Demand/Supply & Price setting in a market Flashcards
Define Demand
Demand is the willingness and ability of consumers to buy a product at a given price
Why does the demand curve slope downwards? (3)
- The Law of Diminishing Marginal Utility: consumers are willing to pay a price equal to the utility (benefit/happiness) of the last unit they purchase (marginal utility). However the utility of each unit we buy is always less than the one before, so the price we will pay also falls.
- The Income Effect: if the price of a good rises then my real income (what I can buy with my income) falls, therefore I buy less.
- The Substitution Effect: if the price of a good rises consumers will switch to alternative, now relatively cheaper products and buy less of the good.
What are the possible causes of a shift in demand? (9)
If anything rather than the price of the good changes then a new demand curve needs to be drawn.
- Fashion/Trends
- Income (real disposable income)
- Weather/Seasons
- Changes in quality
- Population
- Change in the price of substitutes (similar products)
- Change in the price of complimentary goods (2 goods you buy together)
- Derived demand - the demand for labour depends on the demand for the product
- Speculation
Define Consumer Surplus
Consumer Surplus is the difference between the price consumers would be willing to pay and the actual market price
Define Supply
Supply is the willingness and ability of firms to sell a product at a given price (we assume the firms are price takers - they do not set the price)
Explain Willingness and Ability in terms of Supply
Willingness: if the price rises, the profit rises, which should encourage new firms to enter the market and existing ones to expand, so the market supply would increase (firms supply in order to make profit)
Ability: supply can be affected by natural/unforeseen factors
Describe the possible causes of a shift in supply
If a factor rather than price changes then the supply curve will shift. If more profit is possible at the same price the curve will shift outwards.
Causes of a fall in costs:
1. Increase in productivity/efficiency (new technology)
2. Cheaper resources/FoPs (lower wages)
Define Producer Surplus
Producer Surplus is the difference between the price a producer is willing to sell at and the market price
Define The Price Mechanism
The Price Mechanism is the interaction of supply and demand to allocate resources in a free market economy
Explain the 3 key roles of price
- A rationing device (it helps to decide who gets what)
- An incentive (for firms to enter the market, disincentive for consumers)
- A signalling device (lets firms/consumers know if there is a surplus/shortage, so signals if they should leave/enter the market)
Explain rational behaviour
Traditional (new-classical) economics is based on the idea that economic agents (consumers, firms, governments, labour) act rationally is. can rank a series of options according to their own net gain and always choose the best one, or maximise their utility.
However, behaviour economics suggests that agents may not be so rational. They point to things such as: habitual behaviour, lack of knowledge, poor at computation, emotional actions.
Define Price Elasticity of Demand
PED = %∆QD/%∆P or (∆QD/∆P)*(P/QD)original
It measures the proportionate response of QD to a proportionate change in P
Elastic: |PED|>1
Inelastic: |PED|
Explain the factors determining PED (4)
- Number of substitutes: few substitutes -> inelastic
- Definition of the market: the wider the definition the more inelastic (Petrol - inelastic, BP - elastic)
- Time: consumers take time to react to a change in P. So in short term PED is inelastic
- Actual price: cheap products tend to be inelastic
Define Income Elasticity of Demand
YED = %∆QD/%∆Y It measures the proportionate response of QD to a proportionate change in income Normal good: positive Inferior good: negative Elastic: |YED|>1 Inelastic: |YED|
Define Cross Elasticity of Demand
XED = %∆QD of A/%∆P of B It measures the proportionate response of QD for good A to a proportionate change in the price of good B Substitutes: positive Complimentary: negative The closer the greater the magnitude
Define Price Elasticity of Supply
PES = %∆QS/%∆P
It measures the proportionate response of QS to a proportionate change in price
Inelastic: PES1
Unitary: PES=1
Explain Short Run and Long Run
Short Run (SR) is the period of time where one factor of production is fixed in quantity. In Long Run (LR) all FoPs can vary. If there is an increase in price then firms would like to increase quantity supplied but may not be able to in the SR. In the SR PES is relatively inelastic. In the LR PES will be relatively elastic.
Describe the factors to consider for PES (6)
- How long does it take to produce the good?
- Are there stocks available? If so PES may be elastic even in SR
- How much spare capacity is there? A lot implies easy to increase quantity supplied - elastic
- Are resources easily available? (especially labour)
- Do prices fluctuate? If so firms may not react to a change in price
- Some commodities are finite so over the very LR PES becomes perfectly inelastic
Explain Indirect Tax
Indirect Tax is a tax on the production/sale of a good/service. It shifts the supply curve vertically up by the amount the tax goes up. It is paid by the producer. It is effectively a cost of production, so increase in tax leads to a decrease in supply. The tax revenue raised is the value of tax * quantity (incidence on consumer + incidence on producer). Incidence on the consumer (always closer to S2) is the burden of tax of tax on the consumers. Incidence on the producer is the burden of tax on the producer, or the tax cost absorbed by the firm.
If the PED is perfectly inelastic consumer pays all the tax
If the PED is perfectly elastic, producer pays all the tax
Define Specific/Unit tax and Ad Valorem tax
Specific or Unit tax - a set amount
Ad Valorem - a percentage of the selling price (VAT, IVA)
Define Subsidy
Subsidy is a payment by the government to a firm to encourage the production/sale of a product. It reduces the costs of production and is like a negative tax.
