1.2 How markets work Flashcards
Underlying assumptions of rational economic decision making
• consumers aim to maximise utility
• firms aim to maximise profits
• governments aim to maximise social welfare
What is demand
Demand is the ability and willingness to buy a particular good at a given price and at a given moment in time
What happens for a movement along the demand curve
A movement along the demand curve is caused by a change in the price of the good.
What happens for a shift in the demand curve
A shift in the demand curve is caused by a change in any of the factors which affect demand
What is the condition of demand
(What does condition mean not what are the conditions)
The conditions of demand are the factors which cause the demand curve to shift. A shift right is an increase in demand and a shift to the left is a decrease in demand
What are the conditions of demand
PIRATES
• population - increase in population, expect a rise in demand
• income - if income increases, demand increases
• related goods - substitute goods, complementary goods.
• advertising - good adverts, demand goes up
• taste/fashion - something more fashionable, demand goes up
• expectations - expectation of future can have impact. Expect a shortage, demand goes up
• Seasons - winter, puffer demand goes up
Relationship between the downward sloping demand curve and diminishing marginal utility
•assumption that consumers behave rationally
The law of diminishing marginal utility states that the satisfaction derived from the consumption of an additional unit of a food will decrease as more of a good is consumed.
If more of a good is comsumed, the less satisfaction from the good. This means that consumers are less willing to pay high prices at high quantities since they are gaining less satisfaction.
What is elasticity of demand
Elasticity of demand is an attempt to measure the responsiveness of quantity demanded to changes in other variables: its own price, the price of other goods and real income. If a good is elastic, it is relatively responsive and if it is inelastic, it is relative unresponsive
What is price elasticity of demand
(Word and equation)
The responsiveness of demand to a change in the price of a good
% change in quantity demanded
———————————————-
% change in price
Numerical values for :
Unitary elastic PED
relatively elastic PED
Relatively inelastic PED
Perfectly inelastic PED
perfectly elastic PED
Unitary electric is where PED =1
Relatively elastic PED > 1
Relatively inelastic PED < 1
Perfectly elastic PED = infinity
Perfectly inelastic PED = 0
Factors influencing PED
• availability of substitutes
• time
• necessity
• how large a % of total expenditure
• addictive
Why is PED significant
• PED determines the effect of the imposition of indirect taxes and subsidies
• the more elastic the D curve, the lower the incidence of tax on the consumer.
What is income elasticity of demand
The responsiveness of demand to a change in income
% change in quantity demanded
———————————————
% change in income
Numerical values for each type of goods YED
inferior good
Normal good
Luxury good
Inferior YED < 0
Normal good YED > 0
Luxury good YED > 1
Why is YED significant
• It is important for businesses to know how their sales will be affected by changes in the income of the population.
• it may have an impact on the type of goods that a firm produces.
What is cross elasticity of demand
The responsiveness of demand for one product (A) to the change in price of another product (B)
% change in quantity demanded of A
——————————————————
% change in price of B
Numeric values of YED for different type of goods
Substitutes
Complementary goods
Unrelated goods
Substitutes XED > 0
Complementary goods XED < 0
Unrelated goods XED = 0
Why is XED significant
Firms need to be aware of their competition and those producing complementary goods. They need to now how price changes by other firms will impact them so they can take appropriate action.
What is supply
Supply is the ability and the willingness to provide a good or service at a particular price at a given moment in time
What caused a movement along the supply curve
A moment along the supply curve is caused by a change in the price of the good
What causes a shift in the supply curve
A shift in the supply curve is caused by a change in any of the factors which effect supply, the conditions of supply
What are the conditions of supply
Cost of production - increase in costs likely shifts supply left and decrease in costs likely shifts supply right
Price of other goods - joint supply is where the production of one good automatically causes the production of another good. For example, beef and leather. If the price of beef goes up, more will get slaughtered and from that the supply of leather will shift right
Weather - agricultural goods for example is dependent on weather
Technology - new tech leads to fall in production costs, shift supply right
Goals of the supplier
Government legislation
Taxes and subsidies
Producer cartels
Why is the supply curve downwards sloping
• if prices are higher, firms will increase production. If prices are lower, firms will decrease production.
• higher prices will encourage new firms to enter, so output will increase
• to increase production, you will need to use up more resources which will cost more and you will only do this if you are going to receive more money. This assumes that the cost of producing a unit increases as output increases.
What is price elasticity of supply
(Word and equation)
The responsiveness of supply to a change in price of the good
% change in quantity supplied
——————————————
% change in price
Numerical values PES
unitary elastic
Relatively elastic
Relatively inelastic
Perfectly elastic
Perfectly inelastic
Unitary elastic PES = 1
Relatively elastic PES > 1
Relatively inelastic PES < 1
Perfectly elastic PES = infinity
Perfectly inelastic PES = 0
What factors affect PES
Time - will have an impact on the amount of a good that can be supplied at any price.
