Chapter 2A Flashcards
Price mechanism
Allocating scarce resources between competitive uses
- Signaling function
- Incentive function
- Rationing function
The three economic questions
- What and how much to produce
- How to produce
- For whom to produce
Key features of the free market economy
- Private ownership of property
- Freedom of choice and enterprise
- Pursuit of self interest
- Competition
Theory of demand
The quantity of a well defined commodity that consumers are both willing and able to buy at a given price during a given period of time ceteris paribus
What does the price mechanism determine
Market equilibrium
The law of diminishing marginal utility
As a consumer consumes more and more of a good the additional satisfaction he derives from each additional unit of good decreases beyond a certain point of consumption
MU= change in TU (total utility) - change in quantity of good
The demand curve
Shows the relationship between price and quantity demanded of a well defined commodity shows quantity demanded of a WDC consumers both willing and able to buy at a given price at a given period of time ceteris paribus
The law of demand
In a given period of time the quantity demanded of a product is inversely related to its price ceteris paribus
The types of relationships between goods
- Substitutes in consumption
Goods that can be used in place of one another in the satisfaction of a similar/particular purpose
2.derived demand
Describes a market in which a good is demand not for its own sake but for the purpose of production of another good. Not both goods are final products
3.Complements in consumption
Goods that are used in conjunction with one another in the satisfaction of a particular purpose
Types of goods
- Normal
increased income leads to increased demand
2.Luxury
increased income leads to increase in percentage increase in demand
3.Inferior
increased income leads to fall in demand e.g: cheap substitutes like supermarket coffee
Change in quantity demanded versus change in demand
Change in quantity demanded is affected by price determinants, it is the shift along the demand curve
Change in demand is affected by non price determinants it is complete shift of the demand curve
Non price determinants of demand
- Govt policies
Policies that influence taste and preferences like the implementation of taxes/subsidies/campaigns
2.Changes in consumer income
Increased–> increasing purchasing power
3.Changes in prices of related goods
decrease in price of a related which serves a similar purpose reduces the demand for a specific good. The two goods are alternatives or substitutes in consumption - Changes in consumer expectation
A consumer whom expects that in the future price may rise might choose to increase his consumption now
5.Changes in taste and preferences
- Increase in number of consumers in the market (population growth)
increased demand for good
G4CI
Individual demand
Demand of a single individual
Market demand
Demand of all consumers in the market
the horizontal summation in a table
Shortage
When the quantity demanded exceeds quantity supplied it causes an upward pressure on prices
Supply
the quantity of a well defined commodity that a producer is both willing and able to supply at a given time and at a given price level ceteris paribus
The law of supply
In a given period of time as the quantity supplied of good is directly related to its price ceteris paribus
Law of increasing opportunity cost
As more and more of a good is produced the opportunity cost of the additional output increases, increasing marginal cost
Supply curve
Shows the relationship between price and quantity supplied of a well defined commodity shows quantity supplied of a WDC producers both willing and able to produce at a given price at a given period of time ceteris paribus
Non price determinants of supply
- Govt policies (indirect taxes; indirect subsidies)
- Change in price of related goods
Goods that are substitutes in production. The quantity of good that producers put up for sale depends on price of related good - Change in costs of relevant resources
an increase in the cost of resources will cause increase in production costs which will render suppliers reducing their supply of a good
4.Natural disasters
Can cause massive destruction to production firms and supply chains which will destroy raw materials required in the production of goods
- Expectations of future price changes
If prices are expected to rise producers may reduce the supply of the good in the short term and build up stocks and only release them into the market when price rises
6.Changes in technology
Increased productive efficiency which will increase rate of production increases qty of good supplied - No.of sellers in the market
Increased supply
What and how much to produce
(bring in the signaling and incentive function)
relies on the demand for a good which reflects which goods consumers are willing and able to pay for. Which enables a producers to divert resources to supply a good that has a greater demand
Producers respond to price signals by changing quantity of good supplied
Producers divert resources from goods with lower prices relative to costs and hence lower profits, to goods that are more profitable
How to produce
In a free market competition forces firms to use least cost combination of inputs to produce a given level of output as least cost combination maximises profits.
Any firm that does not employ least cost combination technique will find other firms that can undercut its price, losing customers and going out of business
For whom to produce
The distribution of finished goods to consumers based on their ability and willingness to pay for the market price of the product
Since prices help in rationing available resources, the answer to this question can be answered by the purchasing power of consumers. Resources are allocated to the production of a good depending on its ‘dollar-votes’
Signaling function
Prices are signals to reflect what is relatively scarce what is relatively abundant providing information to buyers and sellers what should be bought and what should be produced
Prices also act as signals to determine which goods are demanded
Rationing function
There is a need to ration resources due to scarcity. Changes in price allows for scarce resources to be rationed for parties who are most willing and able to buy
Incentive function
Changes in prices act as an incentive for changes in quantity of goods supplied/consumed to maximise profits/marginal utility. Provides suppliers with incentives to reallocate their resource
