Demand, supply, and elasticities Flashcards
State the law of demand
as the price of a product falls, the quantity demanded will increase (ceteris paribus)
assumptions of the law of demand
Law of diminishing marginal utility:
As we consume more of a good, the satisfaction received from the additional good consumed decreases. For the consumers to want to buy an additional unit, the price will need to decrease.
Substitution effect:
As the price of a good rises, consumers substitute (buy more) of a less expensive good.
Income effect:
As the price of a good falls, the consumer’s “real income” (purchasing power) increases. In other words, you can buy more with the same amount of money.
non-price determinants of demand
Income:
– Normal goods: as our income rises we tend to spend more on them
– Inferior goods: as our income rises we demand less of them
Price of other goods:
– Substitutes: the increase in the price of one will lead to an increase in demand for the other
– Complements: the increase in price of one will lead to a decrease in demand for another
Preferences and tastes:
If there is a positive change towards a product them demand will increase.
Population:
– As a population grows/reduces, the demand for products like food, housing, public transit etc. increases
– As a popiulation ages, demand for more age-appropriate products (e.g. healthcare) increases
Income distribution:
A redirection of wealth from the rich to the poor may increase demand for basic goods.
movements along vs shifts of the demand curve
Along the curve: represents a change in price only (results in a change in quantity demanded)
Shift of the curve: represents a change in any other factor (results in a change in demand)
state the law of supply
As the price of a product rises, the quantity supplied will increase (ceteris paribus)
assumptions of the law of supply
Law of diminishing marginal returns:
As more units of variable input are added to one or more fixed inputs, the marginal product of the variable at first increases, but there comes a point when it begins to decrease.
Increasing marginal costs: as more and more of something is consumed, marginal costs increase over the short-run.
non-price determinants of supply
Cost of factors of production:
As the price of resources increases, so does the cost of making the product. Assuming cost increases cannot be passed onto the consumer in the short term, firms will cut back production.
Prices of related goods:
– Competitive supply: As profits incresase for one product, production is moved away from the product that uses similar resources
– Joint supply: If the production of a product increases, the production of another good found in the same place would also increase
Future price expectations:
If firms expect the future price of a product to increase, the firm will likely start to increase the supply of the product.
Taxes and subsidies:
– As taxes increase, firms will reduce supply.
– The introduction of a subsidy leads to an increase in supply.
Technology:
New technologies usually reduce production costs, thus making production more profitable (increase in supply).
Number of firms:
More firms mean an increase in supply.
Shocks or unpredictable events:
For example, a war would lead to an decrease in supply.
movements along vs shifts of the supply curve
- A movement along the curve is caused by a change in price (called a “change in quantity supplied”)
- A shift of the supply curve is caused by a change in a determinant of supply (called a “change in supply”)
what is consumer surplus
the difference between what consumers paid and the price they were willing to pay.
also said to represent the utility gained by consumers.
what is producer surplus
the difference between the price suppliers were willing to accept and the price the market cleared at.
what is social/community surplus
the sum of consumer and producer surpluses.
allows economists to model social welfare.
allocative efficiency at the competitive market equilibrium means that:
- social/community surplus is maximized
- marginal benefit = marginal cost
assumptions of rational consumer choice
Consumer rationality:
- consumers can rank their preferences (completeness assumption)
- consumers are consistent with their preferences [if a>b and b>c then a>c] (transitivity assumption)
- consumers always prefer more (satiation assumption)
Utility maximization:
Consumers will seek to maximize their utility with the financial resources they possess (underpins the laws of marginal utility and iminishing marginal utility)
Perfect information:
Consumers know all possible products, product qualities, and prices.
limitations of the assumptions of rational consumer choice
(behavioral economics)
Biases:
Systematic errors in thinking or evalutaing that depart from normal standards of thought or judgement. Biases that affect consumer choices include:
- Rules of thumb: simple guidelines based on experience and common sense, simplifying complex decisions that would have to be based on the complex consideration of every possible choice (e.g. one portion of salad is equal to 2 handfuls)
- Anchoring: the use of irrelevant information to make decisions, which often occurs due to it being the first piece of information that the consumer happens to come across (e.g. you find a pair of jeans that cost $150, then you find a similar one for $100 and you buy it thinking it’s a bargain, but then you discover you could’ve gotten the same thing elsewhere for $50)
- Framing: how choices are presented (framed) affects our perception of them, even though the rational consumer should be indifferent to this (e.g.1. framing via language – sonsumers prefer beef described as 80% lean rather than 20% fat, even though they are the same thing) (e.g.2 framing via the seller’s environment – consumers could be willing to pay a higher price for jeans in a boutique than for the identical pair of jeans in a discount store)
- Availability: information that is most recently available, which peple tend to rely on mopre heavily, though there is no reason to expect that this information is any more reliable than other information that was available at an earlier time.
