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Edexcel Economics (AS) > [1.2] How Markets Work > Flashcards

[1.2] How Markets Work Flashcards

1
Q

In economics, what two assumptions are made about rational decision making?

A
  • Consumers aim to maximise utility (the benefit that a good brings them).
  • Firms aim to maximise profits.
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2
Q

What is demand?

A

Demand is the quantity of a good or service that consumers are willing and able to buy in a given period of time.

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3
Q

What is the law of demand?

A

As the price of a good increases, the quantity demanded for that good decreases.

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4
Q

What factors will cause an outward shift in demand?

A
  1. An increase in the size of the population (more people able to buy good).
  2. An increase in the incomes of consumers
  3. A rise in the price of a substitute product (so people will switch to the good).
  4. A fall in the price of a complement product (so more people are buying the complement good, so more people will buy the good).
  5. Advertising may cause an outward shift in demand by changing consumer preferences.
  6. A positive change in consumer preferences toward a good may cause an outward shift in demand.
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5
Q

How does diminishing marginal utility explain the law of demand?

A

The utility gained from purchasing one extra unit of a good decreases as the quantity purchased increases, which makes consumers less willing to spend their money on that good past a certain quantity.

By lowering the price, consumers may still be tempted by the increase in total utility despite the falling marginal utility, so will still purchase the good.

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6
Q

What is price elasticity of demand?

A

The responsiveness of quantity demanded to a change in the price of a good.

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7
Q

How can price elasticity of demand be calculated?

A

Percentage Change in Quantity Demanded / Percentage Change in Price

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8
Q

What term describes a good that has a PED of 0?

A

Perfectly Inelastic

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9
Q

What term described a good that has a PED of 1?

A

Unitarily Elastic

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10
Q

What term describes a good that has a PED of greater than one?

A

Elastic

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11
Q

What term describes a good that has a PED of less than one?

A

Inelastic

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12
Q

What factors affect price elasticity of demand?

A
  • Necessity (necessities=inelastic)
  • Number of substitutes available (more subs=more elastic)
  • Addictiveness/habitual consumption
  • Proportion of income spent on good
  • Durability of good (if good lasts long time, people will wait to buy another one only when it is cheaper)
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13
Q

What is income elasticity of demand?

A

The responsiveness of demand to a change in incomes.

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14
Q

How can income elasticity of demand be calculated?

A

Percentage Change in Quantity Demanded / Percentage Change in Income

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15
Q

What are inferior goods?

A

Demand for inferior goods falls as incomes rise. This means they have an income elasticity of demand (YED) of less than zero.

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16
Q

What are normal goods?

A

Demand for normal goods increases as incomes rise. This means YED must be greater than zero and less than one.

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17
Q

What are luxury goods?

A

Demand for luxury goods increases by a larger proportion than the rise in income. YED is greater than one.

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18
Q

What is cross elasticity of demand?

A

The responsiveness of quantity demanded of Good A to the change in price of Good B.

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19
Q

How can cross elasticity of demand be calculated?

A

Percentage Change in Quantity Demanded of Good A / Percentage Change in Price of Good B

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20
Q

If cross elasticity of demand between two goods is negative, what is the relationship?

A

They are complements.

As the price of one rises, the quantity demand for the other decreases.

21
Q

If cross elasticity of demand between two goods is positive, what is the relationship?

A

They are substitutes.

As the price of one rises, the quantity demanded for the other increases.

22
Q

If cross elasticity of demand between goods is zero, what is the relationship?

A

They are unrelated.

23
Q

How do firms use cross elasticity of demand?

A
  • The firm can assess the impact of a change in the price of competing product on its revenue.
  • The firm can better understand its rivals and competition.
24
Q

How do firms use income elasticity of demand?

A

Firms can use income elasticity to assess the impact of the usual business cycle on its revenue.

For income elastic products, revenue will be more volatile as sale falls during slower economic times (fewer well paying jobs, so incomes lower).

On the other hand, revenue will be more stable for income inelastic goods - that will be unaffected as incomes fall during the regular business cycle.

25
Q

How can price elasticity of demand be used to maximise revenue?

A

If demand is price inelastic, firms should raise their prices in order to increase revenue. This is because the percentage rise in price will be greater than the percentage fall in quantity demanded.

If price is elastic, firms should reduce their prices in order to increase revenue. This is because reducing prices will have a proportionally greater increase in quantity demanded.

26
Q

How does price elasticity of demand affect the burden of an indirect tax on firms?