Stocks - if a business has a stockpile of goods, when the price goes up, they will simply decide to use up some or all of their stockpiles and therefore, supply will become more elastic
Working below full capacity - if a business is working below full capacity and there is an increase in price, they can easily respond by producing to their full capacity so the supply curve will become more elastic Working below
Availability of factors of production
Ease of entry into the market
Availability of substitutes
What is price determination
The equilibrium point refers to the point at which there are no more forces bringing about change. Price equilibrium is where supply is equal to demand.
When is there excess demand
If the price is set below the equilibrium, there is excess demand
When is there excess supply
If the price is set higher than the equilibrium, there is excess supply
What does the price mechanism do in a free market economy
Allocates resources
What is the rationing function of the price mechanism
The price system is a way of rationing goods because when price increases, some people will no longer be able to afford to buy the product and other may no longer have the desire to buy the good. The limited resources can be rationed and allocated to the people who are able to afford them and those who value them most highly.
What is the signalling function of the price mechanism
The price mechanism acts as a signal where resources should be used. When price rises, producers move resources into the manufacture of that product. The change in price indicates to suppliers and consumers that market conditions have changed so they should change the quantity bought and sold - when price equilibrium moves, output equilibrium moves with it
What is the incentive function of the price mechanism
It acts as an incentive for people to work hard. Buyers realise the more money they have the more they can buy. Suppliers realise the more they produce the more money they make.
How does the price mechanism work in a local market (supermarkets )
Covid meant supply chains disrupted. No imports, supermarkets less on shelves. Demand for food high, supply low, price of food rises to ration off excess demand so only consumers who value that food highly will buy.
How does the price mechanism work on a national market (housing market)
Price lf housing differs across the UK. High in south, low in north. London for example is the second largest financial hub and has high levels of tourism. This means that prices are high to ration off excess demand to provide housing to those who value the area the most
How does the price mechanism work in global markets (OPEC)
In 1973 OPEC declared an oil embargo. Skyrocketed price of oil. The disequilibrium of demand and supply meant that the high prices deterred consumers who didn’t value oil highly, leaving the market open only to those consumers who did.
What is the consumer surplus
Consumer surplus is the difference between the price the consumer is willing to pay and the price they actually pay, set by the price mechanism.
What is producer surplus
Producer surplus is the difference between the price the supplier is willing to produce their product at and the price they actually produce at, set by the price mechanism.
Perfectly elastic and inelastic demand effect on Consumer surplus
Perfectly elastic demand will mean that there is no consumer surplus.
Perfectly inelastic demand will mean that consumer surplus is infinite
The more inelastic demand, the higher consumer surplus is likely to be.
Effect of an increase/decrease in demand on the consumer and producer surplus
An increase in demand increased consumer and producer surplus.
A decrease in demand decreased the consumer and producers surplus
Effect of an increase/decrease in supply on the consumer and producer surplus
An increase in supply will lead to Ian increase in producer and consumer surplus
A decrease in supply would lead to a decreased in producer and consumer surplus
What is an indirect tax
An indirect tax is a tax on expenditure where the person who is ultimately charged the tax is not the person responsible for paying the sum to the government. The business is required to pay the tax but the customer is charged instead.
What is ad valorem tax
Ad valorem tax is a tax where the tax payable increases in proportion to the value of the good. The tax is a % of the cost of the good
On a graph, the supply curve tilts because the tax is a % of the value
For example, VAT
What is specific tax
Specific tax is where an amount is added to the price. The tax increased with the amount bought rather than the value of goods
For example, excise duties on alcohol, tobacco and petrol are a specific amount.
Impact of a specific tax on supply, price and output
Supply shifts left
Price increases
Output decreases
Impact of tax on producers and the government
The producer sees a rise in costs and a fall in output.
The government gains tax revenue
What is the incidence of tax
(Also in terms of elasticity)
The incidence of tax is the tax burden on the taxpayer
If the demand curve is perfectly elastic, the supplier will pay all the tax. If the demand curve is perfectly inelastic or the supply curve is perfectly elastic, all the tax will be passed onto the consumer.
What is a subsidy
A subsidy is a grant given by the government and is the opposite of tax. It’s an extra payment to encourage production / consumption of a good or service.
Effect of a subsidy on:
Supply
Output
Price
Increase in supply
Increase in output
Fall in price
How does the influence of other people effect rationality
Assumption that people act to maximise benefits but sometimes individuals can be influenced by social norms. (Bias). Someone may do something to fit in. They will become unwilling to change the bias even if it benefits them
How does the influence of habitual behavior effect rationality
Most people have habits and these reduce the amount of time it takes to do something, because consumers no longer have to consciously think about their actions. Habits creases a barrier to to decision making as they limit or prevent consumers considering an alternative.
How does consumer weakness at computation effect rationality
Many consumers aren’t willing or able to make comparisons between prices and so they will buy more expensive goods than needed, for example, many customers buy multipack goods because they assume they are cheaper but this is not always the case.
Also some consumers are are poor at self control and so do things they know they shouldn’t.
