theme 1- 1.2 how markets work

Question 1

rational decision making

Answer 1

an assumption that consumers act rationally by aiming to maximise their utility and producers act rationally by aiming to maximise profit

Question 2

demand

Answer 2

amount demanded by consumers at given prices over a certain period of time- must include ability to pay for the product/service

the demand curve is downward sloping from left to right, indicating more is demanded as price falls

Question 3

substitution effect

Answer 3

when there is a rise in price, the consumer tends to buy more of a relatively lower priced good than a higher one- move to a substitute if price rises, decreasing demand

Question 4

income effect

Answer 4

rise in price -> fall in real income (purchasing power decreases), for normal goods, will lead to a fall in demand

Question 5

movements along the demand curve

Answer 5

caused by price changes, decrease increases demand + vice versa

Question 6

reasons for shifts in the demand curve

Answer 6

• real incomes (if increased, increases demand for most goods + services -> shift to the right)
• size/age distribution of the population (bigger = more demand)
• tastes, fashions and preferences
• prices of substitutes and complements
• amount of advertising or promotion
• interest rates (cost of borrowing money, higher = decreased demand)

Question 7

diminishing marginal utility

Answer 7

based on the idea that consumers gain satisfaction/utility from the goods they consume
states that as a person consumes each unit of a product, the marginal utility (extra utility) falls- inverse relationship between price and quantity demanded

Question 8

price elasticity of demand (PED)

Answer 8

measure of the responsiveness of quantity demanded when price changes
= % change in quantity demanded /
% change in price
inelastic = change in price has no effect on quantity demanded
elastic = change in price will have large effect on quantity demanded
unitary = each change in price will have the same change in demand

Question 9

PED values

Answer 9

will always be -ve as price and quantity move in opposite directions
between 0 (inelastic) and -1 (elastic)

Question 10

PED as a demand curve

Answer 10

inelastic- more vertical
elastic- more horizontal
unitary- c curve

Question 11

factors influencing PED

Answer 11

• availability of substitutes (more = more elastic)
• proportion of income spent on a product (low = inelastic)
• nature of product e.g. addictive = inelastic
• durability = more elastic as possible to postpone purchases
• length of time under consideration

Question 12

relationship between PED and total revenue

Answer 12

when demand = inelastic, price changes cause total revenue to change in the same direction + vice versa
when demand = unit elastic, price changes cause total revenue to remain unchanged
when demand = perfectly elastic, price changes cause total revenue to fall to 0
when demand = perfectly inelastic price changes cause total revenue to change in the same direction by the same proportion

Question 13

significance of PED

Answer 13

to firms:
- if they know that demand for their product is inelastic then they can increase TR by increasing price + vice versa
to consumers:
- if firms raise prices of inelastic goods that means a decrease in real income
to the government:
- to max tax revenue, put indirect taxes on inelastic products, BUT the consumer bears most of the tax burden

Question 14

cross elasticity of demand (XED)

Answer 14

measure of the responsiveness of quantity demanded of one product (Y) to a change in the price of another product (X)
= % change in quantity demanded of Y /
% change in price of X
if +ve, the products are substitutes
if -ve, the products are complements

Question 15

significance of XED to firms

Answer 15

• helpful for setting prices
• know that complementary goods can command higher prices e.g. printers are relatively cheap but ink cards are relatively expensive

Question 16

income elasticity of demand (YED)

Answer 16

measures the responsiveness of quantity demanded of a product to a change in real income
= % change in quantity demanded /
% change in real income
if +ve, the product is income elastic, a normal good
if between 0 and +1, the product is income inelastic
if -ve, the product is an inferior good

Question 17

normal goods on a graph

Answer 17

positive relationship between income and demand so looks like /
= because demand increases with income

Question 18

inferior goods on a graph

Answer 18

negative relationship between income and demand so looks like \
= as demand falls with income

Question 19

significance of YED

Answer 19

for firms:
- if know demand is income elastic then they know it will fall in a recession + vice versa
- important when making investment decisions
for the government:
- max tax revenue = indirect tax products that are income elastic
- may help when estimating tax revenues from indirect taxes

Question 20

supply

Answer 20

refers to the amount supplied by producers at given prices over a certain period of time

Question 21

shape of the supply curve

Answer 21

upward sloping: /
indicates that more will be supplied as price increases as it is more profitable for the producer

