How markets work Flashcards
What are the underlying assumptions of rational decision making?
Consumers aim to maximise utility
Firms aim to maximise profit
Government aims to maximise social welfare
When price goes up…
There is a contraction in demand (QD decreases)
Define demand
Demand is the ability and willingness to buy a good or service at a given price at a given time
Factors that shift demand
Population
Income
Related goods
Advertising
Trends/tastes/fashion
Expectations
Seasons
Government legislation
Why does the demand curve slop downwards?
Because price and quantity have an inverse relationship
Why law explains why price and quantity have an inverse relationship?
The law of diminishing marginal utility
In order to predict how consumers will spend their money, what do we have to assume?
That they are going to behave rationally and spend their money according to what gives them the greatest level of satisfaction/welfare
Define total utility
The satisfaction derived from the overall consumption of a good
Define marginal utility
The change in satisfaction from the consumption of an additional unit of the good
What is the law of diminishing marginal utility?
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
Define price elasticity of demand (PED)
Give its formula
The responsiveness of the quantity demanded of a good in response to a change in price
PED = %change in QD/ %change in price
Why might we get a PED that is greater than 1 after the minus sign?
The top of the formula (% change in QD) is bigger than the bottom (%change in price)
- elastic demand
What do all PED’s have in common?
Always negative
When demand is elastic, PED is in-between…
- 1 and negative infinity
Why might we get a PED that is smaller than 1 after the minus sign?
The top of the formula (% change in QD) is smaller than the bottom (% change in price)
- inelastic demand
When demand is inelastic, PED is in-between…
0 and -1
When demand is unitary elastic, PED is..
And explain why
PED is equal to -1
- percentage change in price will always lead to a percentage change in QD of the same size.
What is PED when demand is perfectly inelastic?
What is PED when demand is perfectly elastic?
Perfectly inelastic PED = 0
Perfectly elastic PED = negative infinity
Name all of the factors which affect PED
Remember NASBIT
Necessity or Luxury
Proportion of Income
Availability of substitutes
Addiction and Habit
Brand loyalty
Proportion of income
Time on PED
Explain the price mechanism when demand falls.
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.
3 functions of the invisible hand
Signalling
Incentivising
Rationing - only takes place when the price increases. (limits demand)
