1.2 - How Markets Work Content Flashcards
1.2 - How Markets Work
What are the Underlying Assumption of Rational Economic Decision Making
1.2.1 - Rational Decision Making
- Consumers Aim to Maximize Utility
- Firms Aim to Maximize Profits
- Consumer Decision-Making - Consumers make choices based on their preferences and budget constraints. Utility-maximizing consumers allocate their budgets to maximize satisfaction.
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Firm Decision-Making - Firms produce goods and services to meet consumer demand.
Profit-maximizing firms adjust production levels and pricing to achieve the highest profit
1.2 - How Markets Work
What are some critiques of the assumptions of Rational Economic decision making
1.2.1 - Rational Decision Making
Critics argue that in reality, consumers and firms may not always behave rationally due to bounded rationality, cognitive biases, and imperfect information
Importance of the Assumptions - Despite the critiques, the assumptions of utility maximization for consumers and profit maximization for firms serve as foundational concepts in economics.
They provide a framework for understanding and analyzing economic decision-making in various contexts
1.2 - How Markets Work
What is the different between a Movement and a Shift of the Demand Curve
1.2.2 - Demand
- Movements Along a Demand Curve - Movements along a demand curve occur when the quantity demanded changes due to a change in the price of the good or service, while other factors remain constant. The law of demand states that, all else being equal, as the price of a good or service decreases, the quantity demanded increases, and vice versa.
- Shifts of a Demand Curve - Shifts of a demand curve occur when factors other than price cause a change in the quantity demanded at every price level. A shift indicates a change in overall demand, not just a response to price changes.
1.2 - How Markets Work
Factors that may cause a shift in the demand curve
1.2.2 - Demand
[5]
- Income
- Consumer Preferences and Tastes
- Prices of Related Goods
- Expectations
- Advertising
1.2 - How Markets Work
How does Diminishing Marginal Utility Influence the Demand Curve
1.2.2 - Demand
The law of diminishing marginal utility contributes to the downward-sloping shape of the demand curve. As price decreases, consumers are willing to buy more because the marginal utility of each additional unit exceeds the price. Example: If a consumer enjoys ice cream, the first scoop provides high utility, but by the fifth scoop, the satisfaction gained from each additional scoop decreases.
1.2 - How Markets Work
What is PED
1.2.3 - Price, income and cross elasticities of demand
Price Elasticity of Demand
Measures the responiveness of the quantity demand to changes in the price of a good
Formula: PED = (% Change in Quantity Demanded) / (% Change in Price)
1.2 - How Markets Work
What is YED
1.2.3 - Price, income and cross elasticities of demand
Incomne Elasticity of Demand
YED measures the responsiveness of the quantity demanded to changes in consumer income
Formula: YED = (% Change in Quantity Demanded) / (% Change in Income)
1.2 - How Markets Work
What is XED
1.2.3 - Price, income and cross elasticities of demand
Cross Elasticity of Demand
XED measures the responsiveness of the quantity demanded of one good to changes in the price of another.
Formula: XED = (% Change in Quantity Demanded of Good A) / (% Change in Price of Good B)
1.2 - How Markets Work
Values for PED
1.2.3 - Price, income and cross elasticities of demand
Perfectly Elastic (PED = ∞): Quantity demanded is extremely responsive to price changes, demand is perfectly elastic.
Relatively Elastic (PED > 1): Demand is responsive to price changes.
Unitary Elastic (PED = 1): Percentage change in quantity demanded is exactly proportional to the percentage change in price.
Relatively Inelastic (0 < PED < 1): Demand is less responsive to price changes
Perfectly Inelastic (PED = 0): Quantity demanded does not respond to price changes, demand is perfectly inelastic.
1.2 - How Markets Work
Values for YED
1.2.3 - Price, income and cross elasticities of demand
Inferior Goods (YED < 0): Demand decreases as income increases (e.g., low-quality goods).
Normal Goods (0 < YED < 1): Demand increases with income but at a decreasing rate.
