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
Define inferior good
A good with a negative income elasticity of demand:
•As income rises, demand for the good FALLS
What does it mean if YED is negative, as it is in most cases
•A rise in income causes a fall in quantity demanded
Why would a rise in income cause a fall in quantity demanded
- People tend to demand higher-quality goods as their incomes rise
- These goods substitute lower-quality products
Examples of inferior goods
Supermarket’s own value brands of food
Income elasticity of a normal good diagram
(real card 15)
Income elasticity of a inferior good diagram
(real card 16)
Define cross elasticity of demand
The responsiveness of demand for good B to a change in price of good A
XED formula
percentage change in price of good A
What is cross elasticity of demand used for
To determine whether goods are complements or substitutes for each other
XED: substitute goods
- Substitute goods are in competitive demand
- E.g a rise in the price of coffee may cause a rise in demand for tea
- XED is positive for substitute goods
- Because the variables of price and demand move in the same direction-positive gradient
XED: complementary goods
- Complementary goods are in joint demand
- They tend to be consumed together
- E.g a fall in price of tennis rackets may cause a rise in demand for tennis balls
- XED is negative for complementary goods
- Because the variables of price and demand move in opposite directions-negative gradients
XED: Unrelated goods
Unrelated goods have an XED value of zero:
•e.g a rise in price of cars will have no effect on the demand of potatoes
XED substitute good diagram
(real card 17)
XED complementary good diagram
(real card 18)
Define supply
- The quantity of a good or service
- that firms are willing to sell
- at a given price over a given period of time
Who supplies goods and services
Sellers or producers in a market
Define supply curve
- The quantity of a good or service
- that firms are willing to sell to a market
- over a range of different price levels
- in a given period of time
Why does the supply curve slope upwards from left to right (reason 1)
- As firms raise output in the short run, they face rising production costs
- These costs are passed on to consumers
- This is done by charging higher prices
Why does the supply curve slope upwards from left to right (reason 2)
- As price rises, firms are encouraged to supply more of a good
- This is to increase profits
- Higher prices may encourage firms to enter a market and this may raise supply
What is the market supply curve
The horizontal summation of individual firm’s supply curves for a particular good or service
When is there a movement along a supply curve
ONLY when there is a change in price
What causes an extension in supply
A rise in price
What causes a contraction in supply
A fall in price
What does an increase in supply refer to
The whole supply curve shifting outwards to the right at every price level
What does a decrease in supply refer to
The whole supply curve shifting inwards to the left at every price level
What factors cause a shift in the supply curve of a good(an increase in supply)
(PINTS PC)
1.Productivity:
•high productivity–>firms costs fall–>outward shift
2.Indirect taxes:
•reduction in indirect taxes–>supply increases
3.Number of firms:
•more firms entering industry–>larger supply
4.Technology:
•improvements in technology–>outward shift
5.Subsidies:
•increased subsidies–>outward shift
6.Production costs:
•costs of production decreases–>outward shift
7.Conditions of weather:
•good weather–>may increase production–>outward shift
Define price elasticity of supply (PES)
The responsiveness of the supply of a good or service to a change in price
PES formula
percentage change in price of a good
What does a positive PES indicate
The two variables of price and quantity move in the same direction-positive gradient
When is PES relatively price elastic
- When PES>1
* The percentage change in supply is greater than the percentage change in price of the good
When is PES relatively price inelastic
- When PES<1
* The percentage change in supply is less than the percentage change in price of the good
When is PES unit elastic
- When PES=1
* The percentage change in supply is equal to the percentage change in price of the good
When is PES perfectly inelastic
- When PES=0
- A change in price has no effect on the quantity supplied
- Supply curve is vertical
When is PES perfectly elastic
- When PES=infinity
* Supply curve is horizontal
Relatively price elastic supply diagram
(real card 19)
Relatively price inelastic supply diagram
(real card 20)
Unit price elasticity supply diagram
(real card 21)
Perfectly price elastic supply diagram
(real card 22)
Perfectly price inelastic supply diagram
(real card 23)
Determinants of price elasticity of supply:
