1.2 How Markets Work Flashcards
what is Homo Economicus
a rational individual that, when making choices, will always go for the option that maximises their utility
what does a rational consumer do
make choices to maximise their utility
what does a rational producer do
aim to maximise their profits (which allows them to maximise their utility to buy more G/S)
evaluation of rational decision making
this idea is flawed, since often people act emotionally, or partly emotionally, not fully rationally
what is demand
the amount of a G/S that a consumer is willing and able to purchase at a given price in a given time period
description of a demand curve
left to right downward sloping
negative/inverse relationship between price and QD
what is the law of diminishing marginal utility
where an individual gains less additional utility from consuming a product, the more of it is consumed
what are the reasons for a perverse demand curve
positional goods
conspicuous goods/goods of ostentation
Giffen goods
what are positional goods
goods which are very scarce and are desired for their ability to show success over other people
what are conspicuous goods
goods people like to buy to show social status or success
what are Giffen goods
staple products that consumers are willing to pay more for even if price rises. this limits RDY, making luxury products even more out of reach so consumption staples rises more as price does
what are the determinants of demand that will shift the demand curve
income - RDY
tastes/fashion
advertising/branding
price/quality of related goods
population + age structure
expectations of future prices
credit availability
seasonal demand
what is a normal good
one where QD increases as RDY increases
what is an inferior good
one where QD decreases as RDY increases
how does income affect demand
RDY directly determines how many G/S a consumer can purchase
how do changes in taste/fashion affect demand
if G/S become more fashionable, demand for them increases
how does advertising/branding affect demand
if more money is spent on advertising or branding, demand for the G/S will increase as more consumers are aware of the product
how does the price/quality of of related goods affect demand
increases in the price or decrease in the quality of substitute goods will increase demand for another good
how does the population/age structure affect demand
increases in population will increase demand overall
changes in the age structure of a population will also affect which G/S are in higher demand
what is marginal utility
the additional utility/satisfaction gained from the consumption of an additional G/S
what is the law of diminishing marginal utility
as additional products are consumed, the utility gained from the next unit is lower than that of the previous unit
how does the law of diminishing marginal utility explain the demand curve
when the first unit is purchased there is utility so consumers are willing to pay a high price, but as utility decreases consumers are not willing to pay as high a price
what is price elasticity of demand (PED)
the sensitivity of quantity demanded to a change in the price of a G/S
what is the equation for PED
%△ in QD / %△in P
what is the range of values on the PED scale
0 to ∞
what does a PED of 0 mean
perfectly inelastic. there is no change in QD after a change in P
what does a PED of 0 - 1 mean
relatively inelastic. the %∆ in QD is less than proportional
to the %∆ in P
what does a PED of 1 mean
unitary. the %∆ in QD is exactly equal to the %∆ in P
what does a PED of > 1 mean.
relatively elastic. the %∆ in QD is more than proportional to the %∆ in P
what are the determinants of PED
necessity vs luxury
quality + quantity of substitutes
price of a product as a proportion of income
time period (short run vs long run)
habit forming/addictiveness of product
number of compliments
what is income elasticity of demand (YED)
the sensitivity of quantity demanded to a change in consumer incomes
what is the formula for YED
%△ in QD / %△in Y
what is the range of values on the YED scale
-∞ to ∞
what does a positive YED mean
normal good
what does a negative YED mean
inferior good
what does a YED of 0 - 1 mean
relatively inelastic. normal necessity/staple
%△ in QD < %△in Y
what does a YED of > 1 mean
relatively elastic. normal luxury
%△ in QD > %△in Y
what does a YED of < 0 mean
inferior good. demand decreases when income increases
what are the determinants of YED
recessions vs economic growth/booms
minimum wage
taxation
what is cross price elasticity (XED)
the sensitivity of QD of good A to a change in price to good B
what is the formula for XED
%△ in QD good A / %△in P good B
what is the range of values on the XED scale
-∞ to ∞
what does an XED of 0 mean
there is no relationship between the goods
what does an XED of 0 - 1 mean
poor substitutes
what does an XED of > 1 mean
good substitutes
what does an XED of 0 - -1 mean
poor compliments
what does an XED of < -1 mean
good compliments
why is PED important to firms
helps them maximise their revenue.
if a G/S is PED inelastic, they should increase P
if a G/S is PED elastic, they should decrease P
to reach unitary PED
why is PED important to Goverments
gives them insight for taxation and subsidies
if tax is imposed when a G/S is PED inelastic, tax revenue can be increased without hurting firms too much
if a subsidy is imposed when a G/S is PED elastic, D will increase even more
why is XED important to firms
helps them maximise their revenue.
adjust pricing strategies for substitute and complementary goods
understand the impact of competitors’ pricing strategies
why is YED important to firms
helps them maintain sales and maximise profits in recessions/booms.