A

If price is inelastic, consumers will carry the majority of the tax burden. This is because firms can raise prices as a result of the tax in the knowledge that the price rise will have a proportionally smaller impact on quantity demanded.

If price is elastic, firms will carry the majority of the tax burden. This is because firms know that raising prices will mean a proportionally larger fall in quantity demanded - this would lead to a loss of revenue.

27
Q

How does price elasticity of demand affect the gain of consumers from a subsidy?

A

If price is inelastic, consumers receive most of the gain a subsidy in the form of lower prices.

If price is elastic, firms receive most of the gain in the form of an increase in quantity demanded.

28
Q

What is supply?

A

The quantity of a good that producers are willing and able to supply in a given period of time.

29
Q

What is the law of supply?

A

As the price of a good increases, the quantity supplied of that good also increases.

30
Q

What factors will cause a rightward shift in supply?

A
  • An increase in productivity (higher output, so average costs fall)
  • Imposition of subsidy
  • A fall in the costs of production
  • The discovery of new technologies that can increase output
31
Q

What is joint supply?

A

Joint supply is when increasing the supply of one good leads an increase in the supply of another good.

e.g. Increasing the supply of sheep will increase the supply of wool.

32
Q

What factors will cause a leftward shift in supply?

A
  • A rise in the costs of production
  • A fall in productivity
  • Imposition of an indirect tax
33
Q

What is price elasticity of supply?

A

The price elasticity of supply is the responsiveness of quantity supplied to a change in price.

34
Q

How can price elasticity of supply be calculated?

A

Percentage Change in Quantity Supplied / Percentage Change in Price

35
Q

What term describes the a good with price elasticity of less than one?

A

Inelastic

36
Q

What term describes the a good with price elasticity of greater than one?

A

Elastic

37
Q

What term describes the a good with price elasticity of equal to one?

A

Perfectly Inelastic

38
Q

What factors influence price elasticity of supply?

A
  • Time scale (more elastic in long run, as firms have time to expand production or enter market)
  • Spare capacity (if more spare capacity, more elastic)
  • Stockpiling (larger stockpiles mean more elasticity as firms can easily start selling)
  • Barriers to entry (lower price elasticity as firms can’t enter market to supply more)
  • Substitutability of factor inputs (i.e. can resources easily be used to produce other types of output).
39
Q

What is market equilibrium?

A

The point at which supply meets demand.

There is no excess demand or supply.

The price at this point is known as the market clearing price.

40
Q

How do market forces fix excess demand?

A

1) Demand exceeds supply, so there is a shortage.
2) As a result of excess demand, prices will rise.
3) Firms will respond to rising prices by supplying more of the good.
4) Quantity demanded will fall in response to the rise in prices.
4) As a result of price rises and a movement along the supply curve, a new equilibrium point is reached.
5) The market has naturally corrected the shortage.

41
Q

How do market forces fix excess supply?

A

1) Supply exceeds demand, so there is a surplus.
2) As a result, firms will start lowering prices and therefore reducing quantity supplied (law of supply).
3) In response to falling prices, quantity demanded will increase.
4) Eventually, a new market equilibrium point is reached.
5) The market has naturally corrected the surplus.

42
Q

What are the three functions of the price mechanism?

A
  • Rationing
  • Signalling
  • Incentive
43
Q

How does the price mechanism perform a rationing function?

A

If demand exceeds supply, prices will rise.

This limits the number of people that can purchase a scarce good.

44
Q

How does the price mechanism perform a signalling function?

A

If prices rise, firms will enter the market in order to meet rising demand (or, fill a gap in the supply).

If prices fall, consumers see this as a signal to enter the market.

45
Q

How does the price mechanism perform an incentivising function?

A

If prices rise, the price mechanism encourages firms to enter the market by offering them increased revenue and profit.

Similarly, consumers have an incentive to purchase goods that have excess supply through lower prices.

46
Q

What is consumer surplus?

A

Consumer surplus occurs whenever a consumer pays less than the highest price they are willing to pay.

On a supply and demand diagram, this is indicated by the area below the demand curve, but above the equilibrium price line.

47
Q

What is producer surplus?

A

Producer surplus occurs whenever a firm sells a good for higher than the lowest price they are willing and able to supply at.

On a supply and demand diagram, this is indicated by the area above the supply curve, but below the equilibrium price line.

48
Q

What is a specific tax?

A

A fixed amount is taxed on each unit sold

49
Q

What is an ad valorem tax?

A

A percentage tax on the price of each unit sold

Edexcel Economics (AS) (10 decks)

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