micro 1.2 - how markets work Flashcards
demand
demand- the quantity of a good or service consumers are willing and able to buy at a given price in a given time period
law of demand:
- there’s an inverse relationship between price and quantity
- as price increases, quantity demanded decreases
contraction —> quantity demanded falls because of an increase in price
extension —> the quantity demanded rises due to an decrease in price
what causes demand to shift? (PIRATES)
- population —> greater population —> demand increases —> shifts right
- income —> for normal goods, if income increases, demand increases —> shifts right// for interior goods, if income increases, demand decreases —> shifts left
- related goods (substitutes and complements) —> substitutes —> a good that serves the same purpose as another good for consumers —> e.g. if price of adidas trainers go up then demand for nike trainers will increase // complements —> products which are bought and used together —> e.g. if price of printers go up, demand for printer ink will decrease
- advertising —> successful advertising —> demand increases —> shift right
- taste/fashion —> if something becomes more fashionable, demand increases and if it becomes less fashionable, demand decreases
- expectations —> expectations of what might happen in the future can have a big impact on the level of demand for some goods —> if people expect a shortage of something, or that price will rise in the future —> demand increases// if people expect that price will fall in the future, demand decreases
- seasons —> some products will find their demand affected by the weather
e.g. hot summers cause an increase in demand for sun cream whilst summers cause a decrease in demand for umbrellas
supply
supply- the quantity of a good or service that a producer is willing and able to produce at a given price in a given time period
law of supply:
- direct relationship between price and quantity
- as price increases, quantity increases
why is there a direct relationship between price and quantity?
- because businesses are profit maximisers, businesses are willing to supply more when the price is increased
contraction in supply —> quantity supplied falls because of a decrease in price
extension in supply —> quantity supplied rises due to an increase in price
what causes supply to shift? (PINTS WC)
- productivity —> productivity increases (being paid the same but they’re producing more in a given time period) —> cost of production decreases —> supply increases —> curve shifts right// productivity decreases —> cost of production increases —> supply decreases —> curve shifts left
- indirect tax —> if indirect tax has been implemented or increased —> COP increases —> supply decreases —> curve shifts left// if indirect tax has been taken away or reduced —> COP decreases —> supply increases —> curve shifts right
- number of firms —> more firms in the market —> more supply in the market —> curve shifts right//
firms leave market —> less supply in the market —> curve shifts left
- technology —> improvements in technology —> COP decreases —> supply increases —> curve shifts right//if technology gets worse —> COP increases —> supply decreases —> curve shifts left
- subsidy —> money grant given by the government to producers to lower costs of production and to encourage an increase in output —> if subsidy is given or increased —> COP decreases —> curve shifts right// if subsidy is taken away or decreased —> COP increases —> curve shifts left
- weather —> good weather will shift supply curve to right // bad weather will shift supply curve to left
- costs of production e.g. transport, labour, raw material —> any of these increase —> supply decreases —> curve shifts left// any of these decrease —> supply increases —> curve shifts right
PED
- PED —> responsiveness of demand to changes in price
- equation —> % change in quantity demanded/% change in price
- PED value is always negative due to the law of demand —> if prices increase (+) then quantity demanded will decrease (-) then we get a negative number// if prices decrease (-) then quantity demanded will increase (+) then we get a negative number
- elastic demand —> quantity demanded changes by a larger percentage than price so demand is relatively responsive to price
- inelastic demand —> quantity demanded changes by a smaller percentage than price so demand is relatively unresponsive to price
- unitary demand —> change in quantity demanded is exactly proportional to the change in price
- perfectly elastic —> a change in price means that quantity falls to 0 and demand is very responsive to price
- perfectly inelastic —> a change in price has no effect on quantity demanded so demand is completely unresponsive to price
coefficients:
- elastic > 1
- inelastic < 1
- unitary = 1
- perfectly inelastic =0
- perfectly elastic = infinity
diagram:
elastic:
- shallow demand curve
inelastic:
- steep demand curve
perfectly elastic:
- horizontal line
perfectly inelastic:
- vertical line
determinants of PED (SPLAT)
- substitutes —> high number of substitutes —> elastic demand// low number of substitutes —> inelastic demand
- proportion of income spent on the goods —> larger proportion spent —> elastic demand// smaller proportion spent —> inelastic demand
- luxury or necessity —> luxury —> elastic demand// necessity —> inelastic demand
- addictive nature —> addictive —> inelastic
- time frame —> small time frame —> inelastic// large time frame —> elastic
PED and revenue:
EOIS (elastic only irritates skin)
elastic opposite, inelastic same
elastic:
- price increases —> total revenue decreases (increase in price —> quantity demanded falls significantly)
- price decreases —> total revenue increases (decrease in price —> quantity demanded increases significantly)
inelastic:
- price increases —> total revenue increases (increase in price —> quantity demanded only changes by a little)
- price decreases —> total revenue decreases (decrease in price —> quantity demanded only changes by a little)
unitary:
- a change in price does not affect total revenue
diagram PED and revenue:
elastic:
- shallow demand curve
- prices decrease —> quantity demanded increases proportionately more than the decrease in price
- initial revenue is P1aQ10, new revenue is P2bQ20
inelastic:
- steep demand curve
- initial revenue is P1aQ10, new revenue P2bQ20
significance of PED:
- pricing decisions —> if demand is price elastic then firms should decrease price to increase total revenue// if demand is price inelastic then firms should increase price to increase total revenue
- employment, stocks, output —> if a firm knows that demand for their product is price elastic and price is going to decrease then they need to be prepared for an increase in quantity —> they need increase employment, stocks and output
- helps government decide how much tax to place on items —> if a product has inelastic demand, tax will increase and more revenue will be generated for the government
YED
- YED —> responsiveness of demand to change in income
- equation: % change in quantity demanded/% change in income
coefficients:
- YED < 0 —> inferior good —> a rise in income will lead to a fall in demand for the good
- 0 to 1 —> normal good —> a rise in income will lead to a rise in demand for the good
- YED > 1 —> luxury good
significance of YED:
- employment, stocks, output —> if you’re producing an inferior good and you forecast a recession coming then you may increase employment, stocks, output —> this is because demand increases// if you’re producing a normal good and you forecast a boom coming then you may increase employment, stocks, output
- pricing decisions —> in a boom, firms might increase the price of a normal good as they expect demand to increase
- important for businesses to know how their sales will be affected by changes in the income of the population —> may impact the type of goods that a firm produces e.g. in a boom, firms might produce more normal and luxury goods where in a recession, firms might produce more inferior goods
XED?
- XED —> responsiveness of demand of good A to a change in price of good B
- equation: % in quantity demanded for A/% change in price for B
coefficients:
substitutes:
- an increase in the price of good B will increase demand for good A
- weak substitute —> 0 to 1
- strong substitute —> 1 to infinity
complementary goods:
- an increase in the price of good B will decrease demand for good A
- weak complements 0 to -1
- strong complements -1 to infinity
unrelated goods:
- XED = 0 —> a change in the price of good B has no impact on good A
significance of XED:
- pricing decisions —> if businesses make strong complements (figure this out through XED figure), they can reduce the price of the first good and increase the price of the second good e.g. reduce price of printers and increase price of ink// reduce price of coffee machine and increase price of capsules
- if goods are close substitutes then businesses might cut prices to get ahead of rivals
- employment, stocks, output —> substitutes: if you decrease prices but the other firm doesn’t —> firms has to be prepared to increase employment, stocks and output// if rival decreases price and you don’t then you have to be prepared to decrease in employment, stock and output
PES and equation?
- PES —> responsiveness of supply to changes in price
- equation: % change in quantity supply/% change in price
price increases —> suppliers will want to supply more but this will depend on the PES:
- elastic —> cheap, easy and quick to increase supply
- inelastic —> expensive, difficult and takes a long time to increase supply
coefficients:
- PES is always positive
- PES value is always positive due to the law of supply —> if prices increase (+) then quantity supplied will increase (+) then we get a negative number// if prices decrease (-) then quantity supplied will decrease (-) then we get a positive number
- elastic supply —> quantity supplied changes by a larger percentage than price so supply is relatively responsive to price
- inelastic supply —> quantity supplied changes by a smaller percentage than price so supply is relatively unresponsive to price
- unitary supply —> change in quantity supplied is exactly proportional to the change in price
- perfectly elastic —> a change in price means that quantity supplied falls to 0 and supply is very responsive to price
- perfectly inelastic —> a change in price has no effect on output so demand is completely unresponsive to price
coefficients:
- elastic > 1
- inelastic < 1
- unitary = 1
- perfectly elastic = infinity
- perfectly inelastic = 0
diagram:
elastic:
- shallow supply curve
inelastic:
- steep supply curve
perfectly elastic:
- horizontal line
perfectly inelastic:
- vertical line
determinants of PES:
- spare capacity —> more spare capacity —> elastic supply
- substitute factors of production —> more substitutes —> elastic supply// less substitutes —> inelastic supply
- stock —> stock available —> elastic supply//stock not available —> inelastic supply
- time frame —> quick to make —> elastic supply// slow to make —> inelastic supply
underlying assumptions of rational economic decision making?
- Consumers aim to maximise utility: Utility is the satisfaction gained from consuming a product
- Firms aim to maximise profit
- Governments aim to maximise social welfare
law of diminishing marginal utility?
law of diminishing marginal utility —> satisfaction derived from the consumption of an additional unit of a good will decrease as more of a good is consumed (assuming the consumption of all other goods remains constant)
how does the law of diminishing marginal utility explain why the demand curve slopes downwards?
