THEME 1, How markets work (1.2) Flashcards
What is on the X and Y axis of the demand and supply model?
- X-axis - Quantity
- Y-axis - Price
What assumptions are made on the supply and demand model?
- Everything remains the same other than the price of the good or service
- Economic agents are rational
What happens to Demand when price moves up along the supply and demand curve?
Contraction in Demand
What happens to Demand when price moves down along the supply and demand curve?
Extension in Demand
What is meant by rational in ECONS?
- Super-smart (can handle any amount of information)
- Well-defined preferences
- Only self-interested
- Utility maximisers
What is utility?
A measure of benefit from consumption
What does bounded self control mean?
- There are limits to the extent individuals can commit to a choice that would be in their best interest
What is the IKEA effect and what is this an example of?
- IKEA customers are loyal to their self-assembled furniture because there is a piece of them in it
- Shows that people are not rational
What is a heuristic?
- A method or technique people use to help them make a decision or solve a problem quicker
What is availability bias?
- Availability bias is a heuristic whereby people make judgments about the likelihood of an event based on how easily an example, comes to mind.
What can availability bias lead to?
- Availability bias can lead to people over-estimating the likelihood of an event happening
- Can lead to a departure from rational decision-making.
When are people more likely to make irrational decisions?
- Infrequent circumstance decisions (e.g. COVID)
- Complex information
- Unfamiliar situations
- When information is lacking
- Time limited
- E.g. choosing a Pension
Who are more likely to be rational?
- People living in relative poverty as they have to be able to save money
Who are more likely to be irrational?
- Young people
- Less life experience
What could be difficult about basing policy decisions on irrational behaviour?
- Behavioural economics focuses on predictable irrationality
- Uncertainty
- Could encourage people to act more irrationally
Why do traditional economies assume that economic agents are rational?
- Often people are more rational than not
- Simplify the issue they are studying
- Will deliver clearer answers
- Ceteris paribus
What is traditional supply and demand analysis based on?
Based on decisions taken at the margin
What is the Law of Diminishing marginal utility?
- Marginal utility gained from consuming an additional marginal item is less than the previous one
- The added benefit of consuming more of a product or service declines as its consumption increases
What is a speculative good?
- Goods which values increase whilst you are holding it
- This has a demand curve that slopes up
- E.g. stocks, bonds, commodity futures, cryptocurrency, fine art
What is marginal utility?
The additional welfare or benefit gained from consuming an additional unit of goods or services.
What is meant by effective demand?
- Desire for a good backed by an ability to pay
Explain what is meant by derived demand.
- When demand for a good or service is not for it’s own utility but for what it can produce
Why would demand increase?
- Effective advertising
- Increase in the price of a substitute
- Decreasing price of complement
- Increase in population
- Income
What are normal goods?
- A normal good is a good that experiences an increase in demand due to an increase in a consumer’s income
What are inferior goods?
- Inferior goods are those goods the demand for which falls with increase in income of the consumer
- Inverse relationship
- E.g. taking a public bus instead of cars
What decisions are supply and demand curves based on?
- Demand and supply curves are based on decisions at the margin
What type of decisions do economic agents make in behavioural economics?
- Irrational decisions
- Behavioral economics challenges the assumption of rational decision-making, highlighting how emotions can influence choices.
How does the market mechanism allocate resources?
- Markets use prices as signals to allocate resources to their highest valued uses
- Not through administrative choices
What type of decisions do economic agents make in traditional economics?
- Rational decisions
What does the diagram look like when price is perfectly inelastic?
- Vertical
What does the diagram look like when price is perfectly elastic?
- Horizontal
What is the PED, when the diagram is vertical?
- PED=0
- Perfectly inelastic
What is the PED, when the diagram is horizontal?
- PED=infinity
- Perfectly elastic
How is PED (Price elasticity of demand) calculated?
- %∆ Quantity demand
- Divided by
- %∆ Price
When PED > 1, what is the elasticity of price?
- Price elastic
What does it mean when a price is elastic?
