How Markets Work Flashcards
What do markets have in common
One thing markets have in common is that buyers and sellers come into contact for the purpose of exchange. A price is agreed for exchange to take place. By price we mean the exchange value of a good or service.
What do buyers represent in markets
Buyers or consumers represent the demand side of the market
What do sellers represent in the market
Sellers or producers represent the supply side of the market.
What is a market
Where consumers and producers come into contact with each other to exchange goods and services.
What do we assume consumers to be
Consumers are assumed to make rational decisions. This means consumers will allocate their income to maximise their utility or satisfaction from the goods and services they purchase.
What is utility
Utility refers to the amount of satisfaction obtained from consuming a good or service. Economists often make the assumption that utility can be measured.
Define utility
The amount of satisfaction obtained from consuming a good or service.
How is a consumer rational
A rational consumer will allocate his or her spending to maximise utility from the goods and services purchased. This requires the individual to equate the utility gained per £ spent on the last unit of each good or service. Eg. If a consumer has an extra £100 to spend then it could be used to buy a £20 T shirt and an £80 pair of shoes. We assume the t shirt would provide 40 units of extra utility (or marginal utility) and the pair of shoes 160 units of extra (or marginal) utility. In this way, the utility gained from the last unit of each good is equated (2 units of utility per £1 spent) maximising consumer utility is shown by the following formula:
Marginal utility of T shirt / price of T shirt = marginal utility of pair of shoes / price of pair of shoes.
What do we assume producers to do
Producers are assumed to make rational decisions. This means firms will use their resources to maximise profits from the goods and services produced. This involves producing at a level of output where total revenue exceeds total cost by the largest amount.
What is rational decision making
Where consumers allocate their expenditure on goods and services to maximise utility, and producers allocate their resources to maximise profits.
What is demand
The buyers of consumers in a market are said to demand goods or services. Demand refers to the quantity of a good or service purchased at a given price over a given time period.
Demand is different from just wanting a good or service, it is a want backed up by the ability to PAY, which is also known as EFFECTIVE DEMAND
Define demand
The quantity of a good of service purchased at a given price over a given time period.
What does a demand curve show
A demand curve shows the quantity of a good or service that would be bought over a range of different price levels ins given period of time.
What is the demand curve like
The demand curve for a good slopes downwards from left to right because, as price falls, the good becomes cheaper compared to substitute goods and also more can be purchased with a given level of income.
Define the demand curve
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.
What’s the market demand curve
The market demand curve is the horizontal summation of each individual demand curve for a particular good or service in the market.
Where is there a movement along the demand curve
There is a movement along a demand curve for a good ONLY when there is a change in its price. A fall in price causes an extension in demand, and a rise in price causes a contraction in demand.
Eg. If demand curve like this \ , a rise in price causes a contraction in demand towards the top left.
How can the downward sloping demand curve be explained by a concept involving marginal utility
The concept of diminishing marginal utility explains this. As one consumes more of a good, the utility or satisfaction gained from each extra unit will tend to fall or diminish.
Note that total utility from the good will increase as more is consumed, but this occurs at a diminishing rate.
As marginal utility falls from each extra good consumed, it means consumers will only buy more of it if the price falls - hence the downward sloping demand curve.
Define marginal utility
The utility or 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.
What does a change in demand refer to
An increase in demand refers to the whole demand curve shifting outwards to the right at every price level. A decease in demand refers to the whole demand curve shifting inwards to the left at every price level.
List 8 factors which can shift the demand curve for a good
A fall in the price of complimentary goods
A rise in the price of substitute goods
A change in fashion and tastes
Increased advertising
An increase in real incomes
A decrease in income tax, leads to an increase in disposable income.
An increase in the population or a change in the age structure of the population so they may like different products.
An increase in credit facilities, makes it easier to obtain funds for goods.
What will a change in price level lead to with the demand curve
A change in price of a good will lead to a movement along the demand curve for that particular good; it will not shift the demand curve.
What is price elasticity of demand
PED is the responsiveness in the demand for a good due to a change in its price.
What’s the formula for PED
PED = %change in quantity demanded of good A / %change in price of good A
= %change D / %change P
In most circumstances, a minus answer is obtained, indicating that the two variables of price and demand move in opposite directions. There is a negative gradient.
