1.2.1 Rational decision making, 1.2.6 Price determination, 1.2.7 Price mechanism

Question 1

What are the underlying assumptions of rational decision making?

1.2.1

Answer 1

Consumers aim to maximise utility (satisfaction).
Make use of all available information.
The choices of one individual don’t influence the choices of others.
Firms aim to maximise profits.

Question 2

What are the issues of assuming rational behaviour?

1.2.1

Answer 2

In the real world, there are plenty of examples of irrational behaviour.
Decisions are made that don’t maximise utility and can cause a loss of economic/social welfare.
It is the failure to forecast future feelings correctly which results in consumers not maximising utility.
Consumers may underestimate the addictive nature of some consumption decisions and consumers tend to overestimate the impact of a present consumption decision.

Question 3

Why is it important to assume rational behaviour?

1.2.1

Answer 3

• Cannot analyse how consumers/firms will act without making assumptions
• Unable to build models
• Identify situations people seem to depart from rationality

Question 4

When buyers and sellers come together they strike a price through ____, which will be where _____ and is known as the _______.

1.2.6

Answer 4

When buyers and sellers come together they strike a price through bargaining, which will be where demand = supply and is known as the equilibrium price.

Question 5

Define market equilibrium

1.2.6

Answer 5

A situation that occurs in a market when the price is such that the quantity demanded by consumers is exactly balanced by the quantity supplied by firms i.e. the price where Qd = Qs.
This is the price that will remove both excess demand and supply and we get market clearing.
By removing excess S & D, the price does not want to move and we get a stable price.
The equilibrium price is not market price.

Question 6

Which book explained the concept of supply and demand as an “invisible hand”?

1.2.6

Answer 6

Adam Smith: The Wealth of Nations 1776
Explained the concept of supply and demand as an “invisible hand” that naturally guides the economy. In a free-market economy, market forces are allowed to allocate resources with prices paying a key role. This is a laissez-faire approach to resource allocation.

Question 7

Shifts in the _____ cause the equilibrium price to change.

1.2.6

Answer 7

Shifts in the demand and supply curves cause the equilibrium price to change.

Question 8

Define price mechanism

1.2.7

Answer 8

A process by which resource allocation is influenced through rationing, incentives and signalling.

Question 9

What do the workings of the market generate an answer to?
How do they do so?

1.2.7

Answer 9

The 3 basic economic questions:

What is produced?
Scarce resources are used to produce goods and services where demand is highest.

How it is produced?
Firms aim to maximise productive efficiency, therefore, minimise average fixed costs to maximise profit per unit.

To whom does the good or service go to?
To the consumer that has sufficient income to be able to afford to purchase the good/service from their employment in the labour market.

Question 10

What are the functions of price in allocating resources in a market?

1.2.7

Answer 10

1. Rationing
2. Incentive
3. Signalling

Question 11

Define price signal

1.2.7

Answer 11

Where the price of a good carries information to producers or consumers that guide the market towards equilibrium and assists in resource allocation.

Question 12

How does the price mechanism/invisible hand work?

1.2.7

Answer 12

1. Rising prices give a signal to consumers to reduce demand or withdraw from a market completely and they give a signal to potential producers to enter a market.
   Conversely, falling prices tell consumers to enter a market whilst sending a negative signal to producers to leave the market.
   Sellers also respond to signals about market conditions.
2. Higher prices provide an incentive to existing producers to supply more because they provide the possibility of more revenue and increased profits - the incentive function being an extension of supply along the existing supply curve. Prices also act as an incentive for buyers. Low prices encourage buyers to purchase more goods because the utility gained per round spent increases relative to other goods. The reverse of this is also true.
3. When resources are scarce, demand exceeds supply and prices are driven up. The greater the scarcity, the higher the price and the more the resources is rationed.
4. The final equilibrium quantity demonstrates both firms and consumers are satisfied, therefore there is efficient allocation of resources.

Question 13

Define disequilibrium and what happens when there is disequilibrium

1.2.7

Answer 13

Where quantity demanded does not equal quantity supplied.
The functions of the price mechanism take over.
A signal would be sent to producers/consumers.

Question 14

Define the profit motive

1.2.7

Answer 14

Firms have an incentive to raise their prices as they can then earn more profit.

Question 15

The price mechanism in the short-run vs long-run

1.2.7

Answer 15

Short-run:
Firms adjust their output
Long-run:
Firms enter and exit the market until there are no longer further incentives for entry or exit.

Consumers - low prices encourage them to purchase more goods since the utility gained per round spent increases relative to other goods.

Question 16

The government’s role in the free market economy

1.2.7

Answer 16

The government provides a basic framework of property rights and a legal framework.
Property rights assure the incentives from the owners of the capital.
The state does not intervene in the production process directly.

Question 17

What was Adam Smith’s warning about free markets?

1.2.7

Answer 17

Factors such as protectionism and collusion between firms made the free market ineffective. He felt that consumers interests needed to be protected if there was market failure.

Question 18

What does the supply curve represent in a competitive market?

1.2.7

Answer 18

The marginal cost, which is the cost of producing an additional unit of a good.

Question 19

Define allocative efficiency
When does an individual market exhibit allocative efficiency?

1.2.7

Answer 19

Achieved when society is producing an appropriate bundle of goods relative to consumer preferences.
Society needs to find a way of using its limited resources as efficiently as possible.
When the price is equal to the marginal cost.

Question 20

What can the demand curve represent?

1.2.7

Answer 20

The willingness of consumers to pay for a good and so the marginal benefit from consuming the good.

Question 21

Where is society most well-off?

1.2.7

Answer 21

Where the price of a good is equal to its marginal cost. If marginal benefit were higher than the marginal cost of producing it, then society would be better off if more of the good were produced.

Question 22

Assumptions the model of supply and demand is based on

1.2.1

Answer 22

Buyers and sellers form clearly defined separate groups.
Well defined private property rights.
Competitive markets.
Buyers and sellers have full information.
Firms are price takers.