- A price change for a product causes a substantial change in either its supply or its demand
What does it mean when price is inelastic?
- The price does not change dramatically, even if supply or demand go up or down
What are the determinants in PED?
- Number of substitutes
- Width of market
- Time
- Percentage of income
- Necessity
How does the width of a market affect PED?
- Wider market = Lower PED
How does time affect PED?
- PED will always get more elastic over time
How does percentage of income spent affect PED?
- The higher % of income, the more elastic a price is.
How does necessity affect PED?
- Necessities will be more price inelastic
- e.g… people will always buy addictive substances even if price increases dramatically.
EXAMPLE
Would petrol, fuels and energy have a low or high PED?
- Low PED as they’re necessary
What is revenue?
- Money gained from selling goods and services
How is revenue calculated?
- Revenue = Price X Quantity
What happens to revenue when demand is inelastic?
- If demand is inelastic, an increase in price leads to a larger increase in total revenue
What happens to revenue when PED>1?
- A fall in price
- Increases revenue
When PED<1 what happens to revenue?
- A fall in price
- Decreases revenue
What happens to revenue when PED=1?
- A change in price has no impact on revenue
Does PED vary along the curve?
- Yes
What is at the top of a demand curve? (Inelastic or Elastic price?)
- Price Elastic
What is at the bottom of a demand curve? (Inelastic or Elastic price?)
- Price inelastic
At what value of PED is there unitary elasticity?
- When PED = -1
What is XED?
- Cross Price Elasticity of demand.
- The responsiveness of demand for one product to a change in the price of another product
How is XED calculated?
- %∆ Quantity of Good A
- Divided by…
- %∆ Price of Good B
If values of XED are positive…
- Goods are substitutes
If values of XED are negative…
- Goods are complements
If values of XED are zero (or close to zero)…
- Goods are unrelated
What is YED?
- Income elasticity of demand
- A measure of the responsiveness of demand for a product or service to a change in consumer income
If YED is negative…
- It is an inferior good
If YED is positive…
- It is a normal good
If YED is positive and greater than 1…
- It is a luxury good
What does the YED diagram for normal goods look like?
- X-axis - Income
- Y-axis - Quantity
- Upwards slope
What does the YED diagram for inferior goods look like?
- X-axis - Income
- Y-axis - Quantity
- Downwards slope
What is supply?
- The quantity of a good or service that a producer is willing and able to supply onto the market at a given price in a given time period.
What is the basic law of supply?
- The price of the product rises so businesses expand supply to the market.
What is PES?
- Price elasticity of Supply
How is PES calculated? (Price elasticity of Supply)
- %∆ Quantity supply
- Divided by
- %∆ Price
How is XES calculated? (Cross Price elasticity of Demand)
- %∆ Quantity Good A
- Divided by
- %∆ Price of Good B
What does the supply curve show?
- A supply curve shows the relationship between market price and how much a firm is willing and able to sell.
What is market supply?
- Market supply is the total supply brought to the market by producers at each price.
Why does the supply curve slope upwards?
- Profit motive
- (When prices increase it becomes more profitable for firms to supply their output)
- Production costs
- (When output expands in SR costs of production tent to rise) (Therefore a higher price is needed to cover these costs)
- New entrants in to the market
- (Higher prices provide an incentive for firms to join the market)
What shifts supply curves?
- Changes is cost of production
- Changes in technology
- Indirect taxes, subsidies and regulations
- Agriculture (climatic conditions)
- Number of producers in the market and their objectives
What is an equilibrium?
- A situation in which there are no forces acting to bring about change.
What is market clearing price?
- Market clears when demand = supply
What is a contraction of demand?
- Occurs when there is a decrease in quantity demanded as price increases
- Upwards movement along demand curve
What is an extension of demand?
- Occurs when there is a increase in quantity demanded as price decreases
- Downwards movement along demand curve
What is a contraction of supply?
- Occurs when there is a decrease in quantity supplied as price decreases
- Downwards movement along demand curve
What is an extension of supply?
- Occurs when there is a increase in quantity supplied as price increases
- Upwards movement along demand curve
What are price controls?