provide more inferior G/S in a recession
provide more normal G/S in a boom
what is the rule with total revenue and PED
in order to maximise revenue, when PED is inelastic firms should increase their price and when PED is elastic firms should decrease their price
what is supply
the amount of a G/S a producer is willing and able to supply at a given price in a given time period
what are all the determinants of supply to a firm
costs
what are the determinants of supply (costs)
costs of FOPs
indirect taxes + subsidies
new technology (increases productivity)
training (increases productivity)
government regulations/laws
weather + seasons
what is price elasticity of supply (PES)
the sensitivity of QS of a G/S to a change in P of that G/S
what is the formula for PES
%△ in QS / %△in P
what is the range of values on the PES scale
0 - ∞
what does a PES of 0 mean
perfectly inelastic. QS is completely unresponsive to a change in P
what does a PES of 0 - 1 mean
relatively inelastic. the %∆ in QS is less than proportional to the %∆ in P
what does a PES of 1 mean
unitary. the the %∆ in QS is equal to the %∆ in P
what does a PES of >1 mean
relatively elastic. the %∆ in QS is more than proportional to the %∆ in P
what does a PES of ∞ mean
perfectly elastic. the %∆ in QS will fall to zero with any %∆ in P. however, supply is unlimited at a particular price
what are the determinants of PES
mobility of FOPs
availability of FOPs
ability to store goods
spare capacity
time period
what is the short-run period of production
when at least one of the factors of production is fixed
what is the long-run period of production
when all the factors of production are variable
what is the CHOR for explaining dynamic markets
identify if the change refers to demand or supply
state which way the curve will shift
state the disequilibrium that now exists in the original market
state if sellers raise or lower prices to clear disequilibrium
explain the contraction or extension in demand to respond
state the new market equilibrium
explain the final market outcome
what is an indirect tax
as tax that firms pay when G/S are bought
what is an indirect subsidy
a payment to a firm from the government
what is a direct tax
a tax directly taken out of income
what is a direct subsidy
a payment to consumers from the government
what are the two types of indirect tax
specific tax (a set sum of money added to all G/S)
ad valorem tax (tax is a % of the total price of a G/S)
what half of the total tax revenue is the consumer incidence
top half
what half of the total tax revenue is the producer incidence
bottom half
who pays more of the incidence when there is an inelastic PED
consumer incidence is higher than producer incidence
who pays more of the incidence when there is an elastic PED
producer incidence is higher than consumer incidence
what does a specific tax look like on a supply + demand diagram
parallel left shift of supply
what does an ad valorem tax look like on a supply + demand diagram
diverging left shift of supply
what is consumer surplus
the difference between the amount a consumer is willing to pay for a G/S and the price they actually pay
what is producer surplus
the difference between the amount a producer is willing to sell a G/S for and the price they actually do sell it for
where is the consumer surplus on a supply + demand diagram
the triangle between the price level, the equilibrium and the top of the D curve
where is the producer surplus on a supply + demand diagram
the triangle between the price level, the equilibrium and the bottom of the S curve
what happens to producer and consumer surplus when there is an increase in supply
both surpluses increase
what happens to producer and consumer surplus when there is an increase in demand
both surpluses increase
what is allocative efficiency
allocating resources in such a way as to maximise net social welfare (NSW)
what is marginal social benefit (MSB)
value placed on a G/S by consuming an extra unit (represented by the D curve)
what is the price/market mechanism
the interaction of demand and supply in a free market that determines price which are the means by which scarce resources are allocated
what is marginal social cost (MSC)
additional cost of producing one extra unit - opportunity cost (represented by the S curve)
what are the four functions of the price mechanism
allocation
incentive to firms
signals to firm to increase or decrease production
rationing
what are the positives of the market mechanism
creates inequality - acts as an incentive to workers, stimulating economic growth
trickle down/invisible hand effect - wealth trickles down through the economy
what are the negatives of the market mechanism
creates inequality
who do rational people consider when making a decision
they act only in their own self interest
what are the causes of irrational consumer behaviour
imperfect or asymmetric information
social norms and conformity
habitual behaviour
weakness at computation
consumer inertia
short-term vs long-term costs and benefits
how does information affect the rationality of a consumer’s decision
imperfect information - not all information being available
asymmetric information - being provided with less information than is available
how does weakness at computation affect the rationality of a consumer’s decision
consumers are not able to gather all the information required to compute which options give them the highest net benefit
how do social norms and conformity affect the rationality of a consumer’s decision
peer pressure often influences consumers to buy things that may not be net beneficial to them
producers also influence consumers through advertising which results in consumers acting emotionally instead of rationally
how does habitual behaviour affect the rationality of a consumer’s decision
consumers often rely on habits to speed up their decision processes, using a ‘rule of thumb’ approach, or using information from the past to make decisions which may be outdated. consumer inertia then develops as convenience is prioritised
how does the short-term vs long-term affect the rationality of a consumer’s decision
consumers tend to see short-term costs or benefits much clearer than long-term costs or benefits, which skews their perspective on a decision
