1.2 How Markets Work Flashcards
What are the three main underlying assumptions regarding rational decision making?
Consumers wish to maximise utility
Firms wish to maximise profit
Governments aim to maximise social welfare
What is demand?
Demand is the ability and willingness for consumers to buy a good or service at a given time for a given price.
What causes movements and what causes shifts in demand?
Movements are caused by changes in price, shifts are caused by non price factor
What causes changes in demand (PIRATES)?
Population
Income
Related Goods
Advertising
Trends
Expected Value (increase price later)
Season
Why does the demand curve slope down?
The Law of Diminishing Marginal Utility - as you consume more the utility derived is lower therefore you will be less likely to pay a higher price
What is the Law of Diminishing Marginal Utility?
The additional utility derived from consuming one extra unit of a good or services falls as units of consumption increases
What is Price Elasticity of Demand?
The responsiveness of demand to a change in price
%Δ Q / %Δ P
What factors affect PED? (SAINT)
Substitutes
Addictiveness
Income
Necessity
Time
Why is PED important?
When governments have plans of impositions of tax or subsidies, PED determines where the burden of the tax will lie
What is Income Elasticity of Demand? (YED)
The responsiveness to demand to a change in income
%Δ Q / %Δ Y
What do the numerical values of YED suggest?
YED<0 Inferior Good
YED>0 Normal Good
YED>1 Luxury Good
What is the significance of YED?
If firms know that the economy is about to go into a boom or a recession they can prioritise the production of normal or inferior goods to boost sales
What is the cross elasticity of supply? (XED)
The responsiveness of a price change of one product to a change in quantity of another product
What do the values of XED mean?
Complements are negative
Substitutes are positive
What is supply?
Supply is the willingness and ability of firms to provide a good or service at a given price over a given period of time
What are the conditions of supply? 8
Cost of production
Price of other firms
Tax/Subsidy
Legislation
Technology
Cartels
Firms objectives
Weather
What is price elasticity of supply?
The responsiveness of supply to a change in price
What are the factors that affect PES? (6)
Ability to stockpile
Time
Availability of Factors of Production
Availability of Substitutes
Barriers to Entry
Wether working at full capacity or not
What is Excess Demand?
When the market clearing price is set below the market equillibrium
What is Excess Supply?
When the market clearing price is set above the market equillibrium
What are the three functions of the price mechanism?
Signalling
Rationing
Incentive
What is the rationing function?
When there is excess demand, firms will increases prices and consumers will be rationed off who cannot afford to pay higher prices
What is the signaling function?
When there is excess demand, it will signal to producers that stocks are selling out immediately and will alert them they are supplying too little
What is the incentive function?
When there is excess demand. firms have the incentive to increase prices so they can make more profit.
What is consumer surplus?
This is the difference between what consumers are willing to pay and what they actually pay
What is producer surplus?
This is the difference in what firms are willing to supply at and what they actually supply at
What is indirect taxation?
This is tax placed on a good or service.
What is a subsidy?
A grant given from the government to lower firms cost of production
What explains why consumers may not behave rationally?
Herd Behaviour
Lack of Computation
Habitual Behaviour