1.Level of spare capacity
1.Level of spare capacity
•High level of spare capacity in a firm:
•Production can be raised quickly so supply tends to be elastic
•A firm operating at full capacity cannot raise output quickly so supply tends to be inelastic
Determinants of price elasticity of supply:
2.State of the economy
2.State of the economy
•In recession there are many unemployed resources
•Therefore there is a high level of spare capacity
•Firms find it relatively easy to raise supply if needed
Determinants of price elasticity of supply:
3.Level of stocks of finished goods in a firm
3.Level of stocks of finished goods in a firm
•A high level of stocks means that the firm can raise supply quickly, so supply is elastic
•E.g car manufacturers often have stockpiles of cars waiting to sell
•Alternatively, a firm operating with low stocks cannot raise output quickly, so supply is inelastic
Determinants of price elasticity of supply:
4.Perishability of the product
4.Perishability of the product
•Some goods cannot be stockpiled
•E.g some agricultural goods such as fruit are highly perishable
•These good tend to have inelastic supply
•However manufactured goods tend to be non-perishable
•They can be stockpiled by firms in order to meet anticipated increases in demand
•E.g household electrical goods such as washing machines
Determinants of price elasticity of supply:
5.Ease of entry to an industry
5.Ease of entry to an industry
•If there are high entry barriers to an industry
•It will be difficult for new firms to enter, even with attraction of high prices and profits
•Existing producers can deliberately create entry barriers making supply restricted and inelastic
Determinants of price elasticity of supply:
6.Time period under consideration-short run
6.Time period under consideration-short run
•The short run is the period of time in which a firm is able to raise supply with its existing capacity
•At least one factor input is likely to be fixed in quantity in short run
•This makes it difficult for a firm to raise production
•Supply tends to be relatively inelastic
Determinants of price elasticity of supply:
6.Time period under consideration-long run
6.Time period under consideration-long run
•The long run is the period of time in which a firm is able to raise supply by adding to its production capacity
•All factor inputs are able to change in the long run
•This makes it easier for a firm to raise production
•Supply tends to be relatively elastic
Why is supply for agricultural products inelastic in the short run
The output from the summer and autumn harvests depends on the amount of seed planted at the start of the year
Why does it take an even longer period of time to raise the supply of products from livestock(milk and beef)
The supply of products from livestock depend on the nurturing of animals over several years
Why is supply for minerals inelastic in the short run
- The length of time required to explore and discover new deposits as well as extracting them
- The costs and technical complexities involved could be phenomenal
- E.g developing a new iron mine will require heavy machinery
Elasticity of supply in short run and long run
(real card 24)
How is price determined
Through the interaction of demand and supply in a competitive market
Define equilibrium price
The price where the quantity demanded equals the quantity supplied for a good or service in a market
When does an equilibrium price and quantity occur
- When there is a balance in the market
* There is no tendency for price or quantity to change
How is the equilibrium price and quantity of a good obtained
From the point of intersection between the demand and supply curves
Define excess supply
Where the quantity supplied exceeds the quantity demanded for good at the current market price
Price and the equilibrium position in a free market
•Price cannot remain above or below the equilibrium position for long in a free market
What do producers do if there is an excess supply
- Producers tend to reduce price to sell the surplus
- This encourages consumers to buy more
- Demand will extend and supply will contract until the equilibrium price is reached
Market equilibrium diagram
(real card 25)
Where is there an excess supply on the diagram
At a price of £100 there is an excess supply of 40 units
Where is there an excess demand on the diagram
At a price of £60 there is an excess demand of 40 units
Why do consumers bid up the price
In order to obtain the good
What is the effect on firms of consumers bidding up the price
Producers are encouraged to supply more
How does the price mechanism eliminate surpluses and shortages of a good
- Due to the invisible hand of the market (coined by Adam Smith)
- Supply will extend and demand will contract until the equilibrium price is reached
Define the price mechanism
