How Markets Work Flashcards
What assumptions are made about consumer and firm behaviour?
- Consumers act rationally, aim to maximise utility (satisfaction)
- Firms act rationally, aim to maximise profits
Demand Definition
The amount a consumer is willing and able to buy at a given price over a certain time
Why is the D Curve sloped downwards + what is this based on (2)
- to show a fall in price leads to increase quantity of demand.
based on
- Substitution effect –> ↑P means Consumer will buy lower price substituted instead of higher price good e.g. margarine instead of butter
- Income effect –> ↑P means consumers suffer ↓R. Income. Purchasing power falls –> lead to fall in Demand
What causes a movement along the Demand curve
- Change in Price
What causes a shift in the Demand curve (6) ?
- Real Incomes - ↑R. Incomes results in ↑D –> Rightward shift in D Curve
- Size or Age distribution of Population - ↑in size of pop –> ↑D –> Rightward Shift
- Tastes, Trends and Preferences –> ↓Popularity of product will cause ↓D –> Leftward Shift - Can be seasonal e.g. Mince pies popular in Christmas
- Prices of Substitutes or compliments –> △P of related good will influence D - e.g. ↑P Beef leads to ↑D Lamb
–> ↑P Petrol lead to ↓D cars + Left Shift - Advertisement - Successful advert –> ↑D –> Right Shift
- Interest rates - affect cost of borrowing money - ↑Interest rates –> ↑Cost of mortgages –> ↓D for houses –> Left Shift
Total Vs. Marginal Utility
Total Utility
- Total satisfaction gained from the total amount of product consumer
Marginal Utility
- the change in utility from consuming an additional unit of the product
What does the Law of Diminishing Utility state?
- As consumption of a product increases, the consumers total utility increases but at a diminishing rate, and the marginal utility falls
–> people prepared to pay less as consumption increases, results in inverse relationship between price and quantity demanded
What is PED + Equasion
- Price elasticity of Demand
–> Measures the responsiveness of QD in response to change of price - PED = %△QD / %△P
–> Remember if its a fall in D, then its (-)
%△ = △Quantity/ OG Quantity x 100
Why is the PED always negative
- Law of Demand
–> Price and QD have an inverse relationship
When is PED Inelastic + what does it means?
Inelastic = PED between 0 and -1
- The change in P has led to a smaller % change in QD
Inelastic = steeper curve
When is PED Elastic + what does it means?
- PED lower than -1 (e.g. -5 or -2)
- △ in P has led to a larger % △ in QD
Elastic = flater curve
What is Unit Elasticity
- Change in P led to same Change in QD
- Value of PED = -1
What Factors influence PED
- Availability of Substitutes –> substitutes available provide incentive to shift consumption when price rises –> Substitutes make D more elastic
- Proportion of Income spent on Product –> if small % Income spent on product (e.g. salt) then D more Inelastic
–> If high % Income spent on product e.g. Holiday then D more elastic - Nature of Product –> If product addictive e.g. alcohol or tobacco, D more inelastic
- Durability –> long-lasting products e.g. cars D elastic as possible to postpone purchase
–> non-durable e.g. milk, Inelastic as must be replaced regularly
What is the relationship between PED and total revenue
- When Demand is inelastic (Between 0 and -1) Price change will change TR in same direction (e.g. ↑P –> ↑TR)
- When D is Elastic (Less than -1) Price change will change TR in opposite direction (e.g. ↑P –> ↓TR)
- Unit elastic TR will stay same
Significance of PED for Firms
If PED inelastic –> can ↑TR by ↑P
If PED elastic –> Can ↑TR by ↓P
Significance of PED for Cosumers
- If inelastic firms may raise prices (to ↑TR) this will reduce R.Incomes of consumers (Decrease Purchasing power)
Significance of PED for Government
- For gov to maximise TR will place indirect taxes on products with inelastic PED e.g. alcohol, tobacco
–> but consumers will bear most of tax burden - Gov can tax products with elastic PED, meaning producers bear tax burden but could make business unprofitable
What is XED (cross elasticity of demand) + forumla
- Measure of the responsiveness of QD of one product (Y) to △P of another product (X)
XED = %△QD (Product Y) / %△P (Product X)
%△ = Pnew-Pold / Pold x 100
What does the XED tell you about the relationship of the products
- Weather the products are Substitutes or Complements
- (+) sign indicates products are substitutes –> ↑P of one cause ↑D for other
- (-) sign indicates products are complements –> ↑P of one causes ↓D for other
Significance of XED for firms
(Cross elasticity of Demand)
- helpful for setting prices
–> Firm selling product with close substitute, expect considerable ↓D for ↑P
–> Complementary goods can command High P e.g. Printer relatively cheap, but Ink relatively expensive
What does YED mean? (Income elasticity of Demand) + formula
- measure of responsiveness of QD to change in Real Income
YED= %△QD / %△R.Income
–> %△ = Pnew-Pold / Pold x 100
What does the YED tell you about the product
- (+) sign indicated product is normal good –> ↑Real Income cause ↑D (+ vis versa)
- (-) sign indicates product is inferior good –> ↑R. Income leads to ↓D
–> Inferior good are goods which are lower quality versions of other higher-quality goods
When YED is between 0 and +1 is Inelastic
YED greater than 1 D = Elastic
Significance of YED for Firms + Gov
Firms
- Know D for products is elastic (Greater than 1) D and TR will ↑ during economic growth, but ↓ during recessions
–> important for investment decisions
Gov
- Gov to maximise Tax Revenue during Economic Boom, place indirect taxes on products with elastic YED (greater than 1)
–> also help estimate tax revenues
Supply definition
