How Markets Work 1.2

Question 1

PWhat is one of the underlying assumptions of rational economic decision making?

(FATMP)

Answer 1

Firms aim to maximise profit: Economic theory assumes that firms are run for their owners and shareholders and so aim to maximise profit in order to keep shareholders happy.

Question 2

What is one of the underlying assumptions of rational economic decision making?

(CATMU)

Answer 2

Consumers aim to maximise utility: Utility is the satisfaction gained from consuming a product. The rational consumer is called Homo Economicus, who makes decisions by calculating the utility gained from each decision and chooses the one which will given them the most satisfaction.

Question 3

What is one of the underlying assumptions of rational economic decision making?

(GATMSW)

Answer 3

Government aim to maximise social welfare: Governments are voted in by the public and work for the public, so should aim to maximise their satisfaction by taking decisions which increase social welfare.

Question 4

What is a condition for demand?

(Pirates)

Answer 4

Population: If population rises, we would expect demand for all products to increase and so the demand curve will shift to the right. This is because the more people there are in the country, the more people who will want the good.

Question 5

What is a condition for demand?

(pIrates)

Answer 5

Income: For most goods, if income increases, demand increase because a person can afford to buy more of the product.

Question 6

What is a condition for demand?

(piRates)

Answer 6

Related goods: If goods are complement or substitutes of each other then a change in the price of another good and cause a shift the demand curve.

Question 7

What is a condition for demand?

(pirAtes)

Answer 7

If a firm carries out a successful advertising campaign, demand is likely to increase. If a competitor firm carries out a successful advertising campaign, demand for the first firm will fall.

Question 8

What is a condition for demand?

(piraTes)

Answer 8

Taste: If something becomes more fashionable, we expect demand to increase and if it becomes less fashionable, then demand will fall.

Question 9

What is a condition for demand?

(piratEs)

Answer 9

Expectations: Expectations of what might happen in the future can have a big impact on the level of demand for some good. For example, If people expect a shortage of something, or that price will rise in the future, then demand for that product will increase.

Question 10

What is a condition for demand?

(pirateS)

Answer 10

Seasons: Some products will find their demand affected by the weather. For example, hot summers cause an increase in demand for sun cream.

Question 11

Explain why the demand curve is downwards sloping.

Answer 11

The demand curve is sloping downwards because if more of a good is consumed, less satisfaction is derived from that good (the Law of Diminishing Marginal Utility). This means that consumers are less willing and able to pay high prices at high quantities since they are gaining less satisfaction.

Question 12

What is a factor affecting PED?

(AOS)

Answer 12

Availability of substitutes: If a product has a lot of substitutes, people will switch to other products when prices increase. Therefore, PED will be elastic. If there are no substitutes, then the demand curve will be inelastic since even if prices go up, people will have to buy that good if they want it as there are no alternatives.

Question 13

What is a factor affecting PED?

(T)

Answer 13

The longer the time it takes to produce a product, the easier it will be for a person to find an alternative supplier of the product. Therefore, making the good more elastic.

Question 14

What is a factor affecting PED?

(% of E)

Answer 14

How large of % of total expenditure: If a good/service represents a very small percentage of a person’s expenditure, a significant increase in price will have a relatively small impact on how much they buy of that product so it will be inelastic.

Question 15

What is a factor affecting PED?

(A)

Answer 15

Addictive: If a product is addictive, the demand curve will be inelastic. No matter how high the prices are, people will still buy the good to fulfil their addiction.

Question 16

What effect does a more elastic demand curve have on the incidence of tax?

Answer 16

The more elastic the demand curve, the lower the incidence of tax on the consumer. This means that when PED is elastic, a tax will only lead to a small increase in price and the supplier will have to cover the majority of the cost of the tax.

Question 17

What effect does an inelastic demand curve have on the incidence of tax?

Answer 17

When demand is inelastic, the tax will be mainly passed on to the consumer. Since consumers are relatively unresponsive to the price of the good, quantity demanded will not fall by a large amount. This means that the tax will be ineffective at reducing output. However, it also means there is a higher tax revenue for the government.

Question 18

What effect does inelastic demand have on a subsidy?

Answer 18

The more inelastic demand, the more the price falls. Inelastic demand means that there is little change in the output. Therefore, subsidies with inelastic demand are ineffective at increasing output. However, they are cheaper for the government to impost since output increases by less and so the government have to pay subsidy on less goods.