Define price elasticity of demand
The responsiveness of demand for a good or service to a change in its price.
What does it mean if PED is greater than 1
The good is relatively price elastic, percentage change in demand is greater than the percentage change in price.
What does it mean if PED is less than 1
The good is relatively price inelastic, the percentage change in demand is less than the percentage change in price.
What does it mean if PED is equal to 1
The good has unit elasticity, percentage change in demand is the same as the percentage change in price.
What does it mean if PED is equal to zero
The good is perfectly inelastic, change in price has no effect on quantity demanded. Demand curve is vertical
What does it mean if PED is infinite
The good is perfectly elastic, a rise in price causes demand to fall to zero. Demand curve is horizontal.
What does PED look like on a graph when it’s unitary elastic
A curve, like a the first half of a u
What does a minus sign answer for PED mean
A fall in price leads to increase of demand
If PED is greater than 1, we also include number with minus eg. -2 and count it as included in this category, the minus sign just tells us the relationship.
What happens with PED and demand curves
Don’t confuse elasticity with the gradient of a demand curve. Straight line demand curves have constant gradients but different elasticities along them.
Tell me about the relationship between price elasticity of demand and total revenue.
Elasticity varies along a straight line demand curve. Elasticity falls as you move a long the curve from top left (elastic demand) to the bottom right (inelastic demand ) and equilibrium position (unit elasticity)
Total revenue forms an n shape curve with the max point/ max total revenue at the equilibrium position of the demand curve.
What is total revenue
Total revenue refers to the total payments a firm receives from selling a given quantity of goods or services. It is the price per unit of a good multiplied by the quantity sold. The total revenue a firm receives from selling a good will be equal to the total spending by consumers on that good.
Define total revenue
The price per unit of a good multiplied by the quantity sold
When will a firms total revenue increase
A firms total revenue will increase as long as price is moving towards the mid position of the demand curve (unit elasticity).
Why is it important for firms to know the PED of their output
It is important to know when making pricing decisions, because this affects revenue and profitability.
What happens to revenue when demand is elastic
If demand is elastic, then a cut in price increases total consumer spending and hence revenue to the firm. On the other hand, a rise in price causes total consumer spending to fall and so firms lose revenue.
What happens to revenue when demand is inelastic
If demand is inelastic, then an increase in price increases total consumer spending and hence revenue to the firm. On the other hand, a fall in price causes total consumer spending to fall and so firms to lose revenue.
What happens to revenue when demand is unit elastic
Once unit price elasticity has been reached, the firm is maximising its total revenue.
Note the relationship between PED and marginal revenue, which falls during a move down the demand curve. As long as marginal revenue is positive, demand is price elastic. When marginal revenue is 0, demand is unit elastic, when marginal revenue is negative, demand is inelastic.
List the determinants of price elasticity of demand
Availability of substitutes
Luxury and necessity goods
Proportion of income spent on the good
Addictive and habit forming goods
The time period
Brand image
Tell me how availability of substitutes is a determinant if PED
The more narrowly a good is defined, the more substitutes it tends to have and so its demand is elastic. For example, cod, a type of fish, has many substitutes such as plaice, rock, salmon and haddock.
However, the more broadly a good is defined, the fewer substitutes it tends to have and so it’s demand is less elastic. For example, there are few close substitutes for fish as a whole and so demand tends to be relatively less elastic.
Tell me how luxury and necessity goods are a determinant of PED
Luxury goods, such as racing cars and caviar, tend to have an elastic demand, whereas necessity goods, like bread and underwear, tend to have an inelastic demand.
Tell me how the proportion of income spent on the good is a determinant of PED
If a high percentage of income is spent on the good, as with a new car or boat, demand tends to be price elastic. However, for goods that take up a small percentage of income, such as newspapers and tomato sauce, demand will tend to be price inelastic.
Tell me how addictive and habit forming goods are a determinant of PED
Tobacco, alcohol, and coffee are types of goods that tend to be price inelastic in demand
Tell me how the time period is a determinant of PED
For most goods, demand is less elastic in the short term than the long term. For example, a rise in the price of household electricity is likely to have only a minor effect on consumption in the short run. In the long run, households can cut back on consumption by switching to gas for their cooking and heating. This means demand eventually becomes more responsive to changes in price .