Luxury Goods (YED > 1): Demand increases significantly with income (e.g., luxury cars).
1.2 - How Markets Work
Values for XED
1.2.3 - Price, income and cross elasticities of demand
Substitutes (XED > 0): An increase in the price of one good leads to an increase in the quantity demanded of the other (e.g., Coke and Pepsi).
Complementary Goods (XED < 0): An increase in the price of one good leads to a decrease in the quantity demanded of the other (e.g., cars and gasoline).
Unrelated Goods (XED = 0): The price change of one good has no effect on the other.
1.2 - How Markets Work
Factors Influencing Elasticites of Demand
1.2.3 - Price, income and cross elasticities of demand
[6]
- Degree of Necessity
- Addictiveness
- Availability of Substitutes
- Time - become more elastic over time
- Income (% of)
- Brand Loyalty
1.2 - How Markets Work
Why is Elasticities of Demand Important to Firms
1.2.3 - Price, income and cross elasticities of demand
- Firms use elasticities to set prices and predict revenue changes.
- Elastic demand means price increases reduce total revenue, while inelastic demand means price increases raise total revenue.
1.2 - How Markets Work
Why are Elasticities of Demand Important to the Government
1.2.3 - Price, income and cross elasticities of demand
- Government uses elasticities to make taxation and subsidy decisions.
- Inelastic goods can bear higher taxes, while elastic goods may see reduced consumption due to taxes.
- Subsidies can encourage the consumption of essential goods.
1.2 - How Markets Work
What is the difference between a movement along the supply curve and a shift of the supply curve
1.2.4 - Supply
- Movements Along a Supply Curve - Movements along a supply curve occur when the quantity supplied changes in response to a change in the price of the good or service, while other factors remain constant. The law of supply states that, all else being equal, as the price of a good or service increases, the quantity supplied also increases, and vice versa.
- Shifts of a Supply Curve - Shifts of a supply curve occur when factors other than price cause a change in the quantity supplied at every price level. A shift indicates a change in overall supply, not just a response to price changes.
1.2 - How Markets Work
Conditions of Supply
1.2.4 - Supply
[8]
- Productivity
- Indirect taxes
- Number of firms
- Technology - level of technology or technological advancements
- Subsidies
- Weather
- Costs
- Government policies and regulation
1.2 - How Markets Work
What is PES
1.2.5 - Elasticity of Supply
Price Elasticity of Supply
Measures the responsiveness of the quantity supplied of a good to changes in its prices
Formula: PES = (% Change in Quantity Supplied) / (% Change in Price
1.2 - How Markets Work
Value for PES
1.2.5 - Elasticity of Supply
- Perfectly Inelastic (PES = 0) - Quantity supplied doesn’t respond to price changes. Price are unable or unwilling to change supply
- Relatively Inelastic (0 < PES < 1) - a percentage change in price results in a smaller percentage change in quantity supplied. Producers have limited flexibility to adjust supply quickl
- Relatively Elastic (PES > 1) - a percentage change in price results in a larger percentage change in quantity supplied. Producers can respond to price changes by adjusting production.
- Perfectly Elastic (PES = ∞) - even a slight price change results in an infinite change in quantity supplied. This is rare and usually occurs in markets where producers can instantly and costlessly adjust production.
1.2 - How Markets Work
Factors Influencing PES
1.2.5 - Elasticity of Supply
- Availability of substitutes
- Stocks - shelf life
- Production time
- Availability of factors of production
- Capacity
- Ease of entry into the market
ASPACE
1.2 - How Markets Work
What are the Functions of the Price Mechanism to Allocate Resources
1.2.7 - Price Mechanism
- Rationing Function - Prices allocate scarce resources among competing uses. When demand is higher than supply then price rises, so only people willing to pay get the goods
- Incentive Function - Provides incentive for producers to allocate resources. Higher prices motivate proders to produce more and vice versa
- Signaling Function - Convey information about market conditions allowing consumers and producers to make informed decisions
1.2 - How Markets Work
The Price Mechanism in Local Markets
1.2.7 - Price Mechanism
In local markets, prices are determined by supply and demand conditions within a specific geographic area. Local factors, such as weather or local preferences, can influence prices. Example: The price of fresh produce at a local farmers’ market may vary based on seasonal factors and local supply.
