1.2 - how markets work Flashcards
1.2.1
what does rational mean?
-economic agents are able to consider the outcome of their choices and recognise the net benefts
what is utility?
-the total satisfaction from a given level of consumption
what is marginal utility?
the change in satisfaction from consuming an additional unit
what will rational agents select?
the choice that provides the most benefits
assumptions about the rational consumer?
-consumers choose independently
-has fixed and consistent tastes
-gather complete information on the alternatives available on the market
-consumers always make an optimal choice
underlying assumptions of rational decision making?
-consumers aim to maximise utility
-firms aim to maximise profit
-gov aims to maximise social welfare
why do consumers act irrationally?
-habitual behaviour
-poor computational ability
-heuristics
-framing effects
1.2.2
what is demand?
-the qty of a good/service that a consumer is able and willing to pay for at a given price at a given time period
what is effective demand?
-must be willing and able to pay
basic law of demand?
-demand varies inversely with price
what is the demand curve?
-a graphical representation on the price and qty demanded by consumers
why does demand curve slope downwards?
-law of diminishing marginal utility [as qty consumed increases, price willing to pay decreases]
-income effect [as price falls consumers can buy more of a good with their income]
-substitutes
shifts in the demand curve?
-population
-income
-related goods
-advertising
-tastes
-expectations
-seasons
marginal utility?
-represents change in satisfaction from the consumption of the next unit of a good
law of diminishing marginal utility?
-the satisfaction derived from the the consumption of an additional unit of a good will decrease as more of a good is consumed
1.2.3
elasticity?
how responsive qty demanded is to a change in price
elastic?
-increase in P smaller than qty demanded
inelastic?
-increase in P larger than change in qty demanded
what is derive demand?
-the demand for a FOP used to produce another good/service
composite demand?
-exists where goods have more than 1 use
-an increase in demand for 1 good leads to fall in supply for another
eg milk
PED?
-price elasticity of demand
-always negative
-responsiveness of qty demanded to a change in the price
what determines PED?
-availability of substitutes
-time
-necessity
-brand loyalty
-addictiveness
-price of a product in relation to income
calculate PED?
%changeQtyD / %changeP
PED>1
= price elastic
-highly responsive
PED<1
=PRICE INELASTIC
-QD unresponsive to price change
why is PED always a negative number?
- demand curve shows an inverse relationship
total revenue?
price x qty
PED=0
- perfectly inelastic
-implies consumers are willing to pay any price
PED<1?
-INELASTIC
-rise in price = increase in total revenue
PED=1
-unitary price elasticity
-change in P met with a proportionate change in demand
-total spending by consumers remains the same at each price level
PED>1
–PRICE ELASTIC
-will increase revenue by decreasing price
PED = INFINITY
-perfectly elastic
-customers willing to pay 1 price
why is knowing PED useful to a producer?
-help firms to assess change in prices effect on revenue
-can be used by businesses to determine whether they should use price discrimination
-help firms to assess effect of a change in indirect tax and whether they can pass some or all onto the consumer
limitations of elasticities?
-problems with inaccurate or incomplete data collection
-PED varies by region/time
-not all firms are profit maximisers
-elasticity will vary within product ranges
-will change market strategies
YED?
-income elasticity of demand
-shows how responsiveness QD for a product is to a change in real income
calculate YED?
% change QD / % change Y
normal goods?
positive YED > 0
-increase in income = more of good demanded
normal neccestities?
-income inelastic YED < 1
-low but positive income elasticity
normal luxuries?
- YED > 1 elastic
-high and positive YED
inferior goods?
-negative YED YED < 0
- increase in income = less of good consumed
-fall of real income in a recession will cause demand for inferior goods to rise
XED?
-CROSS PRICE ELASTICITY OF DEMAND
-how responsive demand of a product is to a change in price of another good
calculate XED?
% change QDa / % change Pb
what are substitutes?
-products in competitive demand
- an increase in price of 1 good will lead to increase in demand of a rival product
-XED value for 2 subs always positive
close substitutes?
-small rise in price of A cause a large rise in demand for B
weak substitutes?
-large rise in price of A leads to a small increase in demand for B
what are complements?
-products in joint demand
-fall in P of 1 product causes an increase in demand of comp product
-XED value for 2 comps always negative
close complement?
-small fall in price A causes a large rise in demand for B
weak complements?
-A large drop in price of A causes a small rise in demand for B
1.2.4
what is market supply?
-the total supply brought to the market by producers at each price
what is supply?
-the qty of a good/service that a producer is willing and able to supply onto the market at a given price in a given time period
what is the basic law of supply?
-as price increases, businesses expand supply to the market - producers respond to the profit motive
market supply;
NEW ENTRANTS?
-higher prices may create an incentive for other businesses to enter a market leading to an increase in the total supply
conditions of supply?
-costs [fall in exchange rates = imported good more expensive, wages-sellers
-ease of production
-productivity
-alternatives
outward shift in the supply curve?
-more can be supplied at each price level
inward shift in the supply curve?
producers can supply less at each price level
what is joint supply?
-where an increase or decrease in supply of one good lads to an increase/decrease in supply of a by-product
what is competitive supply?
-exists when there are alternatives products that business could make with its FOP
1.2.5
price elastic? ;
output
-producers can easily increase their output without a significant rise in cost or time delay
price inelastic?
-firms find it hard to change production in a given time period
PES?
% change QS / % change P
PES = 0
- perf elastic
-increase in demand can be met without change in the market price
factors effecting PES?
-TIME
-mobility of FOP
-availability of suns
-spare capacity
PES: time?
