How Markets Work Flashcards
What is marginal utility?
Marginal Utility is the additional satisfaction or utility gained from consuming one additional unit of good or service
What is total utility?
The total satisfaction or utility from consuming each and every unit of a good or service
What is the law of diminishing marginal utility?
The more you consume, the less benefit you get from consuming
Explain the relationship between marginal and total utility?
Total utility is the cumulative satisfaction/benefit you get over time, the marginal utility is the difference. It is inversely proportional
What is rationality?
1) People try to maximise their economic self interest
2) They are able to assess the economic costs and benefits to themselves of making alternative choices
What is bounded rationality?
We are rational within our own knowledge (e.g., smoking)
Why is the assumption of rational decision making flawed?
For example, consumers are often more influenced by emotional purchasing decisions than a rational computation of net benefits.
E.g., do consumers act rationally when they make impulse purchases?
- Irrationality distorts markets and produces fundamentally different outcomes than what would be achieved if all economic agencies acted rationally.
How do firms act rationally?
Producers act rationally by selling goods and services in a way that maximises profit.
Supply Demand Curve Diagram Notes…
1) There is no shift (new curve) if price changes - just move up/down the curve
What does it mean when the demand curve moves?
Occurs when the commodity has a change in price and quantity demanded leading to the curve to move in a specific direction (contraction or expansion). Indicates a change in quantity demanded.
What does it mean when there is a shift in the demand curve?
When the price of the commodity remains constant but there is a change in quantity demanded due to other factors, leading to the curve to shift in or out. (left or right). Indicates a change in demand.
What are the non-price determinants of demand?
P - Population size and demography
I - Income
R - Related Goods
A - Advertising and awareness
T - Tastes and preferences (Weather, season, fashion)
E - Expectations of future price changes / changes in income / changes in factors that affect consumer and business confidence: interest rates, job security, credit availability etc.
What is the definition of demand?
Ceteris Paribus - the quantity of a good or service that consumers are willing and able to buy at a given price in a given time period
What is the difference between notional and effective demand?
Notional demand is a good you like but don’t purchase
Effective demand where you back it up with a purchase
What happens when price increases?
Demand decreases. This is because when prices fall, people are more willing to buy more as it is cheaper, even though utility also decreases.
- For a firm to encourage a consumer to purchase more, prices need to fall, because marginal utility falls when we consume more
Why the demand curve usually slopes down from left to right?
When prices rise, people buy less and go for cheaper alternatives so demand falls.
What is the income effect?
When prices rise, income forbids buying more
When prices fall, incomes allow more to be purchased
What does the gradient show?
Steep demand curve means it is relatively inelastic
Soft demand curve means it is relatively elastic
How does graph change when factors of demand change?
Shift left and right when PIRATE factors change
Contract or Extend when price changes
What is the definition of supply?
Ceteris Paribus - The quantity of a good or service that producers are willing or able to produce at a given price in a given time period
What is the difference between notional and effective supply
Nominal - What they want to supply
Effective - What they actually supply
Difference between extension and contraction
Price Increasing = Extension
Price Decreasing = Contraction
What are motives for suppliers?
Profits
Why does the supply curve usually slope upwards from left to right?
As prices rise, businesses have greater incentive to supply because they’re receiving a higher return on their investment
Increase quantity means prices must rise, as unit cost increases they produce more.
What factors shift the supply curve?
C - Costs of production (changes in cost of wages, raw materials, transport etc will affect profitability)
R - Related Goods and Services (change in the price/profitability of substitutes and complements may encourage producers to switch production)
E - Expectations of future prices (producers will switch production to products whose price and therefore profitability is expected to improve in the future)
S - Subsidies or taxes on goods and services (Subsidies will reduce costs and raise profitability. Indirect taxes will raise costs and reduce profitability)
T - Technology (Advances in tech will increase productivity and therefore profitability)
What is equilibrium?
A state of equality or balance between market demand and supply - no excess demand or supply
Model Evaluation when demand decreases
” As a result of the decreased Jam price, the demand for Bread has increased as they are complements. This has caused the demand curve to shift outwards from D -> D1. As a result market equilibrium has moved from PQ -> P1Q1. This shows both the equilibrium price and quantity have increased.
How do you measure price elasticity?
PED - A measure of the responsiveness of quantity demanded to a change in price
How will the following react to a rise in price?
