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Economics: Theme 1 > 1.2 How Markets Work > Flashcards

1.2 How Markets Work Flashcards

1
Q

What are the underlying assumptions of rational decision making in economics? (2)

A
  1. Consumers will aim to maximise utility.

2. Firms will aim to maximise profits.

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2
Q

Why might consumers not behave rationally (behavioural economics)? (4)

A
  1. Habitual behaviour.
  2. Inertia (overloaded with information and choice).
  3. Influence of the behaviour of others (“social learning”).
  4. Consumer weakness at computation (how the choice is presented).
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3
Q

What is shown by a demand curve?

A

A demand curve shows the relationship between the price and the quantity demanded of a good over a given time period.

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4
Q

What is the law of demand?

A

The quantity of a good demanded per period of time will fall as price rises and rise as price falls (ceteris paribus).

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5
Q

What would cause a movement along the demand curve?

A

A movement along the demand curve will ONLY be caused by a change in price.

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6
Q

What has occurred when the demand curve shifts?

A

Consumers have changed their perception regarding the worth of the good.

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7
Q

What could cause the demand curve to shift? (5)

A
  1. Number/price of substitute goods.
  2. Number/price of complementary goods.
  3. Distribution of income.
  4. Expectations of future price changes.
  5. Tastes.
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8
Q

What is marginal utility?

A

Marginal utility is the additional satisfaction gained by the consumer per unit of a good/service consumed.

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9
Q

What is meant by diminishing marginal utility?

A

As a consumer consumes many units of a good/service, the total utility increases per unit but by a smaller amount each time. Marginal utility decreases with quantity.

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10
Q

What is a veblen good?

A

A veblen good is a good by which the quantity demanded increases with higher prices.

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11
Q

What is a normal good?

A

A normal good is a good by which the quantity demanded increases with higher income.

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12
Q

What is an inferior good?

A

An inferior good is a good by which the quantity demanded increases with lower income.

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13
Q

What is price elasticity of demand (PED) and how is it calculated?

A

PED measures the degree of responsiveness in quantity demanded after a given change in price.

% change in quantity demanded/% change in price

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14
Q

What are elastic goods and how can they be identified numerically?

A

Elastic goods experience a proportionately greater change in quantity demanded after a given price change. They have a shallow demand curve.

Elastic goods have a PED above 1.

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15
Q

What are inelastic goods and how can they be identified numerically?

A

Inelastic goods experience a proportionately smaller change in quantity demanded after a given price change. They have a steep demand curve.

Inelastic goods have a PED below 1.

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16
Q

What is a perfectly elastic good and how can it be identified numerically?

A

A perfectly elastic good has a horizontal demand curve and a PED value of infinity.

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17
Q

What is a perfectly inelastic good and how can it be identified numerically?

A

A perfectly inelastic good has a vertical demand curve (a change in price has NO effect on quantity demanded) and a PED value of 0.

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18
Q

What is meant by unitary elasticity?

A

A good has unitary elasticity if its PED = 1. A change in price results in an exact change in quantity demanded.

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19
Q

What factors influence the PED of a good? (8)

A
  1. Habit forming.
  2. Luxury or necessity.
  3. Availability of substitutes.
  4. Proportion of income spent on good/service.
  5. Switching costs.
  6. Peak or off-peak.
  7. Short of long term (goods become more elastic in long term as substitutes are developed).
  8. Breadth of definition (e.g. bread is inelastic, Hovis/specific brands are elastic).
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20
Q

What is the relationship between PED and total revenue?

A

Unitary elasticity results in optimum revenue. (See diagram in notes)

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21
Q

What is income elasticity of demand (YED) and how is it calculated?

A

YED measures the degree of responsiveness in quantity demanded after a given change in income.

% change in quantity demanded/% change in income

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22
Q

What is meant by a positive YED coefficient?

A

Goods with a positive YED coefficient are normal goods. If the YED is inelastic (below 1) the good is a necessity, and if the YED is elastic (above 1) the good is a luxury.

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23
Q

What is meant by a negative YED coefficient?

A

Goods with a negative YED coefficient are inferior goods.

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24
Q

What is cross elasticity of demand (XED) and how is it calculated?

