How markets work Flashcards
Define market
Where consumers and producers come into contact with each other to exchange goods and services
What do different types of markets have in common
Buyers and sellers come into contact for the purpose of exchange and a price(exchange value of a good/service) is agreed for exchange to take place
Who represents the demand side of the market
Consumers/buyers
Who represents the suppl side of the market
Producers/sellers
Define utility
The amount of satisfaction obtained from consuming a good or service
What do economists assume about utility
That it can be measured
What is the consequence of consumers not having enough income to buy all goods/services they want
They have to make a choice about what goods and services to buy and in what quanitites
How would a rational consumer allocate their spending
They would allocate their spending to maximise utility from the goods and services purchased
What does this allocation require
The individual must equate the utility gained per £ spend on the last unit of each good or service
Example of marginal utility for a consumer
- If a consumer has spent an extra £100 to spend, it could be used to buy a £20 shirt and £80 trainers
- The shirt would provide 40 units of marginal utility
- The shoes would provide 160 units of marginal utility
- In this way, the utility gained from the last unit of each good is equated to 2 units of utility per pound spent
Maximising utility for consumer example
Marginal Utility of shirt Marginal utility shoes
———————————– = ———————————
Price of shirt Price of shoes
Maximising utility forumula
Marginal Utility of Good 1 Marginal utility of Good 2
———————————– = ———————————
Price of Good 1 Price of Good 1
What are producers also assumed to make
Rational decisions
Define rational decision making for consumers
Where consumers allocate their expenditure on goods and services to maximise utility
Define rational decision making for firms
Where producers allocate their resources to maximise profits from the goods/services produced
What would rational decision making for firms involve
This involves producing at the level of output where total revenue > total cost
Define demand
The quantity of a good/service purchased at a given price over a given time period
What are buyers or consumers in a market said to do
Demand goods or services
Define effective demand
Demand which is backed up by the ability to pay
Define demand curve
A curve which shows the quantity of a good or service that would be bought over a range of different price levels in a given period of time
Why does the demand curve for a good slope downwards from left to right
- As price falls, the good becomes cheaper compared to substitute goods
- More goods can be purchased with a given level of income
Define market demand curve
The horizontal summation of each individual demand curve for a particular good or service
When is there a movement along a demand curve
ONLY when there is a price change
Extension in demand cause
A fall in price
Contraction in demand cause
A rise in price
Extension and contraction in demand diagram
(real card 3)
Define marginal utility
The satisfaction obtained from consuming one extra unit of a good or service
Define diminishing marginal utility
As successive units of a good are consumed, the utility gained from each extra unit will fall
Example of the law of diminishing utility
- E.g at a buffet, the first meal may give a high level of utility if you are hungry
- However a second meal will not provide as much utility as the first as you would be less hungry
- The more meals consumed, the less utility gained
What would happen to the total utility from consuming a good
The total utility from consuming a good will increase as more is consumed but will occur at a diminishing rate
Example of total utility
You may feel sick after eating too many meals causing a drastic fall in marginal utility
How can the concept of diminishing marginal utility explain the downward-sloping demand curve
- As marginal utility falls from each extra good consumed:
- Consumers will only buy more of the good if price falls
- This explains the downward-sloping demand curve
Total utility and quantity of good consumed diagram
(real card 4)
Marginal utility and quantity of good consumed diagram
(real card 5)
What does an increase in demand refer to
The whole demand curve shifting outwards to the right at every price level
What does a decrease in demand refer to
The whole demand curve shifting inwards to the left at every price level
Demand curve shift example
(real card 6)
What factors can shift the demand curve for a good
PIRATES
•Population changes
•Increase in real incomes for normal goods
•Related goods: 1.substitute good price rise
2.complementary good price fall
•Advertising of specified good
•Tastes and fashions change
•Expectations of future price changes
•Seasons impact changes in demand
Define price elasticity of demand(PED)
The responsiveness of demand for a good or service to a change in price
PED formula
Percentage change in price of good A
What answer is obtained in most answers
A minus answer is obtained indicating that the two variables of price and demand move in opposite directions. There is a negative gradient
What does it mean if a good is relatively price elastic
•PED is greater than 1
•% change in demand is greater than % change in price
E.g 10% rise in price of holidays may cause a 20% decrease in quantity demanded- so PED is -2
(-20/10 = -2)
What does it mean if a good is relatively price inelastic