- Maximum prices set by GOVt
What do price controls often lead to?
- Shortages
What are price floors?
- Minimum prices set by GOVt
What do price floors often lead to?
- Surpluses
What is a consumer surplus?
- Difference between what consumers are willing to pay and what they actually pay
What is a producer surplus?
- Difference between the market price and the minimum price producers would accept
What is the price mechanism?
- The system by which prices adjust to balance supply and demand in a free market economy.
What is the effect of an indirect tax on the supply of a good?
It decreases supply
What happens to the supply curve when production costs decrease?
The supply curve shifts to the right
What happens to the price elasticity of supply when production capacity is fully utilized?
Supply becomes less elastic
What is price volatility?
Price fluctuations of a commodity
When demand increases and supply is price elastic, most of the adjustment to a new equilibrium falls on price… TRUE OR FALSE
False
What are the functions of the price mechanism?
- Rationing
- Incentive
- Signalling
Can composite demand influence government policy decisions?
- Yes
- Governments may need to regulate or manage resources with composite demand to ensure fair distribution and prevent shortages in critical sectors.
What is the primary function of the price mechanism in a market economy?
- Allocate resources efficiently
Is the demand for luxury goods is more price elastic than for necessities?
- Yes
What happens to total revenue if demand is elastic and price decreases?
- Revenue decreases
In a command economy do consumer preferences drive production decisions.
- No
Will a subsidy to producers will increase supply?
- Yes
In competitive supply, are the goods are typically substitutes.
- No
- In competitive supply, goods are not substitutes but rather compete for the same resources.
What role do prices play in the price mechanism?
- Signal information
What is the law of demand?
- As price decreases, quantity demanded increases
What is advalorem tax?
- A percentage tax
- E.g. VAT
How to calculate consumer surplus:
- Area of the triangle
- 0.5 X Base X Height
What is consumer surplus?
- The difference between what consumers are willing to pay and what they actually pay in the market.
What is producer surplus?
- The difference between the market price and the producer’s marginal cost of production.
- The additional profit that producers earn when they sell a good or service at a price higher than their minimum acceptable price
What is indirect tax (diagrammatically)?
- Vertical distance between 2 supply curves
What is the main indirect tax in the UK?
VAT
If PED>1 where will the incidence of the tax fall?
Mainly on the producer
If PED<1 where will the incidence of the tax fall?
Mainly on the consumer
What is a subsidy?
- A payment from GOVt to a producer to lower their costs of production and encourage them to produce more
Example of a subsidy.
- Subsidies for people buying electric vehicles
- Food and energy subsidies – often used in emerging / developing countries
Which curve do subsidies affect on an SD diagram - and how?
- Supply curve
- Shift to the right
Effects of subsidies.
- Subsidies increase output and lower prices for consumers, which could help families
on low and fixed incomes. - They could help boost demand during periods of economic decline.
If demand is price inelastic, how will the subsidy effect price?
- Large effect on equilibrium price.
- This give a greater consumer gain
What is joint supply?
- This is when goods are bought together, such as a digital camera and
a memory card. - An increase in demand for digital cameras is likely to lead to an
increase in demand for memory cards.
What is composite demand?
- This is when the good demanded has more than one use.
- E.g. Milk
- An increase in the
demand for cheese will mean that more cheese is supplied, and therefore less butter
can be supplied.
Is there a consumer surplus with perfectly elastic demand?
No
What happens to consumer surplus when there is perfectly elastic inelastic demand?
Consumer surplus is infinite
When supply is perfectly elastic what is producer surplus?
0
When supply is perfectly inelastic what is producer surplus?
Producer surplus is infinite
What is indirect tax?
- A tax on expenditure
- The person who is charged the tax is not responsible for paying the sum to the government
What are the two types of indirect tax?
- Ad valorem tax
- Specific tax
What is ad valorem tax?
- When tax is a percentage of the cost of the good
What is an inertia in behavioural economics?
- The tendency of individuals to maintain their current course of action, even when faced with new information