A

XED measures the degree of responsiveness in quantity demanded X after a price change in Y.

% change in quantity demanded X/% chance in price Y

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25
Q

What is meant by a positive XED coefficient?

A

Goods with a positive XED coefficient are substitute goods. If the XED is inelastic (below 1) the goods are weak substitutes, and if the XED is elastic (above 1) the goods are strong substitutes.

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26
Q

What is meant by a negative XED coefficient?

A

Goods with a negative XED coefficient are complementary goods. If the XED is inelastic (below 1) the goods are weak complements, and if the XED is elastic (above 1) the goods are strong complements.

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27
Q

What is meant by an XED of 0?

A

The goods are unrelated; a change in price Y will not result in a change in demand for X.

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28
Q

How could elasticity of demand effect the imposition of taxes and subsidies?

A

The government would be more likely to tax PED inelastic goods and subsidise PED elastic goods.

29
Q

How could firms respond to changes in real income in terms of the elasticity of their goods?

A

If real incomes increase, firms may choose to focus on producing more luxury goods. If real incomes decrease, firms may choose to focus on producing more inferior goods.

30
Q

What is the significance of elasticity of demand to firms in regards to the changes in prices of substitute and complimentary goods?

A

If the price of a strong substitute goes down, firms will have a greater incentive to bring their prices down further. If the price of a strong complement goes up, firms may choose to put the price of their good up also in order to increase profits.

31
Q

What are substitute goods?

A

Substitute goods are seen as alternatives to each other.

32
Q

What are complementary goods?

A

Complementary goods are consumed together.

33
Q

What is shown by a supply curve?

A

A supply curve shows the relationship between the price and the quantity supplied of a good over a given time period.

34
Q

What would cause a movement along the supply curve?

A

A movement along the supply curve will ONLY be caused by a change in price.

35
Q

What could cause the supply curve to shift? (5)

A
  1. Changes in costs of production.
  2. Nature/unpredictable events.
  3. Expectations of future price changes (firms may stockpile goods).
  4. Profitability of substitutes in supply (firms may switch to producing more profitable alternatives).
  5. Profitability of goods in joint supply (a rise in production for one results in a rise in production for the other).
36
Q

What are substitutes in supply?

A

Substitutes in supply are two goods by which increasing production of one requires diverting resources away from producing the other.

37
Q

What are goods in joint supply?

A

Goods in joint supply are two goods by which an increased production of one leads to an increased production of the other.

38
Q

Why does an increase in the price of a good result in an increase in quantity supplied? (3)

A
  1. Firms may switch from producing less profitable goods to the higher priced good.
  2. If the price remains high, new producers are encouraged to set up production.
  3. Beyond a certain level of output, costs of production rise more rapidly. Firms require a higher price to persuade them to produce extra output at greater costs.
39
Q

What is price elasticity of supply (PES) and how is it calculated?

A

PES is the degree of responsiveness of quantity supplied in response to a given price change.

% change in quantity supplied/% change in price

40
Q

What are PES elastic goods?

A

For PES elastic goods, a change in price will result in a proportionately greater change in quantity supplied. PES is greater than 1.

41
Q

What are PES inelastic goods?

A

For PES inelastic goods, a change in price will result in a proportionately smaller change in quantity supplied. PES is smaller than 1.

42
Q

What factors influence PES? (5)

A
  1. Factor immobility (can factors be transferred easily?).
  2. Stockpiling (greater elasticity if firms have large stocks - not possible for perishable goods).
  3. Spare capacity (cannot increase supply if already working at full capacity).
  4. Scarcity (if raw materials are scarce, supply is inelastic).
  5. Time (the quicker a good is made the more elastic it is, innovation means goods also more elastic in long term).
43
Q

What is the equilibrium price for a good/service?

A

The equilibrium price for a good/service is the price at which the market clears (i.e. supply = demand).

44
Q

How can a shortage be shown by a demand/supply diagram, and how is this issue resolved by market forces?

A

A shortage is where demand exceeds supply (i.e. below the equilibrium price). Consumers become willing to pay more because there is less of the good.

45
Q

How can a surplus be shown by a demand/supply diagram, and how is this issue resolved by market forces?

