1.2 - How Markets Work Flashcards
Rational decision making
Where consumers allocated their expenditure on goods and services to maximise utility and producers allocate their resources to maximise profits.
What is demand?
The quantity of a good or service purchased at a given price over a given period of time.
Shape of the demand curve
It is downward sloping because of the law of diminishing marginal utility. As successive units of a good are consumed, the utility gained from each extra unit will fall.
Factors that can shift the whole demand curve
- real incomes
- size or age distribution of the population
- tastes, fashions or preferences
- prices of substitutes or complements
- amount of advertising or promotion
- interest rates
- income tax
Price elasticity of demand
The responsiveness of the demand of a good/service to a change in its price.
Interpreting PED
PED > -1 - elastic -1 < PED < 0 - inelastic PED = -1 - unit elasticity PED = infinity - perfectly elastic PED = 0 - perfectly inelastic
Relationship between PED and total revenue
Inelastic:
-price decreases, total revenue decreases
-price increases, total revenue increases
Elastic:
-price decreases, total revenue increases
-price increases, total revenue decreases
Unitary:
-prices changes leaves total revenue unchanged
Determinants of PED
- availability of substitutes: many then its elastic
- luxury and necessity goods
- proportion of income spent on good, if its a high proportion of income then it will be elastic
- addictive and habit-forming goods make demand inelastic
- time period spent: more elastic in the long run
- brand image, if its strong then demand will be inelastic
Income elasticity of demand
The responsiveness of demand for a good or service to a change in real income.
Normal and inferior goods
- normal goods: positive YED. As real incomes rise, so foes demand for the good
- inferior good: negative YED. As real incomes rise, demand fort the good falls
Interpreting YED
- income inelastic: 0 < YED < 1
- unitary elastic: YED = 1
- income elastic (luxury): YED > 1
Cross elasticity of demand
The responsiveness of demand for good A to a change in the price of good B.
Substitute, complementary and unrelated goods
Substitutes: in competitive demand, positive XED
Complements: in joint demand, negative XED
Unrelated: XED is 0
What is supply?
The quantity of a good or service that firms are willing to sell at a given price and over a given period of time.
Shape of the supply curve
As firms raise output in the short run, they face rising production costs and so charge higher prices. As price rises, it encourages firms to supply more of a good to increase profits or more firms enter the market.
Factors that shift the demand curve
- costs of production
- productivity of the workforce
- indirect taxes
- subsidies
- technology
- discoveries of new materials
Price elasticity of supply
The responsiveness of the supply of a good or service to a change in its price.
Interpreting PES
- elastic: PES > 1
- inelastic: PES < 1
- unit elasticity: PES = 1
- perfectly elastic: PES = infinity
- perfectly inelastic: PES = 0
Determinants of PES
- level of spare capacity: lots then elastic
- state of the economy: recession then elastic
- level of stocks of finished goods: high means elastic
- perishability: high then inelastic
- ease of entry into an industry: barriers then inelastic
- time period: elastic in long run, inelastic in short run
What are excess supply and demand?
Excess supply: where quantity supplied exceeds quantity demanded for a good at the current market price
Excess demand: where the quantity demanded exceeds the quantity supplied for a good at the current market price
What’s the price mechanism?
The use of market forces to allocate resources in order to solve the economic problem of what, how and for whom to produce.
- rationing device
- incentive device
- signalling device
Consumer and producer surplus
- consumer: the extra amount of money consumers are prepared to pay for a good or service above what they actually pay
- producer: the extra amount of money paid to producers above what they are willing to accept to supply a good or service
What is an indirect tax?
A tax imposed on good and services supplied by businesses. It includes both specific and ad valorem tax.
What is a subsidy?
A govt grant to firms, which reduces production costs and encourages an increase in output.
Reasons explaining irrational behaviour
- considerations of the influence of other people’s behaviour: ‘social learning’ a person subconsciously learns from the behaviour of others as a guide to their own behaviour.
- the importance of habitual behaviour: they are difficult to change if repeated frequently and are associates with rewards. Incentives are needed to change habits
- consumer weakness at computation: people don’t think long term, struggle to calculate probabilities and are influences by how a choice is presented.