How is brand image a determinant of PED
Some goods have a strong brand image, eg Levi jeans and Coca Cola. Demand for these goods is typically price inelastic as consumers are often 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 income
What is YED
Income elasticity of demand, is the responsiveness of demand for a good or service to a change in real income.
What is real income
Real income refers to the spending power of money income - the amount of goods and services which can be purchased with ones nominal income.
What’s the formula for YED
YED = percentage change in demand for a good / percentage change in real income
YED = %change In D/ %change in Y
What does it mean when YED is positive
In most circumstances, YED is positive, which means the two variables of income and demand move in the same direction. In other words, a rise in income causes a rise in quantity demanded.
This is a NORMAL GOOD
Note that some economists identify goods which have a YED above +1 as a LUXURY GOOD, but these are STILL a type of normal good.
A good with YED less than 1 means ….
The good is relatively income inelastic
A good with YED above 1 is…
A good that is relatively income elastic in demand
A good with YED equal to 1 means…
The good has unitary elasticity
Define normal good
A good with a positive income elasticity of demand. As income rises, so too does demand for the good.
Describe an inferior good
Occasionally, YED is negative which means the two variables of income and demand move in opposite directions. This is because people tend to demand higher quality goods as their income rises, substituting them for lower quality products.
Examples include minced meat and supermarkets own value brands of food eg Waitrose essential 🤮🤮🤮
Define inferior good
A good with a negative income elasticity of demand. As income rises, demand for the good falls.
Compare the demand curves for a normal vs inferior good
On a graph of income (y) and quantity demanded (x),
A normal good has a positive gradient demand curve
An inferior good has a negative gradient demand curve. (As income rises QD falls)
What does XED stand for
Cross elasticity of demand
What is cross elasticity of demand
it is the responsiveness of demand for good B to a change in price of good A.
What’s the formula for XED
XED = percentage change in demand for good B/ percentage change in price for good A
XED = %change in D for good B/ %change in P for good A
Define cross elasticity of demand
The responsiveness of demand for good B to a change in price of good A
What’s a common error with XED
Students compare change in demand for one good to change in demand for another - THIS IS WRONG NO !
What is XED used for
It is used to determine whether goods are complements or substitutes for each other.
What are substitute goods
Substitute goods are in competitive demand. For example, a rise in the price of coffee may cause an increase in demand for tea. XED is positive for substitute goods, as the two variable of price and demand move in the same direction. There is a positive gradient.
What are complementary goods
Complementary goods are in joint demand. They tend to be consumed together. For example, a fall in the price of tennis rackets may cause an increase in demand for tennis balls. XED is negative for complementary goods, as the two variables of price and demand move in opposite directions. There is a negative gradient
What are unrelated goods
Unrelated goods have a XED value of zero, for example, an increase in the price of cars will have no effect upon the demand for potatoes.
What do the demand curve on graphs of XED for substitute and complementary goods look like
On a graph of price of a good A (y) and quantity demanded of good B (x)
Substitute goods have a positive gradient, as a price of good A increase demand for good B increase
Complementary goods have a negative gradient demand curve
What does a cross elasticity of zero mean
There is no relationship between the goods, such as a chocolate bar and beef
What is supply
The sellers or producers in a market are said to supply goods and services.
Supply refers to the quantity of a good or service that firms are willing to sell at a given price and over a given period of time.
Define supply
The quantity of a good or service that firms are willing to sell at a given price and over a given period of time.
What is the supply curve
A supply curve is 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.
Which way does the supply curve slope
It slopes upwards
Why does the supply curve slope upwards
It slopes upwards from left to right since: as firms raise output in the short term, they face rising production costs and so pass these costs onto consumers by charging higher prices. Furthermore, as price rises, it encourages firms to supply more of a good to increase profits. indeed, higher prices may encourage firms to enter a market and so raise supply.
What’s is the market supply curve
The market supply curve is the horizontal summation of individual firms supply curves for a particular good or service.
When is there a movement along a supply curve
There is movement along a supply curve for a good ONLY when there is a change in price. A rise in price causes an extension in supply, and a fall in price causes a contraction in supply
What does an increase in supply refer to
An increase in supply refers to the whole supply curve shifting outwards to the right at every price level. A decrease in supply refers to the whole supply curve shifting inwards to the left at every price level
List factors that can cause the supply curve to shift.
