How markets work

Question 1

What are the underlying assumptions of rational decision making?

Answer 1

Consumers aim to maximise utility
Firms aim to maximise profit
Government aims to maximise social welfare

Question 2

When price goes up…

Answer 2

There is a contraction in demand (QD decreases)

Question 3

Define demand

Answer 3

Demand is the ability and willingness to buy a good or service at a given price at a given time

Question 4

Factors that shift demand

Answer 4

Population
Income
Related goods
Advertising
Trends/tastes/fashion
Expectations
Seasons

Government legislation

Question 5

Why does the demand curve slop downwards?

Answer 5

Because price and quantity have an inverse relationship

Question 6

Why law explains why price and quantity have an inverse relationship?

Answer 6

The law of diminishing marginal utility

Question 7

In order to predict how consumers will spend their money, what do we have to assume?

Answer 7

That they are going to behave rationally and spend their money according to what gives them the greatest level of satisfaction/welfare

Question 8

Define total utility

Answer 8

The satisfaction derived from the overall consumption of a good

Question 9

Define marginal utility

Answer 9

The change in satisfaction from the consumption of an additional unit of the good

Question 10

What is the law of diminishing marginal utility?

Answer 10

The satisfaction derived from the consumption of a good will decrease as more of the good is consumed

• meaning consumers are less willing to pay high prices at high quantities since they are gaining less satisfaction

Question 11

Define price elasticity of demand (PED)

Give its formula

Answer 11

The responsiveness of the quantity demanded of a good in response to a change in price

PED = %change in QD/ %change in price

Question 12

Why might we get a PED that is greater than 1 after the minus sign?

Answer 12

The top of the formula (% change in QD) is bigger than the bottom (%change in price)

• elastic demand

Question 13

What do all PED’s have in common?

Answer 13

Always negative

Question 14

When demand is elastic, PED is in-between…

Answer 14

• 1 and negative infinity

Question 15

Why might we get a PED that is smaller than 1 after the minus sign?

Answer 15

The top of the formula (% change in QD) is smaller than the bottom (% change in price)

• inelastic demand

Question 16

When demand is inelastic, PED is in-between…

Answer 16

0 and -1

Question 17

When demand is unitary elastic, PED is..

And explain why

Answer 17

PED is equal to -1

• percentage change in price will always lead to a percentage change in QD of the same size.

Question 18

What is PED when demand is perfectly inelastic?

What is PED when demand is perfectly elastic?

Answer 18

Perfectly inelastic PED = 0
Perfectly elastic PED = negative infinity

Question 19

Name all of the factors which affect PED

Answer 19

Remember NASBIT

Necessity or Luxury
Proportion of Income
Availability of substitutes
Addiction and Habit
Brand loyalty
Proportion of income
Time on PED

Question 20

Explain the price mechanism when demand falls.

Answer 20

Firstly, the falling price will signal to producers that consumers don’t want as much of their good, so they should reduce production.

Secondly, the falling price will reduce the incentive for producers to supply as less profit can be made.

So production will decrease, leading to a contraction in supply.

Question 21

3 functions of the invisible hand

Answer 21

Signalling
Incentivising
Rationing - only takes place when the price increases. (limits demand)