The use of market forces to allocate resources in order to solve the economic problem of what, how and for whom to produce
Define price
The exchange value of a good or service
What does the price mechanism refer to
The mechanism refers to the way price responds to changes in demand or supply for a factor input or product
What is the objective of the price mechanism
To reach a new equilibrium position in the market by allocating resources in a market economy
What are the 3 functions of the price mechanism
- Functions as a rationing device
- Functions as an incentive device
- Functions as a signalling device
How does the rationing device work
- Resources are scarce
- Therefore goods and services produced from them are limited in supply
- The price mechanism allocates these goods and services to those who are prepared to pay the most for them
- In effect, price will rise or fall until equilibrium is reached between the quantity demanded and quantity supplied
How does the incentive device work
- Rising prices act as an incentive to firms to produce more of a good or service since higher profits can be earned
- Rising prices also mean firms are able to cover the extra costs involved with increasing output
How does the signalling device work
- The price mechanism indicates changes in the conditions of demand or supply
- An increase in demand for a good or service raises its price and encourages firms to expand supply
- A decrease in demand lowers the price and causes firms to contract supply
- More or fewer resources are allocated to the production of a particular good or service
What will any of the factors which may shift demand or supply curves lead to
A change in price of a good or service
Define consumer surplus (definition 1)
The extra amount of money consumers are prepared to pay for a good or service above what they actually pay
Define consumer surplus (definition 2)
The utility or satisfaction gained from a good/service in excess of the amount paid for it
Define producer surplus(definition 1)
The extra amount of money paid to producers above what they are willing to accept to supply a good/service
Define producer surplus(definition 2)
The extra earnings obtained by a producer above the minimum required for them to supply the good or service
Consumer and producer surplus diagram
(real card 26)
Where is consumer surplus in the diagram
It is the area above the equilibrium price but below the demand curve
Where is producer surplus on the diagram
The area below the equilibrium price and above the supply curve
Define tax
A compulsory charge made by the government on goods, services, incomes or capital
What is the purpose of a tax
To raise funds to pay for government spending programmes
What are the two types of tax
Direct and indirect
Define direct tax
A tax levied directly on an individual/organisation and are generally paid on incomes
e.g income tax
Define indirect tax
- A tax imposed on the purchase of goods or services supplied by businesses
- It represents tax on expenditure
What are the two types of indirect tax
Specific and ad valorem tax
Define specific tax
A tax charged as a fixed amount per unit of good
E.g a packet of cigarettes or an excise tax(duties)
Define ad valorem tax
A tax charged as a percentage of the price of a good
E.g VAT of 20% added on to a meal
How does an indirect tax affect a good or service
It will raise the price of a good or service
What would happen when the tax is added to the supply price
It will cause the supply curve to shift vertically upwards and to the left (decrease in supply)
What does a specific tax cause on the diagram
A parallel shift of the supply curve to the left
What does an ad valorem tax cause on the diagram
A pivotal rotation of the supply curve to the left
Specific tax diagram
(real diagram 27)
Ad valorem tax diagram
(real diagram 28)
Define incidence of tax
The distribution of the tax paid between consumers and producers
How does the incidence of tax fall on consumers and producers
It falls partly on consumers and partly on producers depending on the relative price elasticities of demand and supply for the good/service
What places most of the tax burden on consumers
A combination of price inelastic demand and price elastic supply
What goods tend to be price inelastic in demand
Addictive goods such as tobacco and alcohol
What do prince inelastic goods mean for firms
Firms can pass most of the burden of tax on to consumers via higher prices
Evaluation-how can producers be impacted negatively by incidence of tax
A combination of price elastic demand and prince inelastic supply tends to place most of the tax burden on producers
What may the incidence of tax lead to in terms of the economy
There may be a reduction in output and employment
What may the incidence of tax lead to in terms of the government