•PED is less than 1
•% change in demand is less than % change in price
E.g 10% fall in price of coffee may cause a 5% increase in quantity demanded- so PED is -0.5
(5/-10=-0.5)
What does it mean if a good has unit elasticity
•PED is equal to 1
•% change in demand is equal to % change in price
E.g 10% fall in price of apples may cause a 10% rise in quantity demanded- so PED is -1
(10/-10=-1)
What does it mean if a good is perfectly inelastic
•PED is equal to 0
•A change in price has no effect on the quantity demanded
•Demand curve is vertical
E.g crack to a full crackhead
What does it mean if a good is perfectly elastic
- PED is equal to infinity
- A rise in price causes demand to fall to zero
- The demand curve is horizontal
Relatively price elastic demand diagram
(real card 7)
Relatively price inelastic demand diagram
(real card 8)
Unit elasticity demand diagram
(real card 9)
Perfectly inelastic demand diagram
(real card 10)
Perfectly elastic demand diagram
(real card 11)
Relationship between price elasticity of demand and total revenue
Elasticity varies along a straight-line demand curve
•Elasticity falls as you move along the curve from top left to bottom right
•At the mid-point demand has unit elasticity
Relationship between price elasticity of demand and total revenue diagram
(real card 12)
Define total revenue
•The total payments a firm receives from selling a given quantity of goods or services
How can total revenue be calculated
The price per unit of a good multiplied by the quantity sold
What is the total revenue a firm receives from selling a good equal to
The total spending by consumers
What will increase as long as price moves towards the mid-position of the demand curve (where there is unitary elasticity)
A firm’s total revenue
Why is it important for firms to know the PED of their output when making pricing decisions
Because this affects revenue and profitability
Elastic demand on total revenue
If demand is elastic:
•A cut in price increases total consumer spending
•This will increase revenue to the firm
•A rise in price reduces total consumer spending
•This will decrease revenue to the firm
Inelastic demand on total revenue
If demand is inelastic:
•A increase in price increases total consumer spending
•This will increase revenue to the firm
•A fall in price reduces total consumer spending
•This will decrease revenue to the firm
What would happen to a firm once unit price elasticity has been reached
The firm would be maximising its total revenue
What happens if marginal revenue is positive
demand is price elastic
What happens if marginal revenue is zero
demand is unit elastic
What happens if marginal revenue is negative
demand is price inelastic
Price rise to total revenue under inelastic demand diagram
(real card 13)
Price fall to total revenue under elastic demand diagram
(real card 14)
Determinants of price elasticity of demand (BAT PAL)
1.Availability of substitutes
1.Availability of substitutes
•The more narrowly a good is defined, the more substitutes it tends to have
•Therefore demand is elastic
•However, the more broadly a good is defined,the fewer substitutes it tends to have
•Therefore demand is less elastic
Determinants of price elasticity of demand(BAT PAL)
2.Luxury and necessity goods
2.Luxury and necessity goods
•Luxury goods such as racing cars tend to have elastic demand
•Necessity goods like bread tend to have an inelastic demand
Determinants of price elasticity of demand(BAT PAL)
3.Proportion of income spent on the good
3.Proportion of income spent on the good
•If a high percentage of income is spent on the good demand tends to be price elastic
•E.g a new car
•However for goods that take up a small percentage of income demand tends to be price inelastic
•E.g a newspaper
Determinants of price elasticity of demand(BAT PAL)
4.Addictive and habit-forming goods
4.Addictive and habit-forming goods
•Alcohol and cigarettes can be addictive and leads to habitual consumption for consumers
•Therefore they tend to be price inelastic in demand
Determinants of price elasticity of demand(BAT PAL)
5.The time period
5.The time period
•For most goods, demand is less elastic in the short run
•Whereas demand is more elastic in the long run
•E.g a rise in the price of household electricity would have a minor effect on consumption in short run
•In long run, households can cut back on consumption by switching to gas for cooking and heating
•Therefore demand eventually becomes more responsive to changes in price
Determinants of price elasticity of demand(BAT PAL)
6.Brand image
6.Brand image
•Some goods have a strong brand image
•E.g Levi jeans and Coca cola
•Demand for these goods are typically price inelastic
•This is because consumers are willing to pay a premium price for them
Define income elasticity of demand
The responsiveness of demand for a good or service to a change in real income
What does real income refer to
The spending power of money income-the amount of goods and services which can be purchased with nominal income
Formula for YED
Percentage change in real income
Define normal good
A good with a positive income elasticity of demand:
•As income rises, demand for the good RISES
What does it mean if YED is positive, as it is in most cases
•A rise in income causes a rise in quantity demanded
What normal goods that have a YED above 1 classify as
Luxury goods
What is a good with a YED less than 1
Relatively income inelastic in demand
What is a good with a YED above 1
Relatively income elastic in demand
What is a good with a YED of 1
Unitary elastic