Improvements in technology
A reduction in labour costs
A reduction in capital costs
A reduction in transport costs
Discovery of new oil fields
An increase in the number of firms in the market/industry
A decrease in market influences, eg firms can now produce more than quotas previously set by theses market influencers
Good weather/climatic conditions to produce
A reduction in indirect taxation
An increase in government subsidies
What does PES stand for
Price elasticity of supply
What is price elasticity of supply
PES is the responsiveness of the supply of a good to a change in its price.
What’s the formula for PES
PES = percentage change in supply of a good / percentage change in price of a good
PES = %change in S /% change in P
Define price elasticity of supply
The responsiveness of the supply of a good or service to a change in its price.
What does it mean if PES is positive
In most cases, a positive answer is obtained, indicating that the two variables of price and quantity move in the same direction, there is a positive gradient.
If PES is greater than one…
The good is relatively price elastic: that is, the percentage change in supply is greater than the percentage change in price of the good.
If PES is less than one…
The good is relatively price inelastic, that is, the percentage change in supply is less than the percentage in price of the good.
If PES is equal to one…
The good is unit elastic, that is, the percentage change in supply is the same as the percentage change in price of the good
If PES is equal to zero…
The good is perfectly inelastic: that is, a change in price has no effect on quantity supplied. The supply curve is vertical.
If PES is infinite…
The good is perfectly elastic. The supply curve is horizontal.
What happens to the supply curve the more elastic it is
It becomes more horizontal, gradient gets lower.
Unit elasticity is a gradient of 1 and price and quantity are directly proportional
List the determinants of price elasticity of supply
Level of spare capacity
State of the economy
Level of stocks of finished goods in a firm
Perishability of the product
Ease of entry to an industry
Time period under consideration
For price elasticity of supply, how is level of spare capacity a determinant
A high level of spare capacity in a firm means that it can raise production quickly, so supply tends to be elastic. A firm or industry operating at full capacity is unable to raise output quickly and so its supply tends to be inelastic
For price elasticity of supply, how is the state of the economy a determinant
In a recession there are many unemployed resources and so there is a high level of spare capacity. Firms find it relatively easy to raise supply if needed.
For price elasticity of supply, how is level of stocks of finished goods in a firm a determinant
A high level of stocks means that the firm can increase supply quickly, so supply is elastic. Alternatively, a firm or industry operating with low stocks is unable to raise output quickly and so supply tends to be inelastic.
For price elasticity of supply, how is perishability of the product a determinant
Some goods cannot be stockpiled, eg, some agricultural goods such as fresh fruit, vegetables and flowers are highly perishable. These goods are typically inelastic in supply. On the other hand, manufactured goods tend to be non perishable and so can be stockpiled by firms in order to meet anticipated increases in demand. Eg. Fridges, freezers and washing machines
For price elasticity of supply, how is ease of entry to an industry a determinant
If there are high entry barriers to an industry then it will be difficult for new firms to enter, even with the attraction of high prices and profits. Sometimes existing producers deliberately create entry barriers, so supply may be restricted and inelastic.
For price elasticity of supply, how is time period under consideration a determinant
This is perhaps the most important determinant of elasticity of supply. The short run is the period of time In which a firm is able to increase supply with its existing capacity. At least one factor input is likely to be fixed In quantity in the short run, which makes it difficult for a firm to raise production. Supply tends to be relatively inelastic. The long run is the period of time In which a firm is able to increase supply by adding to its production capacity. All factor inputs are variable in the long run, making it easier for a firm to raise production. Supply tends to be relatively elastic.
Why, for many agricultural products, is supply inelastic in the short run
Because the output from the summer and autumn harvests depends on the amount of seed planted at the start of the year. It takes an even longer period of time to raise the supply of products from livestock, such as milk and beef, because these depend on the nurturing of animals over several years .
Why might the supply of minerals be inelastic in the short run
Due to the length of time required to explore and discover new deposits and then extract them. The costs and technical complexities involved could be phenomenal. Eg. Developing a new iron ore mine will require heavy machinery and the construction of new rail and road links.
DONT CONFUSE DETERMINANTS OF PES WITH DETERMINANTS OF PED!!!!
