Demand, Supply and Equilibrium Flashcards
Demand
The willingness and the ability to purchase a particular good at a given price and time, ceteris paribus.
The Law of Demand
- Price increase, quantity demanded decrease
- Price decrease, quantity demanded increase
Non-price Determinants for Shifts in Demand Curve
PEPSIC
Preference
Expectations
Population
Substitutes
Income
Complementary
Assumptions of the Law of Demand (HL)
- The income effect
- The substitution effect
- The law of diminishing marginal utility
Income Effect (HL)
- A price drop increases real income, boosting quantity demand.
- A price rise reduces real income, reducing quantity demanded.
Substitution Effect (HL)
When a product’s price falls, it becomes more attractive, leading consumers to substitute it for pricier options.
The law of diminishing marginal utility (HL)
As consumption increases, the additional satisfaction from each unit decreases, so consumers buy more only at lower prices.
Eventually, marginal utility reaches zero, and they stop wanting more.
Supply
The willingness and ability to produce a particular good at a given price and time, ceteris paribus.
The Law of Supply
Price increase, quantity supplied increase
Price decrease, quantity supplied decrease
Shifts in the Supply Curve (non-price determinants)
- Input costs
- Price of other goods the supplier could make (sometimes called a “supplier substitute”)
- Weather
- Technology
- Expectations
- Government intervention
Indirect tax/Expenditure
A tax on goods and services
Subsidy
A payment by the government to a producer per unit of output to increase the supply of a good or to lower production costs.
Assumptions underlying the law of supply (HL)
- The law of diminishing marginal returns
- Increasing marginal costs
The law of diminishing marginal returns (HL)
After reaching an optimal production level, adding more of a production factor results in smaller output increases
Marginal costs (HL)
Increase cost caused by producing one more unit of the good
Equilibrium
Is where the supply and demand intersect
Allocative efficiency
Resources are allocated into their best possible use (the most efficient way from society’s point of view)
Consumer surplus
When consumers buy a product at a price lower than they were willing to pay
Producer surplus
When producers sell a product at a price higher than they were willing to sell it for
HL ONLY - Rational consumer choice
Rational choice theory states that individuals make logical decisions to maximize their self-interest:
- consumers aim to maximize utility
- producers aim to maximize profit
Biases 1 - Rule of thumb
Making practical decisions based on experience and default choices.
E.g. Children choosing the same food at McDonalds
E.g. When we assume that discounted prices are cheaper than the average price
E.g. Drivers in autopilot mode when choosing route home
Biases 2 - Anchoring
People compare the unfamiliar to the familiar and often base decisions on the first information they encounter, even if it’s irrelevant.
Biases 3 - Framing
Presenting information in such a way that it creates a bias in favour of a particular decision
E.g. Yogurt is sold as 90% fat free it would be more successful than if labelled 10% fat
Bias 4 - Availability
People overestimate likelihood of event due to recent occurrences or emotional associations.
Bounded rationality
People often make decisions without access to all relevant information, or the ability to process it due to limited capacity
Bounded self-control
People conform to social norms and group preferences (which may not be their own preferences).
People exercise self-control only within limits.
Bounded selfishness
Rational consumers may act selflessly, sacrificing personal gain for the public good.
Imperfect information
When people have inaccurate, incomplete or unreliable information, so decision making is not optimal.
Choice architecture
Designs how choices are presented, guiding people to avoid poor or irrational decisions.
Default choices
- When a person is automatically signed up into a system, or it is the given decision if no action is taken
E.g. employees enrolled in a pension scheme
E.g. restaurants default side option is a salad
Mandated choices
When people must make a decision in advance about their participation in an activity.
E.g. applying for a new driving license, we are asked whether we wish to donate organs in the event of death
E.g. Governments ask individuals to declare how they will vote (by post or in a polling station).
Nudge theory
Nudges are small prompts by choice architects to subtly influence behavior without removing choice.
Nudge Theory - When does it work best?
E - Easy (removing friction and simplifying things in order to influence people)
A - Attractive (break through attention)
S - Social (humans are influenced by what others do)
T - Timely (determining when people are most responsive)
HL ONLY - Business objectives
profit maximisation (MR = MC)
- profit increase if MR > MC
- profit decrease if MC > MR
Alternative business objectives
- Corporate social responsibility (CSR)
- Market share
- Satisficing
- Growth
Market Share
A firm’s portion of total value of sales in a particular industry
Corporate social responsibility (CSR)
Firms aim for ethical objectives rather than aiming solely or primarily for profit
Satisficing
Aiming for a satisfactory or adequate level of profit rather than the maximum profit
Growth
Increasing the size and scale of the firm
Status quo/inertia bias
When confronted with numerous choices, consumers prefer to maintain status quo and do nothing
Hyperbolic discounting
Tendency for humans to prefer smaller short term rewards over larger later rewards
Movement along demand curve
Movement along supply curve
Consumer and Producer Surplus
Shift in Demand
Shift in Supply
Explaining a diagram
1. Interpret the question and state assumptions and which determinant is occurring.
2. Curve shift.
3. Effect on price and quantity.
4. Effect on the other curve (extension or contraction).
E.g.
Assuming that jam and marmalade are substitutes (one can be used in place of the other), which is a determinant of demand, if the price of marmalade increases then consumers will buy more jam. This shifts the demand curve for jam outwards, increasing demand, from D to D1, which will cause the price to increase from P to P1, and the quantity to increase from Q to Q1. This leads to an extension along the supply curve.