The government may be reluctant to place high indirect taxes on these types of goods
Effects of specific tax on a good (real card 31)
- Equilibrium price is Pe before tax
- After tax is imposed supply curve shifts to S1
- Equilibrium price rises to P1
- Equilibrium quantity falls to Q1
- Total tax area is XYWP1
What is the incidence of tax paid by consumers shown by in the diagram
- There is an actual rise in market price from Pe to P1
- Consumers pay the amount of tax shown by the area XZPeP1
- The tax paid by producers is the remaining area ZYWPe
Define subsidy
A government grant to firms which reduces production costs and encourages an increase in output
E.g train companies are given subsidies to increase their service to benefit both the firms and consumers
How does a subsidy affect price of a good or service
Price would fall
Impact of subsidies to cosumers
- The subsidy is often paid directly to producers
- As the producer responds by raising output, market price falls
- This indirectly passes on some of the gain to consumers
What happens if demand is price inelastic when a subsidy is introduced
The market price falls by a relatively large amount which increases the benefits to consumers
What happens if demand is price elastic when a subsidy is introduced
The market price falls by a relatively small amount so there is less gain for consumers
Introduction of a government subsidy for a good
(real card 32)
Subsidy impact on equilibrium price on diagram
- Before the subsidy equilibrium price is Pe and Qe
- After subsidy the supply curve shifts to S2
- Equilibrium price falls to P2
- Quantity rises to Q2
- Total subsidy area is RLGP2
What is shown by the actual fall in market price from Pe to P2
The amount of subsidy that consumers gain
How do consumers gain from the good
They pay a lower price for the good
What is the consumer subsidy area
RTPeP2
What is the remaining subsidy area/gain made by producers
TLGPe
What do economists assume about consumers and rationality
- They assume that consumers behave in a rational manner
- Therefore they allocate their income to buy goods and services
- To maximise their utility or satisfaction
Where does rational economic decision making come from
- A deductive approach to the subject
- Where models are created on the basis of how consumers are expected to behave
- And their aim should be to maximise total utility
How does an inductive approach to economics differ to the deductive approach
- This approach starts by investigating how consumers actually behave
- Models are then developed from the results
- This view of behaviour tries to explain why they may not always make rational decisions
- E.g consumers may seek a satisfactory level of utility rather than maximising utility
What factors explain irrational consumer behaviour
- Influence of other people’s behaviour
- Importance of habitual behaviour
- Consumer weakness at computation
Influence of other people’s behaviour
- A ‘herd like’ mentality is often displayed in various markets where it is clear that consumers who come late to the market receive little benefit
- E.g if some people start buying a share in a particular company others may follow even though prices will rise
- Property markets remind how consumers could lose out by purchasing at the peak of an economic cylce
- This would lead to asset values crashing in a downturn
Importance of habitual behaviour
1.Consumers and habits
- Consumers are creatures of habit
- They prefer what they know rather than risking something new where there is more uncertainty
- E.g switching bank accounts to get lower charges
What could explain these consumer habits
There are difficulties involved for a consumer to change from what they would normally do
•E.g there may be mistakes in the final bills and considerable time may be wasted filling out forms
•So there are difficulties involved in changing bank suppliers
•For some consumers doing nothing is preferred to obtaining better deals
Importance of habitual behaviour
2.Unrealistic expectations of future behaviour
- Consumers are often unrealistic about their future behaviour
- E.g many adults are overweight yet continue their habit of eating too much
- This is because they expect to change their habit in the near future
- However often this does not happen
- E.g overweight adults would remain overweight leading to long-term health problems
- This is a case of overvaluing utility of current habits and undervaluing the utility of the rationally better option
Consumer weakness at computation
- Imperfect market knowledge underlies the weakness that some consumers display in calculation
- In reality consumers do not always buy a good at the cheapest price possible or of the best quality
- This is because markets do not always operate efficiently
- It is impossible for consumers to have full knowledge on which to base their decisions