Bouned rationality:
Consumers are rational only within limits, as consumer rationality is limited by consumers’ insufficient information, the costliness of obtaining information, and the limitations of the human mind to process large amounts f information. As a consequence, rather than maximize, consumers seek to satisfice, meaning that they seek a satisfactory outcome rather than an optimal one.
Bounded self-control:
People exercise self-control only within limits, which means they often do not have the self-control required of them to make rational decisions.
Bounded selfishness:
People are selfish only within limits. The assumption of self-interested behavior underlying the maximisation principle cannot explain the numerous accounts of selfless behaviour and willingness to contribute to the public good even at the cost of reduced personal welfare.
Imperfect information:
Consumers do not and cannot have such full access to information, which meansthey are unable to maximize utility as they make choices based on faulty and incomplete information.
nudge theory
a method designed to influence consumers’ choices in a predictable way, without offering financial incentives or imposing sanctions, and withot limiting choice
profit maximization
(business objective)
Profit maximization means maximizing the profit earned by a business.
A firm’s output would therefore be determined by the profit maximizing point.
corporate social responsibility
(business objective)
Self-interest of a firms can lead to negative environmental problems and societal issues, which can in turn lead to a poor image and possible government regulation, incentivizing firms to display corporate social responsibility:
- avoidance of polluting activities
- supprt human rights (no child labour, gender equality, etc.)
- support the arts and athletics
- donate either money, supplies, or staff time to charities
There is no evidence that CSR reduces profits. It costs money, but may help gain consumers and investors.
market share maximizing
(business objective)
Market share refers to thhe % of total sales in a market that is earned by a single firm. A large markewt share means you sell many units and thus can achieve economies of scale. Some firms measure their success by market share.
If you maintain your market share, as the market grows so does your revenue. However, to increase maket share means lowering prices (reduces profit) or spending money on R&D (expense that lower profit).
satisficing
(business objective)
Firms that have this as an objective try to achieve a satisfactory level of profits together with satisfactory results for many more objectives, rather than optimal results for any one objective.
growth
(business objective)
Some firms opt for expanding the size of their business rather thhan profits. Benefits:
- a growing firm can achieve economies of scale and lower average costs
- allows for diversification by market and products (reduces risk)
- increases market power
- reduces the corporate risk during poor economic times
functions of the price mechanism
As signals, prices communicate information to decision-makers.
As incentives, prices motivate decision-makers to respond to the information.
what is price elasticity of demand
How sensitive quantity demanded is to a change in price
what is perfectly elastic PED
a change in price results in the quantity demanded being 0
represented by a horizontal demand curve
what is perfectly inelastic PED
a change in price results in no change in quantity demanded
represented by a vertical demand curve
what is unitary PED
A change in price leads to a corresponding equal change in quantity demanded.
- As prices rises (x%), demand reduces by the same amount (x%), and vice versa
- As prices rise the total revenue remains constant, thus price has no effect no revenue
No real-life examples
what is elastic PED
+effect on revenue
Demand is highly sensitive to changes in price.
- As price rises (e.g. 8%) demand reduces by a larger amont (e.g. 17%), and vice versa
- As prices rise, total revenue decreases (thus to increase revenue, firms should lower prices)
Real-life examples: clothes from Zara, breakfast cereals, etc.)
what is inelastic PED
+effect on revenue
A change in price leads to a corresponding small change in demand.
- As prices rise (e.g. 19%) demand reduces by a smaller amount (e.g. 11%), and vice versa
- As prices rise, total revenue increases (thus to increase revenue, firms should raise prices)
Real-life examples: tobacco, alcohol, gasoline, etc.
why does PED change along a downward sloping demand curve
- As price increases consumers will be more inclined to purchase substitute goods
- As price increases the proportion of income spent on the product will increase
- As price increases the % change in quantity demanded increases while the % change in price decreases
determinants of PED
Number and closeness of substitutes:
The greater the number and similarity of substitutes the greater the product’s elasticity.
Necessity of the product and how widely product is defined:
E.g.: water is a necessity (inelastic), but Fiji water isn’t (elastic)
Time period considered:
Consumers adjust to changes in price at different rates. In the short term, PED tends to be inelastic, but in the long term it becomes more elastic as consumers seek out other alternatives.
Necessities vs. luxuries:
Necessities are inelastic, luxuries are elastic. Howecer, addicitomn can affect this relationship (e.g. cigarettes are a luxury but tend to have inelastic PED)
Proportion of income spent:
Tge larger the proportion of income spent, the more elastic the demand.
what is the relationship between PED and total revenue (of firms)
For inelastic goods, the higher the price the higher the revenue.
For elastic goods, the lower the price the higher the revenue.
why is PED for primary commodities usually lower than the PED for manufactured products?