Question 19

Why is YED significant for firms?

Answer 19

It is important for businesses to know how their sales will be affected by changes in the income of the population. If the economy is improving and people’s incomes are rising it is vital that a business knows whether this is likely to increase their sales or not.

It may have an impact on the type of goods firms produce. During times of prosperity, firms might produce more luxury goods and less inferior goods.

Question 20

What does unitary elastic PED mean?

Answer 20

Unitary elastic PED is where PED = 1. The quantity demanded changed by exactly the same percentage as the price.

Question 21

What does perfectly elastic PED mean?

Answer 21

Perfectly elastic PED is where PED = infinity. A change in price means that quantity falls to 0 and demand is very responsive to price.

Question 22

What does perfectly inelastic PED mean?

Answer 22

Perfectly inelastic PED is where PED = 0. A change in price has no effect on output so demand is completely unresponsive to price.

Question 23

What does it mean if two goods have a XED that is equals 0?

Answer 23

If XED = 0, a change in the price of good B has no impact on good A.

Question 24

Why is XED significant for firms?

Answer 24

Firms need to know how price change by other firms will impact them so they can take appropriate action.

Question 25

What is one of the conditions of supply?

(COP)

Answer 25

Cost of production is a condition of supply.

If a business has an increase in their costs but their selling price stays the same, they will make less profit per unit. So, they will increase their prices in order to avoid making a loss and so less is supplied at each price, meaning the supply curve will shift to the left. If they have an decrease in costs, the supply curve will shift to the right.

Question 26

What is one of the conditions of supply?

(POOG)

Answer 26

The price of other goods is a conditions of supply.

Joint supply is where the production of one good automatically causes the production of another good (e.g. the production of beef automatically produces leather). Therefore, if the price of beef rises, farmer will slaughter their cows and so will get more leather, causing a shift to the right and an increase in supply.

Competitive supply is where the production of one good prevents the supply of another (e.g. if the farmer kills his cows, he can no longer produce the milk). Therefore, the rise in the price of beef may cause a decrease in supply of milk and a shift to the left.

Question 27

What is one of the conditions of supply?

(T)

Answer 27

If new technology is introduced then it will lead to a fall in production costs as there is higher productive efficiency. This will encourage firms to produce more goods at the same price and so the supply curve will shift to the right.

Question 28

What is one of the conditions of supply?

(GL)

Answer 28

Government legislation is a condition of supply.

For example, the UK government is due to ban the sale of new diesel and petrol cars from 2035 to reduce the -ve externalities associated with fossil fuels. This means that supply of diesel and petrol cars in the UK will eventually stop altogether. However, it is likely that the supply electric cars will increase as there is no longer a market for diesel and petrol cars in the UK.

Question 29

Why is the supply curve upwards sloping in most cases?

Answer 29

If prices are higher, firms will increase production to take advantage of the higher profits they can make. If price are lower, firms will cut back on any unprofitable production and so supply will decrease.

Higher prices will also encourage new firms to enter the market as it seem more profitable, and so output will increase.

Question 30

If supply is unitary elastic…

Answer 30

the curve starts from the origin.

S1

Question 31

If supply is relatively elastic…

Answer 31

the curve starts from the price axis.

S2

Question 32

If supply is relatively inelastic…

Answer 32

the curve starts from the quantity axis.

S3

Question 33

What is a factor affecting PES?

(T)

Answer 33

Time is a factor affecting PES.

In the short term (the period of time when at least one factor of production is fixed), a firm could sell more products but will still be restricted by the factors of production, meaning supply will still be relatively inelastic.

In the long term (when all factors of production are variable), a firm can increase production as all factors are variable and therefore the supply curve will be elastic. The longer the period of time the supplier has to make a change and increase production, the more elastic the supply curve.

Question 34

What is a factor affecting PES?

(S)

Answer 34

Stocks of a firm affect PES.

If a firms has a stockpile of goods, when prices increase, the firm will simply decide to use up some or all of their stockpiles in order to take advantage of the higher profits they can make. Therefore, will supply will be elastic.

Question 35

What is a factor affecting PES?

(BFC)

Answer 35

Working below full capacity affects PES.

If a firm is working below full capacity (e.g. they are producing 50 goods but could produce 100) and there is an increase in price, they can easily respond by producing to their full capacity and so the supply curve will be more elastic.

