1.2 How markets work Flashcards
What is utility
Total amount of satisfaction experienced when a product or service is consumed
What is the underlying assumption of rational economic
decision making for consumers
seek to maximize their overall utility
What is the underlying assumption of rational economic
decision making for firms
Rational firms aim to maximize their profits to ensure business sustainability and growth
What is demand
The quantity of goods or services that consumers are willing and able to buy at a given price
What causes movement along the demand curve
A change in price
What causes a movement along the demand curve
A change in price
What is diminishing marginal utility
As a person consumes more of an item or product, the satisfaction (or the utility) they derive from it decreases
What is price elasticity of demand
Measures the responsiveness of demand after a change in price
What is the formula for PED
%∆ in quantity demanded / %∆ in price
What does elastic mean
Very responsive to change in price
What does inelastic mean
Not responsive to change in price
If PED between 0 & 1…
Demand is relatively inelastic
If PED > 1…
Demand is relatively elastic
If PED = 0…
Demand is perfectly inelastic
If PED = ∞
Demand is perfectly elastic
If PED > 1
Demand is relatively elastic
What factors determine PED (inelastic)
- Price of product in relation to total income
- Cost of substituting between different products
- Brand loyalty and habitual consumption
- Degree of necessity
What factors determine PED (elastic)
- No* of close substitutes
- Degree of necessity - luxury
How is PED useful for producers
If elastic - can maintain price to increase profitability
If inelastic - will increase price to increase profitability
What is YED
Shows how responsive the demand for a product is based on change in real income
What is the formula for YED
%∆ in quantity demand / %∆ in real income
What is a normal good
As income increases, demand increases
What is a inferior good
As income increases, demand decreases
What is the YED of a luxury good
YED > 1
What is the YED of a necessity
0 < YED < 1
What is the YED of a inferior good
YED < 0
What is XED
Measures the responsiveness of demand for one good after a change in the price of another good
What is the formula for XED
(%∆ in Quantity Demanded of Good A) / (%∆ in Price of Good B)
What is a substitute good
a product or service that can be used in place of another product or service
What is a complimentary good
Two or more goods typically consumed or used together
What are unrelated goods
The price change of one good has no effect on the other
How does XED benefit firms
Substitutes: Firms will upgrade advertisement to ensure customers don’t switch
Complimentary: Firms will produce goods that have to be purchased together
How are elasticities significant to firms
- use elasticities to set prices
- helps to decide how much to tax
How do taxes differ based off of it’s elasticity
Elastic goods = see reduced consumption due to tax
Inelastic goods = can bear higher taxes
What is elastic demand
Quantity demanded is highly responsive to price changes
What is inelastic demand
Quantity demanded is not responsive to change in price
How are elasticities significant to government
- Used to make taxation decisions.
- Subsidies can encourage the consumption of essential goods
- Can implement price controls and regulations
What is supply
The quantity of a good or service that producers are willing and able to supply onto the market
What causes a movement across a supply curve
A change in price
What causes a shift across a supply curve
- Production cost
- Weather conditions
- Technological Advancements
- Government Policies and Regulations (i.e taxes, subsidies)
What is PES
measures the responsiveness of the quantity supplied of a good to changes in its price.
What is the formula for PES
(%∆ in Quantity Supplied) / (%∆ in Price)
If PES is perfectly elastic
PES = ∞
If PES is perfectly Inelastic
PES = 0
If PES is relatively Elastic
PES > 1
If PES is relatively Inelastic
0 < PES < 1
What factor affect PES
- Time period and production speed
- Ease and cost of substitution to produce other goods
- Spare capacity (raw material available)
What is equilibrium and what does it mean for buyers and sellers
Price at which demand is equal to supply
* Allows for buyers to purchase everything they want
* Allows for producers to sell produced goods at a price that covers costs and earns profit
What is the affects of excess demand
- Price is below equilibrium price
- Puts upwards pressure on price to reduce demand
- Leads to shortages
How does excess demand affect firms and consumers
- Firms increase pricing to improve profitability
- Consumers have to pay more
What is the affect of excess supply
- Price is above equilibrium
- Puts downwards pressure on price
- Potential for wastage
How does excess supply affect firms and consumers
- Firms will lower price to be able to sell
- Consumers have to pay less
What are the functions of the price mechanism
- Rationing
- Incentive
- Signalling
How does rationing work
Through the price mechanism the price increases to reduce demand and ensure that the limited supply is allocated to those willing to pay the highest price
How does incentive work
In the price mechanism, higher prices incentivize producers to supply more to maximise profit, while lower prices discourages producers to supply
How does signalling work
- Rising prices signal increased demand or a shortage, -> producers to supply more.
- Falling prices signal decreased demand or surplus -> producers to reduce supply
How does price mechanisms work in local markets
- People in a specific area may demand more of certain things
- If it’s hard to get products to a certain place, there might be less supply, causing prices to rise
- Different areas may prefer different products
How does price mechanisms work in national markets
- Broader trends, like shifts in consumer preferences, technology, or global events
- Government policies (taxes, subsidies, or regulations)
- Takes into account the total demand for goods and services from all consumers in the country
How does price mechanisms work for global markets
- If supply is low prices are high everywhere (i.e oil)
- Natural disasteers can impact supply and prices
- what’s in demand in one place can affect prices everywhere (increaing prices)
What is consumer surplus
The difference between the price a consumer is willing to pay for a good and the price they actually pay.
What is producer surplus
The difference between the price a producer is willing to accept for a good and the price they actually receive
How does changes in demand affect consumer/producer surplus
- Increased demand raises prices, reducing consumer surplus but increasing producer surplus.
- Decreased demand lowers prices, increasing consumer surplus but reducing producer surplus.
How does changes in supply affect consumer/producer surplus
- Increased supply lowers prices, increasing consumer surplus but decreasing producer surplus.
- Decreased supply raises prices, reducing consumer surplus but increasing producer surplus.
n/a
n/a
How do indirect taxes impact consumers surplus
Higher taxes raise the price of goods, reducing consumer surplus and lowering demand.
How does higher indirect taxes impact producers
Increases production costs, reduces the price producers receive, and decrease producer surplus due to lower demand.
How does indirect tax impact Governments
Government: Receives tax revenue that can be used for public spending.
What is tax incidence
refers to who bears the burden of the tax (consumers or producers). If demand is more inelastic than supply, consumers bear a larger portion of the tax burden. If supply is more inelastic, producers bear a larger portion.
What is the impact of subsidies on coumers
Consumers: Subsidies lower the price of goods, increasing consumer surplus and encouraging more consumption
How does subsidies impact producer surplus
Producers: Receive higher prices or support from the government, increasing producer surplus.
How does subsidies affect the government
Government: Pays for the subsidy, which can lead to budgetary pressure
Why may consumers act irrationaly
- Influence
- Haitual behavour
- Consumer weakness at computation
How does influence cause irrationality
Consumers may follow trends or peer behavior, often making irrational choices based on social influence rather than rational decision-making.
How does habitual spending impact rationality
Consumers often make decisions based on habit rather than careful thought, continuing to purchase goods or services they’ve always bought without evaluating whether it’s the best choice.