😳😟
The larger the gradient of a supply curve….
The more inelastic it is
What do economists assume about consumers and producers
Economists assume that consumers and producers make rational decisions: this means consumers spend their income to maximise utility and producers allocate their resources to maximise profits.
Tell me about shifts and moves along the demand curve
A movement along the demand curve is caused by a change in the price of the good, whereas a shift in the demand curve is caused by changes in real income, tastes, and the price of substitutes and complementary goods
Why is the demand curve downward sloping
It can be explained by diminishing marginal utility. As an additional unit of a good is consumed, marginal utility falls, so consumers will only buy more of a product as its price falls.
A change in the price of a good towards unitary elasticity of demand will lead to…..
An increase in total revenue
What are the determinants of PED for a good
They include, the availability of substitutes, the proportion of income spent on it, the time period and whether its addictive
What are the YEDs for normal and inferior goods
Normal goods have a positive and inferior goods have a negative income elasticity of demand
What XEDs do substitute and complementary goods have
Substitute goods have a positive and complementary goods have a negative cross elasticity of demand
What are movements along the supply curve and shifts of the supply curve caused by
A movement along a supply curve is caused by a change in the price of the good, whereas shifts in a supply curve are caused by other factors: for example, changes in the costs of production, technology, the ability of firms to enter and exit an industry, indirect taxes and government subsidies
What are the determinants of PES of a good
Levels of spare capacity, state of the economy, level of stocks, perishability, ease of entry and exit to an industry, and time period under consideration.
What does a vertical supply curve indicate
Indicates that the supply of a good is perfectly price inelastic. Eg, the capacity of the Wembley stadium is 90,000 seats.
How is price determined
Price is determined through the interaction of demand and supply in a competitive market.
What is an equilibrium price and quantity
An equilibrium price and quantity occurs when there is a balance in the market.
There is no tendency for price or quantity to change. The equilibrium price and quantity of a good are obtained from the point of intersection between the demand and supply curves
Define equilibrium price
The price where the quantity demanded equals the quantity supplied for a good or service in a market.
In a free market what happens if price is above or below equilibrium
In a free market, price cannot remain above or below the equilibrium position for long.
What happens when there’s excess supply in a free market
In order to sell the surplus, producers tend to reduce price and thus encourages consumers to buy more, demand extends and supply contracts until the equilibrium price is reached
Define excess supply
Wheee the quantity supplied exceeds the quantity demanded for a good at the current market price.
What happens when there is excess demand in a free market
Consumers tend to bid up the price in order to obtain the good and this encourages producers to supply more. Supply extends and demand contracts until the equilibrium price is reached.
What does the price mechanism do with excess demand or excess supply
The price mechanism automatically eliminates surpluses and shortages of a good - something that the economist Adam Smith referred to as the invisible hand
Who referred to the price mechanism as an invisible hand
Adam Smith
Define excess demand
Where the quantity demand exceeds the quantity supply for a good at the current market price
What is the price mechanism
Refers to the way price responds to changes in demand or supply for a product or factor input, so that a new equilibrium position is reached in the market. It is the principal method of allocating resources in a market economy. It has several functions
What is price
Price is the exchange value of a good or service
Define 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
List the 3 functions of the price mechanism
Rationing device
Incentive device
Signalling device
What is the rationing device function of the price mechanism
Resources are scarce, which means that the 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 the quantity supplied.
What is the incentive device function of the price mechanism
Rising prices tend to 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.
What is the signalling device of the price mechanism
The price mechanism indicates changes in the conditions of demand or supply. For example, an increase in demand for a good or service raises its price and encourages firms to expand their supply, while a decrease in demand lowers the price and causes firms to contract their supply. Consequently, more or fewer resources are allocated to the production of a particular good or service.
Any of the factors which may shift demand or supply curves will lead to a change in…..
Price of a good or service
What is consumer surplus
Consumer surplus is the extra amount of money consumers are prepared to pay for a good or service above what they actually pay. It is the utility or satisfaction gained from a good or service in excess of the amount paid for it.
What is producer surplus
Producer surplus is the extra amount of money paid to producers above what they are willing to accept to supply a good or service. It is the extra earnings obtained by a producer above the minimum required for them to supply the good or service.
What does the area of consumer surplus look like
Consumer surplus is the area above the equilibrium price but below the demand curve.