Question 36

What is a factor affecting PES?

(AOS)

Answer 36

Availability of substitutes affects PES.

If a good has a lot of producer substitutes, supply will be elasitc. For example, one model of a car is a substitute for another model of car as producers can easily switch between the two meaning suppliers can alter the pattern of production if price rises or falls so supply will change.

Question 37

What is the equilibrium point?

Answer 37

The equilibrium point refers to the point at which there are no more forces bringing about change.

Question 38

Explain price equilibrium.

Answer 38

Price equilibrium is where supply is equal to demand, so where the supply and demand curve crosses. This price is also known as the market clearing price because all products supplied to the market are cleared (bought), but now buyers are unable to buy the product.

Question 39

Explain excess demand.

Answer 39

There is an excess demand when the price is set below the equilibrium. At the price P2, suppliers are willing to supply and QS but consumers demand QD, meaning there is an excess demand in the orange shaded area.

As a result, there is a shortage in the market. Firms know hey can charge higher prices and still sell their good, so this will cause an extensions in supply and they will charge P1 for a quantity Q1. The higher price will also lead to contraction demand. The price are now in equilibrium.

Question 40

Explain excess supply.

Answer 40

There is excess supply is price is set higher than the equilibrium. At price P2, suppliers are willing and able to supply at QS but consumers only demand QD, meaning there is an excess supply of the orange shaded areas.

As a result, firms have unsold goods. This will encourage firms to put them on sales to sell the excess goods, causing prices to fall ad supply to contract to P1 and demand will extent to P1. The market will now be in equilibrium.

Question 41

What is the rationing function of the price mechanism?

Answer 41

The price mechanism has a rationing function.

The price system is a way of rationing goods because when price increases, some people will no be able to afford to buy the product and others may longer have the desire to by the good. The limited resources can be rationed and allocated to the people who are able to afford them and those who value them most highly.

Question 42

What is the signalling function of the price mechanism?

Answer 42

Price has a signalling function.

The price mechanism acts as a signal where resources should be allocated. When prices rises, producers allocated resources into the manufacture of that product. The change in price indicates to suppliers and consumers that market conditions have changed so they should change the way quantity is bought and sold - when price equilibrium moves, output equilibrium moves with it.

Question 43

What is the incentive function of price?

Answer 43

It acts as an incentive for people to increase their productivity in order to increase their income. Consumers realise that the greater their income, they are able to buy more products.

Suppliers realise that if they produce more goods, they will achieve greater profits as long as the marginal revenue from selling one extra unit of output is greater than the marginal costs of producing the extra unit of output.

Furthermore, low price act as incentive for consumer to buy more of the good and high price act as an incentive to suppliers to sell more of the good.

Question 44

Explain consumer surplus.

Answer 44

Consumer surplus is the difference between the price a consumer is willing to pay and the price they actually pay, set by the price mechanism.

This is illustrated by the triangle ABP1. The demand curve shows the price consumers are willing to pay.

So, the difference between then demand curve and the price shows the consumer surplus.

Furthermore, consumer surplus shows the welfare gained for consumer buying the good. The total satisfaction receive from buying the good is ABQ10. They spend P1BQ10 to gain this satisfaction. Therefore their net gain is ABP1, the consumer surplus.

Question 45

Explain producer surplus.

Answer 45

Producer surplus is the difference between the price the supplier is willing to produce their product at and the price they actually produce at, set by the price mechanism. This is illustrated by the triangle P1B0.

The supply curve shows the price suppliers are willing to sell their good for, so the difference between the supply curve and the price shows the producer surplus.

Question 46

How does elasticity of demand affect consumer surplus.

Answer 46

Perfectly elastic demand will mean that there is no consumer surplus.

Perfectly inelastic demand will mean that consumer surplus is infinite.

The more inelastic demand, the higher the consumer surplus.

Question 47

How does elasticity of supply affect producer surplus?

Answer 47

When supply is perfectly elastic, producer surplus is 0 and when it is perfectly inelastic, producer surplus is infinite.

The more inelastic supply, the higher the producer surplus is likely to be.

Question 48

What is community surplus?

Answer 48

Community surplus is the total welfare to society.

Community surplus = consumer surplus + producer surplus.