1.2 - How Markets Work
Price Mechanism in National Markets
1.2.7 - Price Mechanism
National markets cover an entire country and consider supply and demand at a broader scale. National policies and regulations, such as taxes and trade policies, can impact prices. Example: The national housing market may be influenced by government policies related to interest rates and mortgage regulations.
1.2 - How Markets Work
Price Mechanism in Global Markets
1.2.7 - Price Mechanism
Global markets involve international trade and can be influenced by factors like currency exchange rates, global supply chains, and geopolitical events. Prices in global markets are interconnected and can impact local and national markets. Example: The price of oil in global markets affects fuel prices around the world, impacting consumers and industries in various countries
1.2 - How Markets Work
What is Consumer Surplus
1.2.8 - Consumer and Producer Surplus
Consumer surplus is the additional benefit or utility that consumers receive when they are able to purchase a good or service at a price lower than what they are willing to pay. It represents the difference between what consumers are willing to pay (their maximum price) and what they actually pay in the market.
1.2 - How Markets Work
What is Producer Surplus
1.2.8 - Consumer and Producer Surplus
Producer surplus is the additional profit that producers earn when they sell a good or service at a price higher than their minimum acceptable price. It represents the difference between the market price and the producer’s marginal cost of production.
1.2 - How Markets Work
What is a Subsidy
1.2.9 - Indirect Taxes and Subsidies
Money grant given to producers by the government to lower costs of production and encourage an increase in output
1.2 - How Markets Work
What are Indirect Taxes
1.2.9 - Indirect Taxes and Subsidies
A tax that increases a firms cost of production but can be transferred onto the consumer via higher price
Or a tax on spending
1.2 - How Markets Work
When are Subsidies used
1.2.9 - Indirect Taxes and Subsidies
PE in consumption – Used when there is an underconsumption of a good, so by lowering the cost of the production via a subsidiary there is a socially optimum quantity of the good and also a lower price level. E.g buses and rail
PE -
1.2 - How Markets Work
What is the impact of indirect taxes on consumers
1.2.9 - Indirect Taxes and Subsidies
- Increased prices
- Possible behavioural changes
- Possible regressive impact
1.2 - How Markets Work
Who gains more from a subsidy if demand is price inelastic?
1.2.9 - Indirect Taxes and Subsidies
The consumer
There is little change in output, but a large fall in price.
1.2 - How Markets Work
Who gains more from a subsidy if demand is price elastic?
1.2.9 - Indirect Taxes and Subsidies
The producer
1.2 - How Markets Work
What are some problems with subsidies for consumers
1.2.9 - Indirect Taxes and Subsidies
- Tend to be poorly targeted if everyone can buy subsidised goods as even rich households can benefit
- Economic theory would suggest that welfare would probably be higher if poor households were given cash payments instead of subsidies, as they could be targeted more effectively
1.2 - How Markets Work
What are some disadvantages of subsidies for the government and producers
1.2.9 - Indirect Taxes and Subsidies
- High opportunity cost.
- Difficult to target (exact size of externality = unknown).
- Can make firms inefficient.
- Difficult to remove.
1.2 - How Markets Work
What are some advantages of subsidies
1.2.9 - Indirect Taxes and Subsidies
- Welfare maximisation (social optimum output is reached (if pigouvian subsidy is utilised).
- Supports exports
- Changes preferences to goods that are subsidiesed, as if passed on price goes down so increase in demand
- Help an industry grow so it can become internationallly competitive
- Positve externality remains
1.2 - How Markets Work
What kind of government intervention occurs with a merit good?
1.2.9 - Indirect Taxes and Subsidies
Subsidies
(Tend to be underprovided by free market)
1.2 - How Markets Work
What kind of government intervention occurs with a demerit good?