Draw a line for equilibrium price to y axis, the area above this line up to the demand curve is consumer surplus
It’s a triangle shape
What does the area for producer surplus look like
Producer surplus is the area below the equilibrium price and above the supply curve
If you draw a line form equilibrium price to y axis, the area below this line up to the supply curve is producer surplus, triangle shape
Is consumer surplus above or below producers surplus
Consumer surplus is ABOVE producer surplus
Use conduce to remember (consume + produce)
What’s the impact of an increase in demand on producer surplus
An increase in demand for a good is likely to raise producer surplus
Draw a diagram if you don’t believe me ☹️
What’s the impact of increase demand on consumer surplus
It’s likely to raise consumer surplus (as will producer surplus)
Assuming all other things remain equal
Tip: don’t always assume a fall in price of a good will increase consumer surplus, it depends on the reason for the fall, eg a decrease in demand for the good will lead to a lower price and lower consumer surplus
Yeah 🤔🤔
What’s the impact of a decrease in supply on consumer surplus
It is likely to reduce consumer surplus
What’s the impact of a decrease in supply on producer surplus
It will likely decrease
What is a tax
A tax is a compulsory charge made by the government, on goods, services, incomes, or capital.
What is the purpose of taxes
The purpose is to raise funds to pay for government spending programmes.
What are the two types of tax
Direct and indirect
What’s a direct tax
A direct tax is levied directly on an individual or organisation. Direct taxes are generally paid on incomes: for example, personal income tax and corporation tax (on company profits)
What’s an indirect tax
An indirect tax is usually levied on the purchase of goods and services. It represents a tax on expenditure. There are two types of indirect tax: specific and ad valorem
What are the two types of indirect tax
Specific and ad valorem
What’s a specific tax
A type of indirect tax, it’s charged as a fixed amount per unit of a good. An excise tax is a good example.
What’s an ad valorem tax
An ad valorem tax is charged as a percentage of the price of a good. For example, VAT of 20% is added on to restaurant meals.
Define indirect tax
A tax imposed on goods or services supplied by businesses. It includes both specific and ad valorem taxes.
What does the imposition of an indirect tax do to price and what does it do to the supply curve generally
It raises the price of a good or service. The tax is added to the supply price, effectively causing the supply curve to shift vertically upwards and to the left ( a decrease in supply)
What does a specific tax do to the supply curve
A specific tax causes a parallel shift of the supply curve to the left.
What does an ad valorem tax do to the supply curve
It causes a pivotal rotation of the supply curve to the left, as supply increases, the gap between the original supply curve and new one becomes larger/distance between them increases.
Define incidence of tax
The distribution of the tax paid between consumers and producers
Where does the incidence of a tax usually fall
It usually falls partly on consumers and partly on producers, depending on the relative elasticities of demand and supply for a good or service. A combination of price inelastic demand and price elastic supply tends to place most of the tax burden on consumers: addictive goods such as tobacco and alcohol tend to be price inelastic in demand. This means firms are able to pass most of the burden of tax on to consumers via higher prices.
What would a combo of price elastic demand and price inelastic supply do to incidence of tax
Tends to place most of the tax burden on the producers. It may also lead to a significant reduction in output and employment. Consequently, a government may be reluctant to place high indirect taxes on these types of goods.
How is the incidence of tax paid by consumers
It is shown by the actual rise in market price.
How can we show an indirect tax on a diagram
Always start from the new equilibrium price position and then draw a vertical line down to the original supply curve, this is the whole tax area
It’s a rectangle shaped area
What is subsidy
A subsidy is a grant, usually provided by the government, to encourage suppliers to increase production of a good or service, leading to a fall in its price. Bus and train companies are often given subsidies in order to increase the number of bus and train services, which benefits both the firms and consumers.
Define subsidy
A government grant to firms, which reduces production costs and encourages an increase in output.
How do you work out the incidence of taxation on consumers and producers on a diagram
At the original equilibrium, the consumer tax is the area from this line up to the point where the demand curve meets the new supply curve and then to y axis. So it’s rectangular in shape.
How do you work out the incidence of taxation on the producer on a diagram
Draw a line from the original equilibrium, then where the new supply meets the demand, draw a line down to the original supply, the area under the original equilibrium is the producer tax.
