1.2 - How Markets Work Flashcards
Rational decision making
When making economic decisions, consumers aim to maximise their utility and firms aim to maximise profits
Demand
Quantity of a good or service that a consumer is able and willing to
buy at a given price during a given period of time
Conditions of demand
- Population
- Income
- Related goods
- Advertising
- Taste/fashion
- Expectations
- Seasons
Law of diminishing marginal utility
The satisfaction derived from the consumption of an additional unit of a good will decrease as more of a good is consumed
Total utility
The satisfaction gained by a customer as a result of their overall consumption of a good
Marginal utility
The change in satisfaction resulting from the consumption of the next unit of a good
Derived demand
When the demand for one good is linked to the demand for a related good
Composite demand
When the good demanded has more than one use, for example milk, assuming there is a fixed supply of milk, an increase in the
demand for cheese will mean that more cheese is supplied, and therefore less butter can be supplied
Joint demand
When goods are bought together
Price elasticity of demand
The responsiveness of demand to a change in price
Formula for price elasticity of demand
% Change in quantity demanded / % Change in price
Elastic demand
A good which is very responsive to a change in price, meaning that the change in demand is greater than the change in price and PED>1
Inelastic demand
A good which is unresponsive to a change in price, meaning that the change in price is greater than the change in demand and PED<1
Unitary elastic demand
A good where quantity demanded changes by exactly the same percentage as price, meaning that PED=1
Perfectly elastic demand
A good where a change in price causes quantity demanded to fall to 0, meaning that PED=Infinity
Perfectly inelastic demand
A good where a change in price causes zero changes to quantity demanded, meaning that PED=0
Factors influencing Price Elasticity of Demand
- Availability of substitutes
- Time
- Necessity
- Percentage of total expenditure
- Addictiveness
How a change in price affects revenue with a elastic demand curve
A decrease in price leads to an increase in revenue and an increase in price leads to a decrease in revenue
How a change in price affects revenue with a inelastic demand curve
A decrease in price leads to a decrease in revenue and an increase in price leads to an increase in revenue
Income Elasticity of Demand
The responsiveness of demand to a change in income
Formula for Income Elasticity of Demand
% Change in quantity demanded / % Change in income
Normal good
A good for which demand increases when income rises and decreases when income falls, meaning YED>0
Inferior good
A good for which demand decreases when income rises and increases when income falls, meaning YED<0
Luxury good
A type of normal good for which demand increases more than proportionally as income rises, meaning YED>1
Cross Elasticity of Demand
The responsiveness of demand for on one product (A) to a change in the price of another product (B)
Formula for Cross Elasticity of Demand
% Change in quantity demanded of good A / % Change in price of good B
Substitute goods
Goods that can be used in place of each other. When the price of one good increases, the demand for its substitute increases, meaning XED>0
Complementary goods
Goods that are consumed together, meaning that when the price of one good increases, the demand for its complement decreases, meaning XED<0
Supply
Quantity of a good or service that a producer is able and willing to
supply at a given price during a given period of time
Joint supply
When increasing the supply of one good causes an increase or decrease in the supply of another good. For example, producing more lamb will increase the supply of wool.
Conditions of supply
- Costs of production
- Price of other goods
- Weather
- Technology
- Goals of the supplier
- Government legislation
- Taxes and subsidies
- Producer cartels
Price Elasticity of Supply
The responsiveness of a change in supply to a change in price
Formula for Price Elasticity of Supply
% Change in quantity supplied / % Change in price
Elastic supply
A good which is very responsive to a change in price, meaning that the change in SUPPLY is greater than the change in price and PES>1
Inelastic supply
A good which is unresponsive to a change in price, meaning that the change in price is greater than the change in supply and PES<1
Unitary elastic supply
A good where quantity supplied changes by exactly the same percentage as price, meaning that PES=1
Perfectly elastic supply
A good where a change in price causes quantity supplied to fall to 0, meaning that PES=Infinity
Perfectly inelastic supply
A good where a change in price causes zero changes to quantity supplied, meaning that PES=0
Factors influencing Price Elasticity of Supply
- Time
- Level of stocks
- Working below full capacity
- Availability of factors of production
- Ease of entry into the market
- Availability of substitutes
Price mechanism
Process by which market forces of supply and demand determine the allocation of resources, production, and distribution of goods and services in a market economy
Functions of the price mechanism
- Rationing
- Signalling
- Incentive
Rationing function
When goods and services are scarce, prices rise to reduce excess demand and ensure that resources are allocated efficiently
Signalling function
When prices rise or fall to signal whether firms should increase or decrease production and whether consumers should buy more or less of a good
Incentive function
When changes in price create incentives for producers and consumers to change their behavior, so for producers higher prices incentivise firms to increase supply because of higher profits whereas for consumers higher prices discourage demand
Consumer surplus
The difference between the price the consumer is willing and able to pay and the price they actually pay
Producer surplus
The difference between the price the producer is willing to charge and the price they actually charge
Economic welfare
The overall well-being and standard of living of individuals, households, and society as a whole. It includes material wealth (income, consumption) and non-material factors (health, education, environment).
Indirect taxes
A tax imposed on goods and services rather than directly on income or wealth. It is paid by producers but passed on to consumers through higher prices
Types of indirect taxes
- Ad valorem taxes
- Specific taxes
Ad valorem taxes
An indirect tax that is charged as a percentage of the price of a good or service rather than as a fixed amount per unit
Specific taxes
An indirect tax that is charged as a fixed amount per unit of a good or service, regardless of its price
Subsidy
Financial support provided by the government to reduce production costs or lower the price of goods and services
Incidence of tax
How the burden of a tax is shared between consumers and producers. It depends on the price elasticity of demand and supply
Rational decision making
An economic principle where individuals, firms, and governments make choices that maximise their utility, profit or overall benefit, based on available information
Alternative views of consumer behaviour
- Influences of other people
- Influence of habitual behaviour
- Consumer weakness at computation