- Milk
- Luxury Brand of Perfume
- A Particular Newspapers
- Inelastic - No substitutes
- Elastic - Substitutes
- Relatively elastic - There are substitutes but people who are already buying the newspapers are less likely to stop
Are budget or high end airline customers going to be very responsive to changes in price
Budged airline customers will be the most responsive (elastic)
An increase in price for the high end airline would have little effect on the first class ticket as they’re still very expensive. There would still be a small demographic of people who’d fly first class
What is the formula for PED
% Change in P
What does PED 0 mean?
Perfectly inelastic - A change in price has no effect on quantity
What does PED 0-1 mean?
Relatively inelastic (e.g., 0.6) - A change in price causes a less than proportional change in QD
What does PED 1 mean?
Unitary Elastic - Price change causes proportional change in QD
What does PED 1-∞ mean?
Relatively Elastic - A change in price causes a more than proportional change in QD
What does PED ∞ mean?
Perfectly Elastic - At a given price, the buyer will buy all the quantity available at that price but will by none at any other price
How could you make demand more price inelastic?
Increase Quality
How to represent price elasticity?
Steep Curve = Inelastic
Flatter Curve = Elastic
What factors influence PED?
1) Num of substitutes
2) Loyalty
3) Necessities
4) Habits or Addictions
5) Luxury Good
How elastic would toothpaste, champagne, tobacco, new car?
- Inelastic - No substitutes
- Elastic - Substitutes
- Inelastic - Addictive
- Elastic - Substitutes and not a necessity
What conclusions can be made about PED and a straight line demand curve?
When the demand curve is drawn as a straight line the ratio of the CHANGE in quantity to the CHANGE in price will be constant (it is the slope of the demand curve). But the ratio of the LEVEL of quantity to price varies along the demand curve.
Will the PED ever be constant along the demand curve?
No
How does the PED change along the demand curve
Centre of curve is unit elastic
Further up the curve (extension) is more elastic
Further down the curve (contraction) is more inelastic
What is the business significance of PED?
In order to maximise revenue, firms want to increase sales quantity and sales price
However, increasing sales price is likely to decrease sales quantity.
So, firms decrease sales price.
Knowing the PED of a product helps a firm to identify a method by which revenue can be raised
Do firms make more or less money when price is elastic?
If PED is elastic - revenue decreases
If PED is inelastic - revenue increases
What should firms do if PED is inelastic or elastic?
Inelastic - firms should raise price
Elastic - firms should lower price
What is income elasticity of demand (YED)
Consumers respond to changes in income by increasing or decreasing their demand for a product and shifting the whole demand curve. Their response depends on their income sensitivity.
What would happen to the following products when incomes increase by 10%?
- Own label cider
- French Wine
- Bottled Water
- Foreign Holiday
- Camping Holiday
- Demand Decrease
- Demand Increase
- Demand Increase
- Demand Increase
- Demand Decrease
What is a normal good?
When income increases, we demand more
What is an inferior good?
As income increases, we demand less
What do the graphs for normal and inferior goods look like?
Normal Goods slope up from left to right
Inferior goods slope down from left to right
What is the formula for YED?
% Change in Y
What does YED tell us based off the sign?
When a good is normal there is a positive sign.
When a good is inferior there is a negative sign
What does YED tell us based off the value?
When a good is perfectly inelastic, YED is 0
When a good is perfectly elastic, YED is ∞
What factors effect YED?
1) Number of substitutes
2) Loyalty
3) Necessities
4) Habit or Addiction
5) Luxury Good
What is Cross Elasticity of Demand (PED)
Consumers may respond to changes in price of related goods and services by increasing or decreasing the quantity they demand. Their response depends on their sensitivity to price changes
To what extent would demand for train travel expand or contract when the price of the following increases by 10%?
- Bus Travel, Petrol, Weekend Breaks in the UK
- Contract - They’re substitutes
- Contract - Less people will travel by car
- Expand - Train journeys are more expensive so less people will travel
What is the formula for CrossED?
% Change in Price of Good B
How does the sign denote the nature of the product?
Compliments have Negative CrossED
Substitutes have Positive CrossED
How does the value denote the nature of the product?
Perfectly Inelastic = CrossED 0
- A change in price of Good B has no effect on Quantity of Good A
Relatively Elastic = CrossED 1- ∞
- A change in price of Good B has a more than proportional change in Quantity Demanded of Good A
Will the following products have a positive, negative, or 0 cross elasticity of demand?
- Tea and Milk
- Paint and Paintbrushes
- Cod and Haddock
- Knitwear and Petrol
- Satellite and Cable Television
- Negative
- Negative
- Positive
- 0
- Positive
