theme 1- 1.2 how markets work Flashcards
rational decision making
an assumption that consumers act rationally by aiming to maximise their utility and producers act rationally by aiming to maximise profit
demand
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
substitution effect
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
income effect
rise in price -> fall in real income (purchasing power decreases), for normal goods, will lead to a fall in demand
movements along the demand curve
caused by price changes, decrease increases demand + vice versa
reasons for shifts in the demand curve
- 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)
diminishing marginal utility
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
price elasticity of demand (PED)
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
PED values
will always be -ve as price and quantity move in opposite directions
between 0 (inelastic) and -1 (elastic)
PED as a demand curve
inelastic- more vertical
elastic- more horizontal
unitary- c curve
factors influencing PED
- 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
relationship between PED and total revenue
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
significance of PED
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
cross elasticity of demand (XED)
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
significance of XED to firms
- helpful for setting prices
- know that complementary goods can command higher prices e.g. printers are relatively cheap but ink cards are relatively expensive
income elasticity of demand (YED)
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
normal goods on a graph
positive relationship between income and demand so looks like /
= because demand increases with income
inferior goods on a graph
negative relationship between income and demand so looks like \
= as demand falls with income
significance of YED
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
supply
refers to the amount supplied by producers at given prices over a certain period of time
shape of the supply curve
upward sloping: /
indicates that more will be supplied as price increases as it is more profitable for the producer
movements along the supply curve
caused by price changes
rise in price = more supply
factors that shift the supply curve
- 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)
price elasticity of supply (PES)
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)