- as more of a good is consumed, there is less satisfaction derived from the good —> consumers are less willing to pay high prices at high quantities since they are gaining less satisfaction
total utility —> satisfaction gained by a consumer as a result of their overall consumption of a good e.g. the satisfaction of eating the whole bar of chocolate
marginal utility —> measures the change in satisfaction from consuming one additional unit
excess supply and excess demand?
excess supply:
price is set higher than the equilibrium —> suppliers are willing to supply QS but consumers only demand QD —> excess supply
diagram:
- normal demand and supply diagram —> label equilibrium P1Q1
- draw price above the equilibrium —> label QS and QD
- difference between QD and QS = excess supply
how does excess supply return back to equilibrium?
excess supply —> prices decrease (sales) —> demand extends and supply contracts —> equilibrium
excess demand:
price is set below equilibrium —> suppliers are willing to supply QS but consumers demand QD —> excess demand
diagram:
- normal demand and supply diagram —> label equilibrium P1Q1
- draw price below the equilibrium —> label QS and QD
- difference between QS and QD = excess demand
how does excess demand return back to equilibrium?
excess demand —> firms charge higher prices —> demand contracts and supply extends —> equilibrium
what is the price mechanism?
price mechanism - prices are determined by the forces of supply and demand, without government intervention —> this is what adam smith meant by the invisible hand
price mechanism functions? (ARSI)
-allocating function
-signalling function
-incentive function
-rationing function
excess demand sends a signal that price is too low —> this incentivises suppliers to increase prices —> high prices ration resources by discouraging consumption —> contraction of demand —> leads to a better allocation of resources
excess supply sends a signal that price is too high —> this incentivises suppliers to decrease prices —> low prices ration resources by encouraging consumption —> extension of demand —> leads to a better allocation of resources
consumer surplus and producer surplus?
consumer surplus —> difference between the price the consumer is willing to pay and the price they actually pay (shows the satisfaction gained by consumers)
CS diagram:
- above price and below demand curve
producer surplus —> difference between the price the supplier is willing to produce their product at and the price they actually receive (shows the economic gain for producers)
PS diagram:
- below price and above the supply curve
society surplus = CS + PS
indirect and direct taxes
direct tax —> paid directly by the individual or business to the government e.g. income tax, national insurance, corporation tax
indirect tax —> tax on expenditure where the person who is charged the tax is not the person responsible for paying the sum to the government
why are indirect taxes used?
- raise government revenue
- solve market failure —> to reduce consumption/production of demerit goods
2 types of indirect tax?
- specific tax —> a fixed amount of tax placed on a particular good (tax per unit)
- ad valorem tax —> tax as a % of the price e.g. VAT
specific tax diagram:
- cost of production increases for firms —> causes supply curve to shift upwards from S1 to S1+tax
- vertical distance between the curves represent the size of the tax
ad valorem diagram:
- cost of production increases for firms —> causes supply curve to shift upwards from S1 to S1+tax
- gap between S1 and S1+tax grows —> when the price is small, the tax will only be a small amount but when the price is high, the tax will be a large amount
- vertical distance between the curves represent the size of the tax
consumer burden/incidence —> tax falling on the consumer
- difference in price part of the box = consumer burden
- draw down from new equilibrium to the old supply curve —> then draw dashed line from supply curve to price
- whatever is left is the producer burden
producer burden/incidence —> tax falling on the producer
- below consumer burden
indirect tax PED:
price elastic demand:
- consumer burden: lower
- producer burden: higher
- government revenue: fall in quantity is proportionately greater than the increase in price —> government revenue decreases
price inelastic demand:
- consumer burden: higher
- producer burden: lower
- government revenue: fall in quantity is proportionately smaller than the increase in price —> government revenue increases
perfectly elastic demand:
- consumer burden: none
- producer burden: entire burden
- government revenue: lowest
perfectly inelastic demand:
- consumer burden: entire burden
- producer burden: none
- government revenue: highest
indirect tax PES:
elastic supply:
- consumer burden: higher
- producer burden: lower
perfectly elastic supply:
- consumer burden: entire burden
- producer burden: none
inelastic supply:
- consumer burden: lower
- producer burden: higher
perfect inelastic supply:
- consumer burden: none
- producer burden: entire burden
consumer behaviour —> reasons why consumers behave irrationally?
- Consumers do not always act rationally —> not maximising utility
- The influence of other people’s behaviour
- The behaviour of other people affects how the consumer acts —> shows us that consumers are not acting rationally
- For example, if there are 2 restaurants and 1 is empty whilst the other has a long queue. Consumers are more likely to queue for their food than go straight into the other restaurant
- The importance of habitual behaviour
- Habits limit/prevent consumers considering an alternative —> continue to commit the irrational action
- Could be due to inertia (can’t be bothered)
- For example, a commuter who is familiar with one route to work is unlikely to consider an alternative route because they would have to re-familiarise themselves with it// it is hard for consumers to give up smoking even though they know smoking is bad for them because they are habituated to it
- Consumer weakness at computation
- The law of diminishing marginal utility suggests that every extra unit consumed provides a smaller benefit to the consumer. Consumers may consume past the optimal benefit point because of their weakness in identifying optimal benefit or self control
- Many consumers aren’t willing or able to make comparisons between prices and so they will buy more expensive goods than needed. For example many customers buy multipack goods because they assume they are cheaper but this is not always the case
- Consumers will make decisions without looking at the long term effects —> so they will make irrational decisions