- They have few substitutes and are considered necessities
- Manufacturers are the main buyers and as these items are part of their livelihood purchase contracts are set well in advance
- With fixed contracts changes in demand, regardles of price, are minimal (e.g. Starbucks will not buy more coffee when prices fall nor reduce the quantity bought when prices rise)
define income elasticity of demand
How sensitive our demand for a product is based on our income
what goods are income elastic?
services and luxury goods
what goods are income inelastic?
necessities
what goods have a positive YED?
normal goods
what goods have a negative YED?
inferior goods
what goods have YED<1
necessities
what goods have YED>1
services and luxury goods
why is YED important for firms?
because it helps firms identify inferior and normal goods, hence helping them to:
- plan appropriately
- allocate and relocate their land, labour, and capital to be more efficient
- make more profit
How can YED help explain changes in the sectoral structure of the economy?
- Agriculture (primary sector) is relatively income inelastic, so as society’s income grows over time, the demand for agricultural outpt grows more slowly than the growth in income
- By contrast, manufacturedd products (seconday sector) are relatively income elastic, so as society’s income grows, the demand for these products grows faster than income
- Many services (tertiary sector) have even higher YEDs, so the percentage increase in the demand for these is much larger
Therefore, over time, the share of agricultural output in the economy shrinks, while the share of manufactured output grows. With continued growth, the services sector expands at the expense of both agriculture and manufacturing.
define price elasticity of supply
How responsive the quantity supplied of a good/service is to a change in price
what is perfectly elastic PES
A change in price results in the quantity supplied being 0
Horizontal supply curve
what is perfectly inelastic PES
A change in price results in no change in quantity.
Vertical supply curve
what is unitary PES
A change in price leads to a corresponding equal change in quantity supplied.
what is elastic PES
A change in price leads to a correspondingly larger change in quantity supplied.
Typical products include: bakery goods, most menu items in a restaurant
what is inelastic PES
A change in price leads to a correspondingly smaller change in quantity supplied.
Typical products include: long lead time agricultural products, natural resources
Why is PES for primary commodities generally lower than the PES for manufactured products?
- Many of these goods have an inelastic supply as supply is unable to increase in the short term
- Suppliers plan, build, and commit to providing relatively large fixed amounts of commodities well in advance
- With fixed large scale capital investments, changes in supply regardless of price changes are minimal (even reducing supply is expensive)
price volatility of primary commodities
With inelastic demand and supply curves, a change in demand or supply creates a large swing in prices.
Determinants of PES
Time period considered:
The longer the time period considered, usually the more elastic the supply of a good. In the short term most goods are relatively inelastic, but in the long term production can usually be ioncreased (more factories, educated workforce, improved technologies)
Mobility of factors of production:
The more easily FOP can be switched out of one line of production and into another (where price is increasing), the greater the PES
Unused capacity:
The greater the spare capacity, the greater the PES, because it is easier for the firm to increase output if there is an increase in price
Ability to store stock:
Some products are easily storable (oil, wheat) and can be swiftly introduced to the market should prices increase
Rate at which costs increase:
If total costs increase significantly relative to the increase in supply, producers will be reluctant to increase supply. This suggests it would take large price movements to change supply.
primary commodities
define
goods arising directly from the use of natural resources, or the factor of production ‘land’
What is the relationship between PED and tax revenue?
the lower the PED of the taxed good, the greater the government tax revenues
What does YED show us?
- if goods/services are normal goods or inferior goods
- if goods/services are necessities or luxuries
What is choice architechture?
definition
the design of particular ways or environments in which people make choices
Types of nudges used in choice architechture
Default choice:
People often make choices due to habit or lack of interest in taking a deliberate action, even if doing nothing may not be the best choice for them. Sometimes they feel more comfortable not having to make a choice. Therefore, one way of influencing people to follow a particular course of action is to provide it as a default choice.
Restricted choice:
A choice limited by the government or other authority.
Mandated choice:
A choice between alternatives that is made mandatory/compulsory by the government or other authority. It can be thought of as a required choice. It is a free choice, but it is compulsory to make that free choice.
Pros & cons of behavioral policies (nudges)
Pros:
- simple and low-cost way to influence behavior in socially desirable ways
- numerous possible applications
- offers consumers and citizens (generally) freedom of choice without forcing them or preventing them to do anything
- may be able to overcome the weaknesses of the theory of consumer behavior, which is not always able to explain seeming irrationality of actual consumer behavior
- policies are based on principles of psychology that have been tested over many years
Cons:
- may not be applicable to different income, social, or cultural groups
- may be used as substitues for necessary but politically costly economic policies, such as imposing taxes on demerit goods
- may be a form of government regulation camouflaged under the guise of freedom of choice
- consumer choices might not be a reflection of their true preferences or be in their best interest
revenue maximisation
(business objective)
Managers tend to want to increase sales and maximize revenues:
- sales are identifiable and very easy to measure, and increasing sales work as a great employee motivator
- rewards tend to be linked to sales
- usually sales tend to increase faster than costs (thus profits increase)
- increased sales create a feeling of success and increases employee confidence