A

A surplus is where supply exceeds demand (i.e. above the equilibrium price). The price is lowered in order to encourage consumers to buy excess stock.

46
Q

What does the price mechanism do?

A

The price mechanism ensures that an equilibrium point between supply and demand is reached in the free market.

47
Q

What are the three functions of the price mechanism?

A
  1. Rationing function.
  2. Incentive function.
  3. Signalling function.
48
Q

What is the rationing function of the price mechanism?

A

The rationing function leads to a movement along the demand curve. It clears the market so that the remaining consumers are only those willing and able to afford the good.

49
Q

What is the incentive function of the price mechanism?

A

The incentive function leads to a movement along the supply curve. It provides information to producers regarding changing consumer wants/needs.

50
Q

What is the signalling function of the price mechanism?

A

The signalling function of the price mechanism shifts the demand or supply curve. Lower prices encourage consumers to enter the market and producers to leave, and rising prices encourage producers to enter the market and consumers to leave.

51
Q

What is consumer surplus?

A

Consumer surplus is the difference between the price a consumer would be willing and able to pay and the actual value placed upon the good. Measures consumer welfare.

52
Q

How can consumer surplus be shown on a demand/supply diagram?

A

Consumer surplus is the triangle above the equilibrium price. The lower the price, the greater the consumer surplus (increase in supply, decrease in demand).

53
Q

How does elasticity affect consumer surplus?

A

Inelastic goods have a greater potential consumer surplus as consumers are willing to pay a greater price to continue consuming the product.
In highly competitive elastic markets, the price is likely to be much closer to the price consumers are willing and able to pay.

54
Q

What is price discrimination?

A

Price discrimination is when producers take advantage of consumer surplus by working out the highest price consumers would be willing and able to pay and extracting this information.

55
Q

Why is it difficult to apply the theories of consumer and producer surplus?

A

Welfare cannot be quantified as marginal utility is subjective and inconsistent. Economists have to estimate the price consumers/producers would have been willing to pay/produce for.

56
Q

What is first degree price discrimination?

A

First degree price discrimination is when producer sells the same good to different consumers at different prices.

57
Q

What is producer surplus?

A

Producer surplus is the difference between the price producers would be willing and able to supply at and the price that they actually receive. Measures producer welfare.

58
Q

How can producer surplus be shown on a demand/supply diagram?

A

Producer surplus is the triangle below the equilibrium price. The greater the price, the greater the producer surplus (increase in demand, decrease in supply).

59
Q

What is a subsidy?

A

A subsidy is a grant given to firms by the government in order to increase production and reduce the market price.

60
Q

How can a subsidy be shown on a demand/supply diagram?

A

A subsidy is shown by a rightward shift in supply.

61
Q

What are the areas on a diagram that represent consumer and producer subsidy?

A

Consumer subsidy is shown by the change in market price of the good. Producer subsidy is shown between the old market price and the remaining subsidy. (See diagram)

62
Q

What is the effect of elasticity on subsidies?

A

Elastic goods will have greater producer subsidy as there is a lesser need for a dramatic price change. Inelastic goods will have a greater consumer subsidy as a large price change is needed for any change in demand.

63
Q

How can total government expenditure be identified on a subsidy diagram?

A

By adding the consumer and producer subsidies together.

64
Q

What is a specific indirect tax?

A

An indirect tax is a tax collected by an intermediary, and a specific tax is fixed per unit sold.

65
Q

How can an indirect tax be shown on a demand/supply diagram?

A

An indirect tax is shown by a rightward shift in supply as the production costs to the firm have increased.

66
Q

What is the incidence of tax?

A

The division of the tax burden between the consumer and the producer. The producer may choose to pay a share of the tax from their profits to avoid a dramatic increase in market price.

67
Q

What are the areas on an indirect tax diagram that represent the consumer and producer shares of tax?

A

Consumer share of tax is shown by the change in market price of a good. The producer share of tax is below this between the old market price and the supply curve.

68
Q

What is the effect of elasticity on indirect taxes?

A

Consumers have a greater share of the tax with inelastic goods as they are willing to pay higher prices. Producers have a greater share of tax with elastic goods to avoid a steep decline in demand.

Economics: Theme 1 (4 decks)

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