How markets work Pt.1 Flashcards
Rational decision making
Decision making process based on people making choices that result in the optimal level of benefit/maximum level of utility for an individual
Rational decision making assumptions
1) Consumers aim to maximise utility
2) Firms aim to maximise profits
Demand
The amount of a product or service that customers are willing and able to pay for at a given price in a given time
- not effected by supply
x and y axis of demand curve
x: Quantity demanded
y: Price
Movements along and shifts of demand curve
Movements: change in price
Shifts: change in conditions of demand (factors) with exception of price, giffen and veblen goods and speculative demand
Movements along demand curve
Contraction (left): increase in price
Expansion (right): decrease in price
- A change in price doesn’t shift the demand curve, only moves it from one point to another
Shifts of demand curve
SCEPTIC
S ubstitute prices
C omplentary prices
E arnings
P opultation
T astes, preferences, ads
I nterest rate/ available credit
C onsumer confidence
Causes of outward shift in demand (increase)
- Increasing disposable income (normal goods)
- Decreasing disposable income (inferior goods)
- Rising price of substitutes
- Falling price of complements (cream for strawberries and cream)
- Effective advertising
Causes of inward shifts in demand (decrease)
- Change in consumer tastes/preferences
- Rise in interest rates (goods bought on credit)
- Potential fall in prices (consumers delay purchasing e.g. sales)
- Rise in unemployment during recession
- Appreciation of exchange rates (imports/substitutes cheaper)
Derived demand
Goods demanded because they are needed for the production of other goods
e.g. demand for steel driven by demand for cars
Why the demand curve slopes downward
Income effect:
- when price falls, the real income of the consumer rises
- increases purchasing power, allows more of that good to be bought
Substitution effect
- when price falls, it becomes cheaper relative to its substitutes
- consumers switch from more expensive substitutes
Diminishing marginal utility
Diminishing marginal returns vs Diminishing marginal utility
Returns focuses on how much of a certain factor of production should be used to make the product
Utility focuses on how much of a product a customer will use
The Law of Diminishing Marginal Utility (satisfaction)
Each extra unit of a good or service will eventually give less extra satisfaction
- consumers will be willing to pay less for more goods
Elasticity
Refers to how responsive something is to a change in a related factor
- Elastic: very responsive
- Inelastic: not very unresponsive
Factors that effect elasticity
Addictiveness
Necessity
Convenience
Price Elasticity of Demand (PED)
Measures the responsiveness of quantity demanded following a change in price
Income Elasticity of Demand (YED)
Measures the responsiveness of quantity demanded to change in real income
Cross Elasticity of Demand (XED)
Measures the responsiveness of quantity demanded for good A following a change in price of good B (related good)
- we make important distinction between substitute products and complementary goods and services
Formulae to calculate PED
%change in quantity / %change in price
Formulae to calculate YED
%change in quantity demanded / %change in income
Formulae to calculate XED
%change in quantity demanded of good X / %change in price of good Y
Interpreting numerical values of PED
Unitary/Unit elastic: exactly (-)1 i.e exactly proportionally responsive
Perfectly elastic: infinity
Relatively elastic: PED>1
Perfectly inelastic: 0
Relatively inelastic: PED<1
Interpreting numerical values of YED
Normal goods: positive but YED<1
(increased income leads to higher demand)
Luxury goods: positive YED>1
(increased income leads to a bigger percentage increase in demand e.g. sports cars)
Inferior goods: negative YED<0
(increased income leads to fall in demand e.g. cheap substitutes like supermarket coffee)
Interpreting numerical values of XED
Substitute goods (in competitive demand): positive XED
Complement goods (in joint demand):
negative XED
Unrelated goods:
XED of 0
Normal goods
Luxury goods
Inferior goods
Factors that effect PED
- Neccessity
- Substitutes/competition
- Convenience
- Addictiveness
- Cost of switching
- Quality
- Income proportion
- Time
- Peak
- Loyalty
Significance of elasticities of demand to firms and government in terms of
- imposition of indirect taxes and subsidies
- changes in real income
- changes in the prices of substitute and complementary goods
Elasticity and Total Revenue relationship
The more elastic a product is, the lower the total revenue due to fall in demand
Supply
The quantity of a good/service that a producer is willing and able to sell onto the market at a given price in a given time period
Movements along and shifts of supply curve
Movements: change in price
Shifts:
Movements along supply curve
Contraction (left): decrease in price
Expansion (right): increase in price
Causes of outward shifts in supply (increase)
- Gov subsidies to cover some supply costs of firms
- Fall in world price of imported components and raw materials
- Reduction in the size of an indirect tax on producers
- Improvement in labour productivity which lowers unit labour costs
Causes of outward shifts in supply (increase)
- Gov subsidies to cover some supply costs of firms
- Fall in world price of imported components and raw materials
- Reduction in the size of an indirect tax on producers
- Improvement in labour productivity which lowers unit labour costs
Causes of outward shifts in supply (increase)
- Gov subsidies to cover some supply costs of firms
- Fall in world price of imported components and raw materials
- Reduction in the size of an indirect tax on producers
- Improvement in labour productivity which lowers unit labour costs
Price Elasticity of Supply
Measures the responsiveness of supply to a change in price
PES formula
%change in quantity supplied / %change in price
Interpreting numerical values of price elasticity
Perfectly elastic: infinity
Relatively elastic: PES>1
Perfectly inelastic: 0
Relatively inelastic: PES<1
Determinants of PES
C omplexity of production
R aw materials
I nventories
M obility
E xcess capacity
S pan of time
Short run vs Long run for PES
Producers of goods/ services typically find it easier to expand production in the long run rather than short run.
- in the short run, it’s costly/difficult to build a new factory, hire many new workers, or open new stores
- over a few years, all of these things are possible.