What’s the exam tip to show a subsidy on a diagram
To show a subsidy on a diagram, always start from the new equilibrium price position and then draw a vertical line up to the original supply curve.
Many students make the mistake of starting from the original equilibrium price position and end up with wrong area
Who is the subsidy often paid to
Often paid directly to producer.
Why do consumers gain from a subsidy
A subsidy is often paid directly to producers, but as they respond by increasing output, the market price falls and this indirectly passes on some of the gain to consumers.
How does the amount of consumer gain for a subsidy change
If demand is price inelastic, then the market price falls by a relatively large amount, increasing the benefits to consumers.
If demand is price elastic, then market price falls by a relatively small amount and so there is less gain for consumers.
What is the amount of subsidy that consumers gain area
It is shown by the actual fall in market price from the original equilibrium to the new one. They gain by paying a lower price for the good.
The area is under the producer subsidy (unlike tax areas)
If you go from new equilibrium and draw up to original supply curve and across both to the y axis, and then go to original equilibrium and draw to y axis, the area under the original equilibrium (rectangle) is consumer subsidy.
What’s the area for the producer subsidy
If you go from new equilibrium and draw up to original supply curve and across both to the y axis, and then go to original equilibrium and draw to y axis, the area above the original equilibrium is the producer subsidy
Rectangle shape
Do consumers always act rationally
No, we can take an inductive approach by investigating how consumers actually behave and then develops models from the results.
Indeed consumers may be considered irrational in seeking a satisfactory level of utility rather than maximising utility. There are several factors that help explain this behaviour.
List factors why consumers may not act rationally
The influence of other peoples behaviour
The importance of habitual behaviour
Consumer weakness at computation
Explain how the influence of other people’s behaviour can make consumers act irrationally
Consumers are influenced by the behaviour of others; for example, if some people start buying a share in a particular company, others may follow, despite thus causing the price to rise and making the share less of a bargain. This ‘herd’ like mentality is often displayed in various markets where it has become clear that consumers who come late to the market receive little benefit.
Explain how the importance of habitual behaviour causes humans to act irrationally
Consumers are creatures of habit and prefer what they know and have, rather than risking something new where there is more uncertainty. There may be difficulties involved with changing a bank or energy supplier etc, using considerable time.
Consumers are often unrealistic about their future behaviour, eg. Many adults are overweight and yet continue habit of eating too much.
How is consumer weakness at computation a reason for irrational consumer behaviour
Many consumers have difficult in calculating best buys, eg knowing that multipacks are often cheaper than individual units, consumers may simply lack skills required to calculate Best Buy.
Imperfect market knowledges underlies the weakness that some consumers display in computation. It is impossible for consumers to have full market knowledge in which to base their decisions.
In a competitive market, what is equilibrium price and quantity of a good determined by
It is determined by the interaction of demand and supply
What is the price mechanism - summary point
The price mechanism is the use of market forces to allocate resources in order to solve the economic problem of what, how and for whom to produce. It’s three functions are to operate as a rationing, incentive and signalling device in the market.
What is consumer surplus
Consumer surplus is the utility or satisfaction gained from a good or service in excess of the price paid for it.
What is producer surplus
Producer surplus is the extra earnings obtained by a producer above the minimum required for them to supply the good or service.
What will excess demand for a good cause
It will cause price to rise until equilibrium is reached, an excess supply of a good will cause price to fall until a new equilibrium is reached
What is an indirect tax
An indirect tax on a good will cause an inward shift in the supply curve, leading to a fall in output and a rise in price.
What will a unit subsidy on a good cause
It will cause an outward shift in the supply curve, leading to a rise in output and a fall in price.
What are some of the alternative views of consumer behaviour
Alternative views of consumer behaviour are based on real world investigations of how consumers actually behave. This indicates that consumers may not aim to maximise total utility, or they may be confused over the behaviour required to do this.
Why does the demand curve slope downwards from left to right
As the price of a good falls, it becomes more affordable for consumers to buy with their income. Also it becomes relatively cheaper than substitute goods and so some consumers will switch to buying it.
What causes a movement along a demand curve for a good
A change in the price of the good in question. A rise in price will lead to a contraction in demand and a fall in price will lead to an extension of demand.
