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
movements along demand curve:
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
shifts of entire demand curve (PIRATES):
- population - greater population - demand increases
- income - for normal goods, if income increases, demand increases// for interior goods, if income increases, demand decreases
- 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
- taste/fashion - if something becomes more fashionable, demand increases
- 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
movements along supply curve:
law of supply:
- direct relationship between price and quantity
- as price increases, quantity increases - 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
shifts of entire supply curve (PINTS WC):
- productivity - productivity increases - COP decreases - supply increases (vice versa)
- indirect tax - if indirect tax has been implemented or increased - COP increases - supply decreases (vice versa)
- number of firms - more firms in the market - supply increases (vice versa)
- technology - improvements in technology - COP decreases - supply increases (vice versa)
- subsidy - if subsidy is given or increased - COP decreases - supply increases (vice versa)
- weather - good weather will increase supply//bad weather will decrease supply
- costs of production e.g. transport, labour, raw material - COP increases - supply decreases (vice versa)
PED
- PED - responsiveness of demand to changes in price
- equation - % change in quantity demanded/% change in price
- PED value is always negative
definitions:
- 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 (vice versa)
- proportion of income spent on the goods - larger proportion spent - elastic demand (vice versa)
- luxury or necessity - luxury - elastic demand (vice versa)
- addictive nature - addictive - inelastic
- time frame - small time frame - inelastic (vice versa)
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 ___, new revenue is ___
inelastic:
- steep demand curve
- initial revenue is ___, new revenue is ___
significance of PED:
- pricing decisions - if demand is price elastic then firms should decrease price to increase total revenue (vice versa)
- 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:
- helps firms maximise profits through periods of recession or economic growth - firms should produce more inferior goods during a recession//firms should produce more normal and luxury goods during periods of economic growth
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:
- helps firms maximise profits - if firms make strong complements, they can reduce the price of the first good and increase the price of the second good e.g. reduce price of coffee machine and increase price of capsules
PES
- PES - responsiveness of supply to changes in price
- equation - % change in quantity supply/% change in prices
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
definitions:
- 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:
- PES is always positive
- 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 (vice versa)
- substitute factors of production - more substitutes - elastic supply (vice versa)
- stock - stock available - elastic supply (vice versa)
- time frame - in the SR, producers may find it harder to respond to an increase in prices as it takes time to produce the product//in the LR, producers can increase FOP and produce more
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 - ceteris paribus)
- 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
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
price determination, excess supply and excess demand
price determination:
- in a free market economy, prices are determined by the forces of demand and supply
- equilibrium is when demand = supply
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
- 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
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
- 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
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 (SIR):
- 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
- 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
price mechanism in a local market:
price mechanism in a national market:
price mechanism in a global market:
consumer surplus and producer surplus
- consumer surplus - difference between the price the consumer is willing to pay and the price they actually pay
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
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 e.g. VAT
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:
- COP increases for firms - supply curve to shift upwards from S1 to S1+tax
- vertical distance between the curves represent the size of the tax
ad valorem diagram:
- COP increases for firms - 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
government revenue:
- vertical distance between 2 supply curves x quantity
producer revenue:
- decreases (econplusdal vid)
consumer burden/incidence:
- tax falling on the consumer
- difference in price part of the box = consumer burden
producer burden/incidence:
- tax falling on the producer
DWL:
- triangle
indirect tax PED:
price elastic demand:
- consumer burden: lower
- producer burden: higher
price inelastic demand:
- consumer burden: higher
- producer burden: lower
perfectly elastic demand:
- consumer burden: none
- producer burden: entire burden
perfectly inelastic demand:
- consumer burden: entire burden
- producer burden: none
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 might not behave rationally:
the influence of other people’s behaviour:
- the behaviour of other people affects how the consumer acts e.g. if there are 2 restaurants and 1 is empty whilst the other has a long queue - consumers are more likely to go to the restaurant with a long queue - this is called herd behaviour
the importance of habitual behaviour:
- consumer inertia - can’t be bothered to switch to another alternative
- rule of thumb - mental shortcuts that people use to make decisions quickly e.g. more expensive = better quality
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
- many consumers aren’t willing or able to make comparisons between prices and so they will buy more expensive goods than needed