-in long run, producers can change FOP
-in short run, may find it harder to respond to an increase in price
1.2.6
what is equilibrium?
-demand = supply
-no excess D or S
outward shift of demand?
- rise in Pe and an expansion of market supply
inward shift of demand?
-fall in Pe and Qe
-contraction of market supply
outward shift in Market Supply?
-fall in qe
-expansion in market demand
inward shift of MS?
- rise in Qe and contraction of MD
what is Pe?
-market clearing price
1.2.7
main functions of the price mechanism?
1 - signal excess demand/supply and need to decrease or increase resources
2- incentivise producers to increase/decrease output to increase profits
3 - ration scarce resources by encouraging/discouraging consumption
4- allocate scarce resources efficiently
the rationing function?
-price mechanism is a way of rationing scarce resources when there is excess demand
-rationed to those who can afford and value them most
the signalling function?
-signal where resources should be used
-change in price indicates market conditions have changed
the incentive function?
-higher prices act as an incentive to existing producers to raise output due to potential increase in profits
causes of price volatility?
-an adverse supply shock can cause market prices to rise sharply
-rising market demand can also cause price spikes
features of product with inelastic PED?
-few substitutes
-habitual purchases
-addictive
-necessity
-low % of income
1.2.8
consumer surplus?
-a measure of the welfare people gain from consuming goods/services
-the difference between price consumers are able and willing to pay for a good/service and they price they actually pay
what happens to CS as market price changes?
-the level of CS changes as the market price for a good/service changes
- rise in market price = fall in consumer surplus
effect of PED on CS?
- high PED = relatively low CS
-low PED = high level of CS
what is a producer surplus?
-measure of producer welfare [ profit ]
- the difference between the price producers are able and willing to supply at and the price they actually receive
-higher prices provide higher incentive to supply more to the market
lower market prices affect prducer surplus?
-lower supply costs cause market price to fall and Qe to rise
-PS increases
increase in market price affect PS?
-increase in market demand = higher price and qty
what is community surplus?
-sum of CS and PS
what is competition policy?
-usually evaluates the effectiveness of markets by looking at CS alone
how is producer surplus beneficial for an economy?
-firms can use surplus to reinvest in the business and grow
1.2.9
what is an indirect tax?
-those imposed by the gov on goods/services
-also called expenditure taxes
-increase supply costs faced by producers
purpose of indirect taxes?
generate tax revenue for the gov
-encourage consumption of good products
indirect taxes on a graph?
-due to tax, less supplied at each price level
-an indirect tax will increase the price of a product, reducing Qty demanded
-tax always shown as vertical distance between 2 supply curves
what is a specific tax?
-a tax set per unit
-causes a parallel shift in the supply curve
what is an ad valorem tax?
-a % tax
-causes a pivotal shidt in the supply curve
perf inelastic, indirect taxes
who pays?
-total tax revenue paid by consumer
-supply curve shist upwards
perf elastic demand
indirect taxes
who pays?
-tax paid by consumer
-however, degrees of supply and demand will determine who absorbs the cost of the tax
what happens when you make demand curve more elastic?
-most of indirect tax will be absorbed by the supplier
- ‘incidence’ of the tax borne by suppliers
what happens when demand curve is inelastic?
-most of indirect tax will be passed onto the consumer
what are subsidies?
-any form of gov support offered to producers and sometimes consumers
eg biofuel subsidies for farmers
-childcare for working families
justification for subsidies?
-introduced for social, economic and political reasons
-help poorer families
-protect jobs in loss making industries
-achieve more equitable income distribution
explaining subsidy diagram?
-gap between 2 supply lines
-producer receives P2 and consumer pays P1
inelastic market demand subsidy?
-has larger effect on the new equilibrium price
elastic market demand subsidy?
-has stronger effect on new equilibrium price
evaluation when assessing indirect taxes?
-does tax achieve its aims?
-are there any unintended consequences?
-is the tax equitable/fair?
evaluation when assessing subsidies?
-does it meet aims?
-will a subsidy affect productivity/efficiency?
-does it help to correct a market failure?
1.2.10
what does basing decisions in incomplete info cause?
-loss of welfare not only for the individual but for society as a whole
what do we assume about behaviour?
-consumers will make decisions in their best interest
-consumers have the relevant information to make rational decisions
what is bounded rationality?
-people adopt rules of thumb instead of calculating optimal decisions
-consumers opt to satisfice rather than maximise
what is loss aversion?
-it is thought the pain of losing is psychologically about twice as powerful as the pleasure of gaining and since more people are willing to take risks to avoid loss
what are heuristics?
-best described as mental shortcuts for decision making to help people make quick answers
what did Gerd Gigerenzer argue?
-heuristics can be an optimal way to respond to occasions where we lack information or time
-learn from experience
-optimal not same as maximising behaviour
habitual behaviour?
-default bias in choices
-repeat choices don’t require cognitive effort
choice architecture?
-describes how decisions we make are affected by the layout of choices
choices influenced by social norms?
-eg changing social stigma around drunk driving
-social norms become accepted by majority of a community
anchoring?
-value often set by anchors in our mind which we use as a mental reference point
asymmetric framing?
-involves including an obviously inferior third choice or hyper expensive 3rd option rather than a simple expensive/cheap choice
availability bias?
-happens when people often judge the likelihood of an event by the ease of which examples come to mind
behavioural nudges?
-alternative to using taxes and subsidies to influence choices
are behavioural nudges effective?
-may make gov policies too paternalistic
-focuses too heavily on psychological biases
-won’t change deeply rooted psychological problems
