1.2 How markets work Flashcards
What does a consumer aim to maximimise?
Utility - the amount of satisfaction obtained from consuming a good or service
What do producers aim to do?
A rational producer aims to maximise profits
What is demand?
The quantity of a good/service purchased at a given price over a given time period
What are the three reasons demand is downwards-sloping?
- The income effect
- The substitution effect
- The law of diminishing marginal utility
Explain the income effect
As the price of a good falls, more can be purchased with any given level of income - and more can be purchased by those on lower incomes
Explain the substitution effect
As prices fall, the good becomes cheaper compared to substitute goods, and therefore demand increases for it.
Explain the law of diminishing marginal utility
As successive units of a good are consumed, the utility gained from each extra good (i.e. the marginal utility) falls, and therefore reduces the quantity demanded.
What is the difference between a movement along a demand curve and a shift of the curve?
A movement is caused by a change in the price of the good, whereas a shift is caused by anything but a price change.
What are the two types of movements along the demand curve?
A fall in price causes an extension in demand and a rise causes a contraction.
What shifts demand? [3]
Various factors, including:
- A fall in the price of complementary goods (derived demand)
- A rise in the price of substitue goods (derived demand)
- Changes in trends and fashion
- Increased advertising
- Increase in income or a decrease in tax
- Increase in population or age structure
- More credit facilities
What is supply?
Supply is the quantity of a good/service that firms are willing to sell at a given price and over a quantity of time
Why is Supply upwards-sloping? [3]
- The profit incentive - firms supply more to increase profits
- At higher prices, more firms are able to cover the costs of production
- Finally, higher prices enourage more firms to enter the market
What shifts supply? [3]
Essentially anything that reduces cost of production/unit of good
- Improvements in technology
- A reduction in labour/capital/transport costs
- Changes in taxes/subsidies
- Products in joint supply and competetive supply
How is price determined?
Through the interaction of supply and demand - at an equilibrium price. This is where quantity demanded = quantity supplied for a good/service in a market.
What is excess supply and excess demand?
When the level of goods either supplied or demanded is greater than the equilibrium quanitity
How is excess supply and demand combatted? [high and low]
If the price is too low - i.e. in excess demand - consumers bid against each other in order to purchase the good, which pushes suppliers to raise the price and therefore reduces the extra demand.
If the price is too high - i.e. in excess supply - firms lower their prices and undercut each other in order to increase demand and sell more, reducing the extra supply.
What are the three forms of the price mechanism?
- Signalling device
- Rationing device
- Incentive device
What is the price mechanism?
The use of market forces to allocate resources
What is the rationing function/device?
Prices serve to ration scarce resources when demand in a market exceed supply.
What is the incentive device?
Rising prices act as an incentive for firms to produce more of a good to earn a higher profit, and cover increased production costs.
What is the signalling device?
Changes in price provide information to producers and consumers about market conditions
What is consumer surplus?
The extra amount of money consumers are prepared to pay for a good or service above what they actually pay
What is producer surplus?
The extra amount of money paid to producers above what they are willing to accept to supply a good or service
Where is consumer and producer surplus (total welfare) maximised?
At equilibirum
How does shifts in demand/supply affect consumer and producer surplus?
An increase in demand increases total welfare
A decrease in supply reduces total welfare
What is price elasticity of demand? (PED)
The responsiveness of demand for a good or service to a change in its price.
What is the formula for PED?
% Change in Qd
_______________________
% Change in price
Explain the possible values of PED
If PED > |1| : The good is relatively price elastic
If PED < |1| : The good is relatively price inelastic
If PED = |1| : The good has unit elasticity
If PED = 0: The good is perfecftly inelastic and price has no effect on demand
If PED = infinity : The good is perfectly elastic, and any change in price causes demand to fall to zero
What determines PED? [4]
- Availibilty of substitutes
- Luxury and necessary goods
- Proportion of income spent on good
- Addictive and habit forming goods
- The time period
- Brand image
What is total revenue?
The price per unit of a good multiplied by the quantity sold
Why is PED useful for firms to know?
When PED = |1|, revenue is maximised.
A price decrease on an elastic good and a price increase on an inalastic good will raise consumer spending and revenue to the firm.
What is marginal revenue? What do its values signfify?
Revenue gained by a firm by selling one extra unit of output.
When MR = 0, revenue is maximised. When it is positive, demand is elastic.
What is price elasticity of supply? (PES)
The responsiveness of the supply of a good or service to a change in its price
Explain the possible values of PES
If PES > 1, supply for the good is relatively price elastic
If PES = 1, supply for the good is unitary elastic
If PES < 1, supply for the good is relatively price inelastic
If PES = 0, supply for the good is perfectly inelastic
If PES = infinity, supply for the good is perfectly elastic
What is the formula for PES?
% change in supply of good
________________________________
% change in price of good
What determines PES? [4]
- Time period - in the short run, supply is likely to be inelastic as it is hard to quickly increase production
- Level of spare capaciy - can production be increased easily
- State of the economy
- Level of stocks of finished goods: i.e designer wedding dresses vs ready made cars
- Perishability of the good - can it be stockpiled etc
- Easy of entry into the industry - High entry barriers means it is hard for new firms to enter, even if they attracted by prices
What is income elasticity of demand (YED)?
The responsiveness of demand for a good or service to a change in real income
What is the formula for YED?
% Change in demand
_________________________
% Change in real income
What is the difference between a postive and negative YED?
If YED is positive, it is a normal good - i.e demand rises with real income
If YED is negative, it is an inferior good - as income rises demand decreases, e.g. value brand meals or domestic holidays
Explain the values of positive YED
If YED > 1, demand is relatively income elastic (also called a luxury good)
If YED = 1, demand is unitary income elastic
If YED < 1, demand is relatively income inelastic
What is cross price elasticity of demand? (XED)
The responsiveness of demand for good B to a change in the price of good A
What is the formula for XED?
% change in demand for good B
_________________________________
% change in price of good A
Explain the possible values of XED
If XED is positive, the goods are substitutes for each other, as an increase in price (and therefore a decrease in demand) for good A leads to an increase in demand for good B. This is called competitive demand.
If XED is 0, the goods are unrelated.
If XED is negative, the goods are complements to eah other and tend to be consumed together. A decrease in demand for good A decreases demand for good B - this is called joint demand.
