How markets work Pt.2 Flashcards
Equilibrium price
Where there is a state of balance between market supply and demand
- at a given price, quantity demanded and quantity supplied are equal
- if there is a change in either, a new equilibrium is established
Excess demand on diagram
Where demand exceeds supply at a given price
- horizontal distance between the demand and the supply curves at a price below the equilibrium price.
Excess supply on diagram
Where supply offered for sale exceeds the quantity demanded by consumers at a given price
- horizontal distance between the demand and the supply curves at a price above the equilibrium price.
Market forces to eliminate excess supply and demand
- When supply of a product decreases and demand increases, the market force increases the price
- When supply increases and demand decreases, the price of the product decreases.
Price mechanism (invisible hand)
How the free market allocates resources i.e. how supply and demand arrive at equilibrium
Functions of the price mechanism to allocate resources
Incentives
Rationing
Signalling
Incentives
Consumers send information to producers (through their choices) about the changing nature of needs and wants
- higher prices are incentive to raise output as profit is higher
- lower prices cause supply to contract as producers reduce output
Rationing
Prices serve to ration scarce resources when demand in a market outstrips supply, higher prices will cause a contraction in demand
- when there is a shortage the price is bid up leaving only those willing and able to pay
- the market price acts a rationing device to equate demand with the supply
Signalling (price adjusting)
When prices adjust to demonstrate where resources are required and where they are not
- Expansion of supply:
If prices rise, it signals to suppliers there are scarcities and more is needed of this product
- Contraction of supply:
If prices fall, it signals to suppliers this product has been oversupplied and they should cut back
Consumer surplus
The difference between the price a consumer is willing and able to pay for a product and the price that is actually paid
- shown by the area under the demand curve and above the equilibrium
Producer surplus
The difference between the price producers are willing and able to sell for and what they actually sell for
- shown by area under equilibrium and above the supply curve
Supply and Demand effect on producer surplus
Supply:
- increase = more producer surplus
- decrease = less producer surplus
Demand:
- increase = more producer surplus
- decrease = less producer surplus
Supply and Demand effect on consumer surplus
Supply:
- increase = more consumer surplus
- decrease = less consumer surplus
Demand:
- increase = more consumer surplus
- decrease = less consumer surplus
Indirect tax
A payment which must be made to the government in addition to the cost of production of certain goods and services
2 types of indirect tax
Ad valorem taxes: a % of the unit cost of a good
- e.g. Value Added Tax (VAT), insurance premium tax
Specific taxes: a fixed tax per unit of the good or service produced
Consumer and Producer incidence
Consumer: how much of an indirect tax the consumer pays
Producer: how much of an indirect tax the producer pays
Indirect tax on diagram
Vertical distance between the pre-tax and post-tax supply curves. Because of the tax, less can be supplied to the market at each price level.
Advantages of indirect tax
- Reduces the consumption of demerit goods (goods harmful to customers)
- Increases government revenue
- Government revenue gained can be spent on further correcting the problem (revenue can be hypothecated)
- Easy to understand and implement
- Can change the distribution of income e.g. taxing products which are consumed by the rich)
Disadvantages of indirect taxes
- Most can have regressive effects on low-income consumers e.g. if inelastic, consumers take most of the burden of tax
- Tax revenue may not be hypothecated back e.g. used to correct market failure
- Higher indirect tax can cause inflation i.e. suppliers decide to pass on a tax by raising prices
- Government revenue from indirect taxes can be uncertain particularly when there is a recession i.e. low employment so less being paying tax
Incidence of indirect taxes on consumers
The burden/incidence is determined by the PED of in response to a price rise. - If the consumer is unresponsive (PED is inelastic), the burden will fall mainly on the consumer
- If PED is elastic, the producer incidence will be greater
Incidence of indirect taxes on producers
When supply is perfectly elastic (PES=infinity) output can be supplied at constant cost
- tax on producers causes an inward shift of the supply curve, but all tax would be paid by the consumer, regardless of PED
- when demand is elastic consumers pay all tax, but equilibrium quantity will contract by a large amount
Subsidies
Represent payments by the government to suppliers that have the effect of reducing the costs and encouraging them to increase output
- lower costs lower prices increasing demand
Effect of subsidy
- to increase supply
- a subsidy on a product will lower its price causing extension of market demand
2 types of subsidies
Producer: guaranteed payment per product created e.g. payments for farmers
- financial support e.g. grant/block payment to cover business losses
Consumer: government payment to consumers designed to allow them to purchase more of a good or service
- might take form of: interest free loans, direct grants
Producer subsidy on diagram
Increase in supply, difference between supply pre-subsidy and supply post-subsidy
Consumer subsidy on diagram
Irrational behaviour
When people make choices/decisions that go against the assumption of rational utility-maximising behaviour
Rational behaviour
When people make choices/decisions that support the assumption of rational utility-maximising behaviour
Causes of irrational behaviour
Consideration of the influence of other peoples behaviour e.g. trends
Importance of habitual behaviour i.e loyalties
Consumer weakness at computation
