price of other goods (substitutes, complements)
- consumer preferences
- time period
how does price affect demand
- price increases, demand decreases
- price decreases, demand increases
how do consumer incomes affect demand
- normal goods: incomes increase, demand increases
- inferior goods: incomes increase, demand decreases
how does price of other goods affect demand
- substitutes: higher price substitutes, demand for other substitute increases
- complements: price increases for one good, demand decreases for other good
how do consumer preferences affect demand
good advertising/ trends, demand increases
how does time period affect demand
- price expected to rise in future, demand increases
- price expected to fall in future, demand decreases to be bought later
normal good
rise in demand as incomes increase (eg: car, plane)
inferior good
fall in demand as incomes increase (eg: bus travel)
substitutes
a good that acts as an alternative to another good
complements
a good bought alongside another good
diminishing marginal utility
the more of an item that you use or consume, the less satisfaction you get from each additional unit
supply
the quantity of a good or service that producers are willing and able to sell at any given price in a given period of time
law of supply
as price of a good increases, the quantity supplied of a good increases
factors that affect supply
- price
- costs of production and technology
- taxes and subsidies
- prices of other goods (joint supply and competitive supply)
- number of firms in market
how does price affect supply
- price increases, quantity supplied increases
- price decreases, quantity supplied decreases
how do costs of production and technology affect supply
- cost of production increases, supply decreases
- cost of production decreases, supply increases
- new technology introduced, supply increases
how do taxes and subsidies affect supply
- tax imposed by gov, supply decreases
- subsidy imposed by gov, supply increases
how does the price of other goods affect supply
- goods in joint supply (eg: sheep produce wool + meat): price of one good increases, supply increases
- goods in competitive supply (two goods produced by the same firm, eg: carrots and potatoes): price of one increases, supply decreases
how does the number of firms in a market affect supply
- more firms join market, supply increases
- firms go out of business, supply decreases
price elasticity of demand
the responsiveness of quantity demanded to a change in price
PED formula
% change in quantity demanded / % change in price
will PED always be negative or positive
negative
PED= 0
perfectly inelastic
PED= between 0 and -1
price inelastic
PED= -1
unitary elastic
PED= between -1 and infinity
price elastic
PED= infinity
perfectly elastic
factors affecting PED
- the availability of substitutes
- necessity or luxury good
- proportion of income spent on good
- time period
how does the availability of substitutes affect PED
- demand is elastic the more substitutes
- demand is inelastic if no substitutes
how do necessities or luxury goods affect PED
- demand is elastic if luxury good
- demand is inelastic if necessity
how does the proportion of income spent on a good affect PED
- demand is elastic if takes up a significant proportion of income (eg: car)
- demand is inelastic if only takes up a small proportion of income (eg: magazine)
how does time period affect PED
- demand is elastic over time as consumers will have time to accept an adjust to changes
- demand is inelastic in the short term as consumers will have less time to adjust
total revenue
TR= price x quantity
how does PED affect total revenue
- if a good has elastic demand, the firm will benefit from an decrease in price to increase total revenue
- if a good has inelastic demand, the firm will benefit from an increase in price to increase total revenue
income elasticity of demand
the responsiveness of quantity demanded to a change in consumer incomes
YED formula
% change in quantity demanded / % change in consumer income
YED: normal good
- positive YED
- incomes increase, demand increases
- YED= between 0 and 1 (income inelastic)
- YED= greater than 1 (income elastic- then considered a luxury good)
YED: inferior good
- negative YED
- incomes increase, demand decrease
- YED= between 0 and -1(income inelastic)
- YED= below -1 (income elastic)
cross elasticity of demand
the responsiveness of quantity demanded for good A to a change in price of good B
XED formula
% change in quantity demanded of good A / % change in price of good B
XED: substitutes
- positive XED
- fall in price of substitute, decrease demand of good
- XED= between 0 and 1 (weak substitute- inelastic)
- XED= greater than 1 (strong substitute- elastic)
XED: complements
- negative XED
- fall in price of complement, increase demand of good
- XED= between 0 and -1 (weak complement- inelastic)
- XED= below -1 (strong complement- elastic)
XED= 0
unrelated goods
price elasticity of supply
the responsiveness of producers of quantity supplied to a change in price
PES formula
% change in quantity supplied / % change in price
will PES always be negative or positive
positive
PES= 0
perfectly inelastic supply
PES= infinity
perfectly elastic supply
PES= between 0 and 1
inelastic supply
PES= greater than 1
elastic supply
factors affecting PES
- time period
- availability of factors of production
- mobility of factors of production
- shelf life of product
how does time period affect PES
- short run (period in which there is at least one fixed factor of production) - likely to be inelastic as producers cannot quickly change supply
- long run (period in which there are no fixed factors of production-all flexible) - likely to be elastic as producers can easily change supply
how does the availability of factors of production affect PES
- elastic if readily available
- inelastic if not readily available
how does the mobility of factors of production affect PES
- elastic if high mobility
- inelastic if low mobility
how does the shelf life of a product affect the PES
- elastic if long shelf life
- inelastic if short shelf life (perishable) as cannot be stored for long periods of time
market equilibrium
quantity demanded = quantity supplied
excess supply
price of the good is above the market equilibrium (top triangle)
excess demand
price of the good is below the market equilibrium price (bottom triangle)
producer surplus
the difference between the selling price and the price the producer is willing to sell the product for (bottom left triangle)
consumer surplus
difference between the consumer’s willingness to pay and the price paid for the product (top left triangle)
functions of the price mechanism
- signalling
- incentives
- rationing
why might consumers not behave rationally
- habitual behaviour where consumers persist in acting in a particular way even if costly
- people make decisions based on the actions of others than a rational evaluation (eg: trends)
