1.4 How markets work: price determination Flashcards
What is market equilibrium?
When the price is such that the quantity that consumers buy at is balanced at the quantity that firms wish to supply.
It represents a trade-off for buyer and seller - higher prices are good for the producers but make the product more expensive for the buyer.
In a free market the market automatically shifts towards this level
What are the 2 types of market disequilibrium?
Excess demand - when market price is set below the equilibrium price, so there is less supply but more demand
Excess supply - supply is greater than demand so unsold goods in the market. Prices tend to be above equilibrium and so more is supplied then demanded. This tends to then cause it to be forced downwards
What is consumer surplus? How is it affected by elasticity?
The measure of the welfare gained from consumption. It is the difference between the maximum amount consumers are willing and able to pay for a good/service and total amount they actually pay, indicated by the area underneath the demand curve.
When supply shifts inwards i.e. if an indirect tax is imposed, consumer surplus falls
The more inelastic it is the higher the consumer surplus as there are people willing to spend a high amount of money.
What is producer surplus?
The difference between the price producers are willing and able to supply a product for and the price they get in the market, shown by the area above the supply curve and below the price. Higher prices provide an incentive for businesses
What is the community surplus?
The sum of the consumer and producer surplus
What is an indirect tax? What are the two types?
A tax imposed by the government to increase the supply costs faced by producers. The amount is shown by the vertical distance between the supply curves.
Examples include VAT, fuel/alcohol/tobacco duty, sugar tax
Specific tax is set per unit and so causes a parallel shift in supply curve
Ad valorem tax is set as a percentage tax, causing a pivotal shift
What is a direct tax?
A tax paid directly to the government, such as income tax, national insurance, corporation tax
What is the effect of an indirect tax on consumer and producer surplus?
The tax causes the supply curve to shift inwards, rising costs and reducing supply and demand inwards.
At the lower demand, consumers pay higher prices and so there is less consumer surplus
At the lower supply, producers supply less at a lower cost.
The tax revenue is indicated by the difference between the two supply curves, and the welfare loss is the triangle created by the two surplus’ moving inwards.
How is the effect of an indirect tax dependent on the elasticity?
If PED is elastic, most of the indirect tax is absorbed by the supplier as there is not a significant fall in consumer surplus
If PED is inelastic, most of the effect is on the consumer as there is a significant fall in consumption and so consumers who still buy pay the price.
What are subsidies?
A form of financial support such as a grand offered to producers and consumers, causing an outward shift of the supply curve leader to a lower equilibrium price and increase in quantity traded. The subsidy per unit is shown by the vertical distance.
How is the benefit from the subsidy split?
The consumer benefit is indicated by the area of the fall in price from equilibrium to the new price.
The producer benefit is the price above where the new equilibrium is at the supply curve - the producer tends to keep part of the subsidy for themselves
Why may subsidies be given?
- Reduce inequality and help poor
- Encourage investment in new sectors
- Protect jobs in recession and declining industry
- Healthcare
- Reduce cost of training and employing workers
- Reduce transport costs (external too)