The amount producers are willing and able to supply at a given price over a certain period of time
Why is the Supply curve upwards sloping
- Indicates that more is supplied as P↑
–> when P↑ it is more profitable for supply so have incentive to ↑production (+vis versa)
What causes Shifts in Supply curve? (6)
- Costs of production –> e.g. wages, raw materials, energy, rent –> ↑Costs cause supply curve to shift left (inwards)
- Productivity of workforce –> ↑Productivity shifts S curve right (outwards)
- Indirect taxes –> Taxes raise cost of Supply –> Cause shift inwards
–> rise in VAT cause S curve to become steeper, whereas specific *unit) tax cause parallel shift in curve - Subsidies –> reduce cost of production –> outward shift in S curve
- Tech - new tech and inventions result in increased productivity, S curve shifts out
- discoveries of new raw materials –> e.g. country discovers new oil reserve, S curve shifts out (costs of production ↓)
What is PES (Price elasticity of supply) + formula
- measure of responsiveness of QS when a products price changes
PES= %△QS/ %△P
Why is PES always positive
- Supply curve is upwards facing
–> P and Q always move in same direction
When is PES Inelastic + Elastic
Inelastic
- when PES is between 0 and 1
–> Change in price led to smaller change in QS
Elastic
- PES greater than 1
–> △P led to larger △QS
What factors influence the PES (4)
- Time –> in SR (when at least 1 factor of production is fixed) difficult to change production, inelastic –> in LR (all factors of production variable) elastic
- Stock –> If stock of finished goods is easily available supply will be elastic as able to quickly increase supply to match price change (e.g. not be able to store perishable goods)
- Spare capacity –> if firm has underutilised machinery or workers possible to engage them more and supply elastic
- Availability + cost of switching factors of production –> if labour or machinery is highly speiclised or expensive to relocate then supply inelastic
When does an excess supply occur?
if P is set above equilibrium price (Pe)
–> If Price is set at P1, QD will be Q1 while QS will be at Q2
–> will create surplus of Q2-Q1
–> Market forces should cause P to fall to Pe which will eliminate excess supply
When does an excess demand occur?
- If Price set below Pe
–> draw diagram - Will cause a shortage –> market forces will cause price to rise, eliminating excess demand
What causes a change in Equilibrium Price
- Shift in D curve
Shift in S curve
What would an Increase and Decrease in D do to equilibrium
Increase
- Cause right/outward shift in D curve
–> ↑P, ↑Q
Decrease
- Cause left /inwards shift in d curve
–> ↓P, ↓Q
What would an Increase and Decrease in S do to equilibrium
Increase
- Cause right/outward shift in S curve
–> ↓P, ↑Q
Decrease
- Cause left/inward shift of S curve
–> P↑, Q↓
What are the Key functions of the price mechanism?
- Rationing Device –> market forces will ensure the amount demanded is equal to amount supplied
- Incentive –> prospect of making profit acts as incentive for firms to product
- Signalling device –> to producers to increase or decrease amount supplied
- Changes in wants –> △ in D will be reflected in △ in P
Define Consumer Surplus + where is it on diagram?
- The differences between how much a consumer is willing to pay, and what thy actually pay (market price)
–> the area under the D curve and above the Market price (e.i. the top triangle)
Define Producer Surplus + where it is on diagram?
- Difference between price firms are willing to sell the good for and the market price
–> the area above the S curve and below the Market price (e.i. bottom triangle)
What factors affect the Consumer Surplus?
- Gradient of D curve
–> Steeper the curve (more inelastic) the greater the consumer surplus will be - Shifts in Demand Curve –> e.g. increase in D (shift of D curve out) will increase Consumer Surplus
factors affecting Producers’ Surplus?
- Gradient of Supply curve –> steeper curve (more inelastic) greater the Producer Surplus
- Shifts in Supply Curve –> Shift outwards of S curve (increase in Supply) will increase Producer Surplus
What is an indirect tax’s + the two types and defenitions?
Indirect takes are taxes on expenditure
–> they Increase the Cost of supply and shift S curve Inwards
Two types
- Ad valorem –> a % of products price –> cause S curve shit inwards + become steeper (more inelastic) –> e.g. VAT which is 20%
- Specific tax –> flat tax rate, set amount of tax per unit –> creates a parallel inwards shift of S curve
Who bears the incidence of tax when D for product is Inelastic
- Incidence of tax = how the tax burden is distributed between groups e.g. consumer / producer
–> when D is inelastic (PED between 0 and -1) consumer bears larger proportion of tax burden
–> total tax revue goes to gov
Who bears the incidence of tax when D for product is Elastic?
Incidence of tax = how the tax burden is distributed between groups e.g. consumer / producer
- When D is Elastic (PED lower than -1) Producer bears tax burden
List some reason why consumers might not behave rationally? (4) + implications of this
- Influence of other people’s behaviour –> behaviour is affected and influenced by others called ‘social learning’ e.g. Everyone you know has apple smartphones more likely to have Apple phone, also with clothing brands
- Habitual Behaviour –> Behaviour done automatically - Habits difficult to change requires incentives to change habits e.g. 5p for a plastic bag
- Inertia –> people are loss averse (put more effort into preventing loss than winning a gain) e.g. people rarely change bank accounts
- Information overloads + complexity of information
–> the principles of rationality will not always accurately describe human behaviour
- policies might have unintended / unpredicted results