Question 22

movements along the supply curve

Answer 22

caused by price changes
rise in price = more supply

Question 23

factors that shift the supply curve

Answer 23

• costs of production (high = shift left)
• productivity (high = shift right)
• indirect taxes (shift left)
• subsidies (shift right)
• new inventions and tech (lead to shift right)
• discoveries of new reserves of a raw material (shift right)

Question 24

price elasticity of supply (PES)

Answer 24

measure of the responsiveness of quantity supplied for a product to a change in its price
= % change in quantity supplied /
% change in price
= always +ve as price and quantity move in the same direction (as it’s upward sloping)

Question 25

values of PES

Answer 25

if between 0 and +1, is price inelastic- as change in price has led to a smaller % change in quantity supplied
if = 1, is unitary elastic
if 1+, is price elastic

Question 26

PES on a graph

Answer 26

perfectly inelastic = |
perfectly elastic = -
unitary elastic= / drawn through the origin

Question 27

factors influencing PES

Answer 27

• time: short run = inelastic, long run = elastic
• availability of stock = relatively elastic
• spare capacity = elastic
• availability and cost of switching resources from one use to another- if expensive = inelastic

Question 28

equilibrium price

Answer 28

determined by the interaction between supply and demand
happens where quantity supplied = quantity demanded
on a graph- the point where the S+D curves meet in an x

Question 29

excess supply

Answer 29

occurs when price is above the equilibrium price
implies that the quantity supplied is greater than the quantity demanded at the existing price
market forces will cause the price to fall to the equilibrium, eliminating excess supply

Question 30

excess demand

Answer 30

occurs when price is below the equilibrium price
implies that the quantity demanded is greater than the quantity supplied at the existing price
market forces will cause the price to rise to the equilibrium, eliminating excess demand

Question 31

changes in the equilibrium price

Answer 31

caused by:
- a change in the conditions of demand (a shift in demand)
- a change in the conditions of supply (a shift in supply)

Question 32

key functions of the price mechanism

Answer 32

key functions:
- as a rationing device- ensures amount demanded = amount supplied
- as an incentive- e.g. profit = incentive to supply
- as a signalling device- so producers know to increase/decrease supply
- to determine changes in wages- change in demand is reflected in a change in price
BUT does not mean prices are stable- any changes in the condition of supply and demand changes equilibrium price

Question 33

market definition

Answer 33

all the buyers and sellers of a product or service involved in making exchanges with each other and who help determine its price
can be local, national or global

Question 34

consumer surplus

Answer 34

the difference between what a person is willing to pay and how much they actually pay
on a graph it is the triangle beneath the demand curve and above the equilibrium price

Question 35

factors affecting consumer surplus

Answer 35

• gradient of the demand curve- steeper = greater surplus
• changes in the conditions for demand- e.g. an increase in demand = increase surplus

Question 36

producer surplus

Answer 36

the difference between the price the producer receives and the cost of supply
on a graph it is the area between the supply curve and the market price

Question 37

factors affecting producer surplus

Answer 37

• gradient of the supply curve- steeper = greater surplus
• changes in the conditions of supply- increase in supply = increase in surplus

Question 38

indirect taxes

Answer 38

taxes on expenditure
e.g. VAT, excise taxes, taxes on gambling
causes an increase in the cost of supply- shift to the left

Question 39

types of indirect tax- ad valorem

Answer 39

a % of the price of a product or service and so cause the supply curve to shift to the left and become steeper
e.g. VAT

Question 40

types of indirect tax- specific

Answer 40

or flat rate tax
a set amount of tax on each unit consumed
the effect of a specific tax is to cause the supply curve to shift to the left, parallel to the original curve

Question 41

subsidies

Answer 41

a grant from the government
reduces cost of production
cause a shift to the right for supply
for consumers to benefit most, demand would have to be inelastic
on a graph, the total cost of the subsidy is the rectangle area between the new price and the excess supply? of the old price

Question 42

why is rationality unrealistic?

Answer 42

the assumption that consumers are rational may be unrealistic as people are subject to a range of motives and influences

Question 43

behavioural economics

Answer 43

applies psychological insights into human behaviour to explain economic decision making

Question 44

reasons why consumers may not behave rationally

Answer 44

• influence of others’ behaviour
• importance of habitual behaviour
• inertia- i.e. loss aversion
• info overload
• complex information
• too much choice
• consumer weakness at computation- e.g. pay more attention to recent events, find it difficult to calculate probability, and are influenced by how the item is presented

Question 45

implications of behavioural economics

Answer 45

means that standard mathematical analysis based on the neoclassical rationality assumption is not accurate
means policymakers have to put a bigger emphasis on psychology of behaviour