How Markets Work- Theme 1 Flashcards
Define market
Where consumers and producers come into contact with each other to exchange goods and services.
Define utility
The amount of satisfaction obtained from consuming a good or service.
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.
Define demand
The quantity of a good or service purchased at a given price over a given time period.
What does a demand curve show?
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.
Describe movement along a demand curved
There is 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
Define marginal utility
The utility or satisfaction 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.
Define price elasticity of demand (PED)
The responsiveness of demand for a good or service to a change in price
How to calculate PED
% change in quantity demanded of goods A/ % change in price of good A
If PED is greater than 1 what is it’s elasticity
The good is relatively price elastic, the % change in demand is greater than the % change in price.
If PED is less than 1 what is it’s elasticity
The good is relatively price inelastic, the % change in demand is less than the % change in price.
If PED is equal to 1 what is it’s elasticity
The good has unit elasticity, the % change in demand is the same as % change in price
If PED is equal to 0 what is it’s elasticity
The good is perfectly inelastic, change in price has no effect on the quantity demanded
If PED is infinite what is it’s elasticity
The good is perfectly elastic, a rise in price causes demand to fall to zero
Define total revenue
The price per unit of a good multiplied by the quantity sold
Why might PED be useful to firms?
Important for firms to know the PED of their output when making pricing decisions, because this affects revenue and profitability
What happens to revenue if demand is elastic?
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 if demand is inelastic
An increase in price increases total consumer spending and hence revenue to the firm. On the other hand, a fall in price causes a total consumer spending to fall and so firms lose revenue.
What happens once unit price elasticity has been reached
The firm is maximising its total revenue
How does marginal revenue affect demand
Marginal revenue positive= demand is price elastic
Marginal revenue 0= demand is unit elastic
Marginal revenue is negative= demand is inelastic
What are the determinants of price elasticity of demand?
- availability of substitutes. The more narrowly a good is defined, the more substitutes it tends to have and so its demand elastic
- luxury(tend to have elastic demand) and necessity goods (tend to have inelastic demand)
- addictive and habit-forming goods, tend to be price inelastic in demand
- brand image
Define income elasticity of demand (YED)
The responsiveness of demand for a good or service to a change in income
How to calculate YED
% change in demand for a good/ % change in real income
Define a normal good
A good with a positive income elasticity of demand. As income rises, so too does demand for the good
What are luxury goods
A type normal good which has a YED above +1
What is a good with a YED less than 1
Relatively income inelastic
What is a good with a YED above 1
Relatively income elastic in demand
What does a YED of 1 mean
It has unitary elasticity
Define inferior good
A good with a negative income elasticity of demand. As income rises, demand for the good falls
Define cross elasticity of demand (XED)
The responsiveness of demand for good B to a change in price of good A
How do you calculate XED
% change in demand for good B / % change in price of good A
What are substitute goods?
Substitute goods are in competitive demand. XED is positive, as the 2 variables 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. XED is negative complementary, as two variables of price and demand move in opposite directions. There is a negative gradient
What are unrelated goods?
Unrelated goods have an XED value of zero.
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 does a supply curve show
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.
What factors could cause a shift in the supply curve of a good
- improvements in technology
- a reduction in labour, capital and transport costs
- increase in government subsidies
- increase in number of firms in the industry
Why does the supply curve slope upwards from left to right?
Because as firms raise output in the short run, they face rising production costs and so pass these costs onto consumers by charging higher prices.
What causes a movement along a supply curve for a good
When there is a change in the goods price
Define price elasticity of supply (PES)
The responsiveness of a good or service to a change in its price
How to calculate PES
% change in supply of a good / % change in price of a good
What happens if PES is greater than 1
The good is relatively price elastic, the % change in supply is greater than the % change in price of the good
What happens if PES is less than 1
The good is relatively price inelastic, the % change in supply is less than % change in price of the good
What happens if PES is equal to 1
The good is unit elastic, the % change in supply is equal to % change in price of the good
What happens if PES is equal to 0
The good is perfectly inelastic, a change in price has no effect on the quantity supplied. The supply curve is vertical.
What happens if PES is infinite
The good is perfectly elastic. The supply curve is horizontal.
Determinants of price elasticity
- level of spare capacity, high level in firm means it can raise production quickly, so supply tends to be elastic.
- state of the economy, in a recession there are many unemployed resources and so high level of spare capacity.
- level of stocks of finished goods in a firm, high level of stock means firms can increase supply quickly, so supply is elastic.
- time period under consideration
How might price elasticity of supply for a good change over time (time period under consideration)
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 period of time in which 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.
What is equilibrium price?
The price where the quantity demanded equals the quantity the quantity supplied for a good or service in a market.
What is excess supply?
Where the quantity supplied exceeds the quantity demanded for a good at the current market price.
What is excess demand?
Where quantity demanded exceeds the quantity supply for a good at the current market price.
What is 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.
What are the functions of the price mechanism?
- a rationing device
- an incentive device
- a signalling device
Explain a rationing device
Resources are scarce, which means that 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 QD and QS
Explain an incentive device
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
Explain a signalling device
The price mechanism indicates changes in the conditions of demand or supply. Consequently, more or fewer resources are allocated to the production of a particular good or service
Define consumer surplus
The extra amount of money consumers are prepared to pay for a good or service above what they actually pay. It’s the utility or satisfaction gained from a good or service in excess of the amount paid for it.
Define producer surplus
The extra amount of money paid to producers above what they are willing to accept to supply a good or service. It’s the extra earnings obtained by a producer above the minimum required for them to supply the good or service
Explain the impact of an increase in demand on producer surplus and consumer surplus
Increase in demand for a good likely to raise producer surplus and consumer surplus
Explain the impact of a decrease in supply on consumer surplus and producer surplus.
Decrease in supply of good likely to reduce consumer surplus ad producer surplus
Define indirect tax
A tax imposed on goods or services supplied by businesses. Includes both specific and ad valorem taxes
what is a specific tax?
A specific tax is charged as a fixed amount per unit of a good. Causes a parallel shift vertically upwards and to the left.
What is an ad valorem tax?
Ad valorem tax is charged as a % of the price of a good. Causes a pivotal rotation of the supply curve to the left.
Define incidence of tax
The distribution of the tax paid between consumers and producers.
Define subsidy
A government grant to firms, which reduces production costs and encourages an increase in output
How does a unit subsidy affect the market pric and output for a good
A subsidy is often paid directly to producers, but as they respond by increasing output, the market price falls and indirectly passes on some gain to consumers. If demand is price inelastic, then the market price falls by a relatively large amount. If demand is price elastic, then market price falls by a relatively small amount.
Give 3 reasons why consumers may not maximise total utility
- influence of other people’s behaviour
- habitual behaviour, consumers prefer what they know and have, rather than risking something new where there’s more uncertainty
- consumer weakness at computation, many consumers have difficulty in calculating best buys