The price mechanisms can be shown to efficiently allocate resources as increasing the welfare of one group will decrease the welfare of another, so community welfare is maximised.

Any other price or output combination will have the same community surplus.

As a result the price mechanism fulfills pareto criterion/

Question 49

What is an indirect tax?

Answer 49

An indirect tax is a tax on expenditure where the person who is ultimately charged the tax is not the person responsible for paying the sum to the government. The business is required to pay the tax but the consumer is charged instead.

Question 50

What is ad valorem tax?

(A type of indirect tax)

Answer 50

Ad valorem tax is where the tax payable increases in proportion to the value of the good. The tax is a percentage of the cost of the good, for example VAT.

Question 51

What is specific tax?

(A type of indirect tax)

Answer 51

Specific tax is where there an amount is added to the price. The tax increases with the value bought rather than the value of the good. For example, excise duties on alcohol, tobacco and petrol are a specific amount.

Question 52

What is the impact of a specific tax?

Answer 52

The introduction of tax causes supply to shift from S1 to S2 because it leads to an increase in the costs of production. This leads to a rise in price from P1 to P2 and a fall in output from Q1 to Q2. The consumer sees higher prices and suffers from the tax burden of the orange area.

The producer sees a rise in the costs of production and a fall in output, suffering from the tax burden of the grey area.

The government gains a tax revenue of AB x Q2.

The size of the tax is the vertical distance between S1 and S2, shown by the line AB.

Question 53

Remember that the effects of an ad valorem tax are the same as a specific tax.

But what is different with the supply curve and why?

Answer 53

The supply curve shifts and tilts, so that gap between S1 and S2 grows. This is because the tax is the percentage of the value.

Therefore, as the price increases the size of the tax also increases.

Question 54

What happens to the incidence of tax if the demand curve is perfectly elastic or if the supply curve if perfectly inelastic?

Answer 54

The supplier will pay all the tax.

Question 55

What happens to the incidence of tax if demand curve is perfectly inelastic or if the supply curve if perfectly elastic?

Answer 55

All the tax is passed on to the consumer.

Question 56

In general, what happens to the incidence of tax when demand curve becomes more elastic, or when the supply curve becomes more inelastic?

Answer 56

The incidence of tax on the consumer decreases, meaning the supplier has to pay more. This means that, all other things being equal, the more inelastic the demand curve, the higher the revenue of tax for the government because the quantity demanded falls less and the more goods that are bought, so the more inelastic the demand the higher the tax revenue.

Question 57

Explain the effect of a subsidy?

Answer 57

Supply increases from S1 to S2, since the producer sees a fall in production costs due to the subsidy. As a result there is a rise in output from Q1 to Q2 and a fall in the price from P1 to P2. The consumer subsidy is the orange box and the producer subsidy is the grey box. The total shaded area represents the government spending: this is equal to the size of the subsidy (AB) times the new output (Q2)

Question 58

What are the underlying assumptions of all rational decision making?

Answer 58

-Consumers aim to maximise utility

-Companies aim to maximise profit

-Governments aim to maximise welfare of citizens.

Question 59

Why do people not always behave rationally?

(IOOP)

Answer 59

People do not always behave rationally due to the influences of other people.

Rationality assumed people act individually to maximise their own benefits but sometimes are influenced by social norms, known as a bias.

For example, someone may buy something to ‘fit-in’ or because everyone else has it, and so they are expected to.

Consumer become unwilling to change the bias, even if doing so will benefit them, if it goes against the norms of society.

Question 60

Why do people not always behave rationally?

(IOHB)

Answer 60

People do not always behave rationally due to the influences of habitual behaviour.

Habits create a barrier to decisions making since they limit or prevent consumer considering an alternative, for example consumer will by more drugs/alcohol even though they know they should give it up.

Habits reduce the amount of time it takes to do something as consumer no longer consciously think about their actions.

Question 61

Why do people not always behave rationally?

(CWAC)

Answer 61

People do not always behave rationally due to consumer weakness at computation.

Many consumer aren’t able to make comparisons between prices and so they will buy more expensive goods than needed, for example many customers buy in multipack goods because they assume they are cheaper, but this is not always this case.

Consumer are sometimes poor at self-control and so do things that do not maximise their own benefit.

Similarly, consumer will make decisions without looking at the long term effects, and so make irrational decisions (e.g. some consumers fail to save up for their pensions as they fail to look long-term).