What causes a shift in the demand curve for a good
The main factors include a change in price of substitute or complementary goods and a change in incomes or tastes. Note that changes in the price of the good will not shift the demand curve.
What does the minus sign mean in price elasticity of demand answers
The minus sign means there is an inverse relationship between the change in price and the change in demand. Thus, a rise in price will cause a fall in quantity demanded. The demand curve has a negative gradient.
What does the actual figure represent in price elasticity of demand answers
The answer indicates how much a 1% change in price cause demand to change by. For example, an answer of 3 means that a 1% change in price will lead to a 3% change in demand for the good.
Why might price elasticity of demand be useful to firms
If a firm knows the price elasticity of demand for the good it produces then it may be able to increase total revenue by changing the price. If demand is inelastic, a rise in price will increase total revenue; if demand is elastic, a fall in price will increase total revenue.
Why might price elasticity of demand be useful to the government
If the government knows the price elasticity of demand for a particular good then it will have an idea of the impact that an indirect tax will have on it. For example, a tax placed on a good with inelastic demand should lead to a high tax yield and have relatively little impact on demand.
Distinguish between normal and inferior goods
Normal goods have a positive income elasticity of demand; as real income rises, demand for the good also rises. Inferior goods have a negative income elasticity of demand; as real income rises, demand for the good falls.
Distinguish between complementary and substitute goods
Complementary goods have a negative cross elasticity of demand: for example, a fall in price of computer games consoles will cause an increase in demand for computer games software. Substitute goods have a positive cross elasticity of demand: for example, a rise in price of beef may cause an increase in demand for lamb.
Why does the supply curve slope upwards from left to right
As the price of a good rises, there is an incentive to supply more since the firm might achieve higher profits. It is also able to cover the extra costs involved in producing more of a good.
What causes a movement along a supply curve for a good
A change in the price of the good in question. A rise in price will lead to an extension in supply and a fall in price will lead to a contraction in supply.
What causes a shift in the supply curve for a good
The main factors include a change in costs of production, technology, the ability of firms to enter and exit an industry, indirect taxes and government subsidies. Note that changes in the price of the good will not shift the supply curve.
What does a positive figure mean in price elasticity of supply answers
A positive number means there is a direct relationship between the change in price and the change in quantity supplied. Thus, a rise in price will cause a rise in the quantity supplied. The supply curve has a positive gradient.
What does the number represent in price elasticity of supply answers
The figure indicates by how much a 1% change in price causes quantity supplied to change. For example an answer of two means that a 1% change in price will lead to a 2% change in quantity supplied of the good.
How might the price elasticity of supply for a good change over time
For most goods, supply tends to be relatively price inelastic in the short run as some factor inputs are fixed in quantity, but becomes relatively price elastic in the long run when all factor inputs are variable.
What is likely to happen to price of a good if supply exceeds demand in a free market
If supply exceeds demand, price will fall, leading to an extension in demand and a contraction in supply. Eventually, equilibrium position is reached.
What is likely to happen to the price of a good if demand exceeds supply in a free market
If demand exceeds supply, price will rise, leading to an extension in supply and contraction in demand. Eventually, a equilibrium position is reached.
Briefly explain how a decrease in demand for a good affects producer surplus and consumer surplus
A decrease in demand for a good will cause its price to fall and so lead to a decrease in producer surplus and consumer surplus.
Briefly explain how a decrease in supply of a good affects consumer surplus and producer surplus
A decrease in supply of a good will cause price to rise but a fall in both consumer surplus and producer surplus.
Distinguish between a specific tax and an ad valorem tax
A specific tax is placed as a fixed amount per unit of good and causes an inward parallel shift in the supply curve. An ad valorem tax is placed as a percentage of the price of a good and causes an inward pivotal shift in the supply curve.
How does a unit subsidy affect the market price and output for a good
A unit subsidy will shift the supply curve outwards (an increase in supply) and reduce the equilibrium price.
What is meant by alternative views of consumer behaviour
Alternative views of consumer behaviour are those which assume consumers do not always aim or behave in a way that maximises total utility from their expenditure.
Outline three reasons why consumers may not maximise total utility
Consumers may not maximise total utility due to: copying other consumers rather than thinking for themselves, keeping with their habits rather than making changes, difficulties in computation.