1.2.9 - Indirect Taxes and Subsidies
Indirect taxes
1.2 - How Markets Work
What are the advantages of indirect taxation?
1.2.9 - Indirect Taxes and Subsidies
- The market produces at the social equilibrium position and social welfare is maximised.
- Raises tax revenue - which could be used to solve the externality through other ways - investment in carbon capture.
- Polluter pays principles - polluter pays external costs, fairer to society.
1.2 - How Markets Work
What are some disadvantages of Indirect Taxation
1.2.9 - Indirect Taxes and Subsidies
- Imperfect information - Difficult to know where to set the tax. May be set too high/low.
- Government might be too focused on raising revenues.
- Might lead to the creation of a black market.
- If demand for the good is inelastic, then taxes will be ineffective at reducing output.
- Taxes are politcally unpopular, so governments may be reulcant to introduce them.
- Regressive
1.2 - How Markets Work
What are the advantages of max/min prices?
- Increase social welfare (can be set where MSB = MSC / consider externalities).
- Can make goods affordable or provide a fair price (Both reduce poverty + ↑ equality).
- Can be used to prevent monopolies from exploiting customers
1.2 - How Markets Work
What are the disadvantages of max / min prices?
- Creates excess supply / demand (Caused by distortion of price signals).
- Difficult to set a new price (don’t know size of externality [Hayek’s criticism of Pigou]).
- Creates a shadow market.
1.2 - How Markets Work
What are the advantages of pollution permits?
- Guarantee that pollution will fall (Internalises externality pigou).
- Increase Gov rev
- Encourages green tech
- Preserves business autonomy
1.2 - How Markets Work
What are the disadvantages of pollution permits?
- Expensive to monitor and police (fines imposed on firms, large enough to ensure they follow regulation).
- Raises costs for businesses (could be passed on to consumers).
- Difficult to know how many to create.
- Imperfect info. means govt. don’t know optimum level of pollutions.
- Need for international cooperation (as climate change is a global issue, this = difficult).
1.2 - How Markets Work
What are the advantages of state provision of good/ services?
- Improves social welfare
- Ensures access to basic goods / corrects market failure (some goods not provided by private sector producers).
- Increases external benefits
1.2 - How Markets Work
Disadvantages of state provision of good/ services
- Expensive - high opportunity cost e.g. administrative costs.
- Gov. may provide wrong level of provision
- Inefficiencies and corruption
- Govt. may have inefficient production. (no incentive to cut costs).
1.2 - How Markets Work
Advantages of provision of information?
- Allows consumers to act rationally.
- Can be used alongside other policies. (e.g. can make demand more elastic - will increase effectiveness of indirect taxes at reducing output).
1.2 - How Markets Work
What are the disadvantages of provision of information?
- Expensive - high opportunity cost.
- Gov. may not have correct info.
- Consumers might not listen (due to irrational behaviour)
1.2 - How Markets Work
What are the disadvantages of regulation?
- Laws are expensive.
- Regulatory capture.
- Increased costs (may be passed on to consumer).
- May reduce competition - firms below shut down point / π motive limited inc. barriers
1.2 - How Markets Work
What are the advantages of regulations?
- Can consider externalities, prevent exploitation.
- (Overcoming market failure + max social welfare).
- Non-market based approach, so doesn’t suffer from problems related to elasticity etc.
1.2 - How Markets Work
What are the 4 main types of government failure?
- Distortion of price signals
- Unintended consequences - Black Markets
- (Excessive) Admin costs
- Information gaps
1.2 - How Markets Work
Outline the assumption of consumer behaviour?
1.2.10 - Alternative views of consumer behaviour
Should be rational but…
* Peer pressure - e.g. fashion trends
* Habits - such as brand loyalty
* Poor compuatation - difficult to compare value of different products and calcualting price per unit so may lead to inefficent choices
What shape does a perfectly elastic demand curve make?
What shape does a perfectly inelastic demand curve make?
- Elastic - Flat when elastic, like the middle part of an ‘E’
- Inelastic- Vertical when inelastic, like an ‘I’
