microeconomics 1.2 - 1.2.3 Flashcards
Reasons why rational decision making doesn’t always apply
- Have limited capacity to calculate all costs and benefits of a decision
- Are influenced by their social networks
- Lack self control and seek immediate satisfaction
- Could make emotional choices in cold and emotional states
- Often fall back on simple rules of thumb when choosing
- Satisfy rather than maximise
- Have a strong default to maintain the status quo
Definition of demand
Demand for a good or service is the quantity that consumers are willing and able to buy at a given price in a given period of time
Definition of effective demand
Only if demand for a product is backed up by willingness and ability to pay the market price does demand become effective or actual
What is the basic law of demand
The basic law of demand is that demand varies inversely with price - the lower the price of a good, the higher the quantity demanded and vice versa, ceteris paribus
Rules for drawing a demand curve
- label the y axis price and the x axis quantity
- draw demand curve downward sloping from left to right and label (d)
- draw dotted line from given price (p) to quantity (q)
What causes movement along the demand curve
Only changes in price causes movement along the demand curve
A higher price leads to a contraction of quantity demanded
A lower price leads to an expansion of quantity demanded
Shows change in quantity demanded
What causes a shift in the demand curve
A shift is caused by non price factors
Shows a change in demand
Definition of derived demand
Derived demand is the demand for a good or service that is used to produce another good or service
The demand is not for the good/service itself but for its ability to produce another good or service
Examples of goods or services in derived demand
- The demand of steel is derived to make cars
- The demand for minerals are derived to make components for electric products
Definition of joint/ complementary demand
- Joint or complementary demand is when the demand for one product is directly and positively related to market demand for a related good or service
- The demand is for two or more goods and services which are demanded together
Examples of things in complementary demands
- Petrol and cars
- Smartphones and apps
Definition of composite demands
Composite demands is where the demand for a good or service is for goods that have more than one use
- The demand is for a good or service to produce more than one type of product
Examples of things in composite demands
- Milk which can be used for cheese, yoghurt, butter, cream
- Land which can be used for farming, recreation or development
What are the determinants for demands in a market
- The type of good
- Consumer incomes
- Seasonal factors
- Consumer fashion and tastes
How does consumer income affect demand
As the income of consumers increases, demand for normal goods will increase
This is shown by a shift to the right of the demand curve
How do seasonal factors affect demand
Consumer increase and decrease their demand for certain goods depending on the season eg. demand for plants at garden centres is linked to planting seasons
How do consumer tastes and fashion affect demand
- People’s tastes change over time and demand for fashionable products changes regularly, often manipulating by advertising
- As some products become more fashionable there is an increase in demand
What other factors affect demand
- Population changes
- Advertising
- The level of competition in the market
- Interest rates and demand
- Social and emotional factors
Describe the income effect
- A fall in price increases the real purchasing power of consumers
- Allows people to buy more with a given budget
- For normal goods demand rises with an increase in real income
Define the substitution effect
- A fall in the price of goods makes it relatively cheaper compared to substitutes
- Some consumers will switch to good leading to higher demand
- Much depends on whether products are age substitutes
What is the concept of utility
Utility is a measure of the satisfaction that we get from purchasing and consuming a good or service
What is total utility
The total satisfaction from a given level of consumption
What is marginal utility
- The change in satisfaction from consuming an extra or additional unit
- Standard economic theory believes the idea of diminishing returns i.e the marginal utility of extra units declined as more is consumed
How does diminishing marginal utility explain the downward sloping demand
- The law of diminishing marginal utility is a law of economics that states that as your consumption increases the satisfaction you derive from each individual unit decreases
- If marginal utility is falling then consumers will only be prepared to pay a lower price
What is price elasticity of demand?
Price elasticity of demand (PED) measures the responsiveness of demand after a change in the goods own price
Basic formula for calculating demand
percentage change in demand over
percentage change in price
When does perfect inelasticity take place and what does this mean
When PED=0
A change in price will not have any effect on demand
When does price inelasticity take place
When PED < 1
The percentage change in demand is less than the percentage change in price
When does unitary price elasticity take place
PED = 1
The percentage change in Demand is same as the percentage change in price
When does price elasticity take place
When PED > 1
The percentage change in Demand is greater than the percentage change in price
When does perfect price elasticity take place
When PED is infinite
An increase in price will lead to demand falling to zero
Factors that determine the PED of a product
- Number of close products available - The more close substitutes there are the more price elastic the demand
- Price of the production in relation to total income - when the % of budget is high, demand is usually more price sensitive
- Cost of substituting between different products - When substitution costs are high, demand will tend to be price inelastic
Brand loyalty and habitual consumption - High levels of brand loyalty makes demand price inelastic - Degree of necessity/ luxury - standard assumption is that necessities have a lower price elasticity whereas luxuries are an optional spend
How does the coefficient of the PED reflect the revenue of the producer
If the coefficient of PED is <1, a rise in market price will lead to an increase in total revenue for the seller of the product. If the coefficient is >1 then the supplier will get greater revenue if they reduce their prices
What is income elasticity of demand
Income elasticity of demand (YED) shows how responsive the demand for a product is to a change in real income
Formula for calculating income elasticity of demand
% change in quantity demanded
% change in real income
What does the income elasticity coefficient of demand mean
Normal goods - They have a positive income elasticity - Luxury goods are where the income elasticity is >1, and necessities are where income elasticity is >0 and <1
Inferior products - have negative income elasticity, they are counter cyclical goods - products whose demand varies inversely to the macroeconomic cycle
What is cross price elasticity of demand
Cross price elasticity (XED) measures responsiveness of demand for good X following a change in the price of a related good Y
Formula for calculating cross price elasticity
% Change in quantity demanded of good X
% Change in the price of good Y
What are substitute goods
- Products in competitive demand
- An increase in the price of one good leads to an increase in demand of another ceteris paribus
- The value of XED for two substitutes is always positive
What are complementary goods
- Complements are products in joint demand
- A fall in the price of one product causes an increase in demand for the complementary product
- The value of XED for two complements is always negative
What are close substitutes in terms of XED
- Have a strongly positive cross price elasticity of demand - small changes in a relative price causes a big switch in consumer demand of a rival products
What are strong complements in terms of XED
- When there is a strong complementary relationship, the cross elasticity will be highly negative
What are unrelated products in terms of XED
- Unrelated products have zero cross elasticity
Uses of price elasticity of demand for producers
- Firms can use PED estimates to predict
- The price volatility in a market following changes in supply - this is important for commodity producers who suffer big price and revenue shifts from one time period to another
What is price discrimination
This is where a supplier decides to charge different prices for the same product to different segments of the market
How is total revenue effected by changes in price of goods in elastic demand
A price increase would decrease total revenue
A price decrease would increase total revenue
How is total revenue effected by changes in price of goods in inelastic demand
A price increase would increase total revenue
A price decrease would increase total revenue
How is total revenue effected by changes in price of goods in unit elastic demand
A price increase / decrease doesn’t change the total revenue
Limitations in calculating elasticity
- Problems with inaccurate or incomplete data collection
- Consumer price sensitivity changes over time
- Elasticity over demand varies by region / time
- Not all businesses are profit maximisers
- Elasticity will vary within product range
- Rival producers will change their market strategies from time to time
