Unit 2 - The price mechanism and the microeconomy Flashcards
Define
Market
where buyers and seller meet with the intention of either buying or selling
Define
Product market
manufactured good
Define
Labour market
market for workers
Foreign Exchange Market
Market for currencies
Commodity market
Agricultural goods
Stock Market
market for financial securities
shares/bills/bonds
Who are buyers?
consumers whose main aim is to maximise utility
also reffered to as households
Define
Utility
Satisfaction derived from consuming a good or service
measures in utils
What is the aim of the seller?
to maximise profits
profits are the yard stick for success
Define
Demand
The amount of goods and services that buyers are willing to buy, at a given price, per period of time, ceteris paribus
What ways can the definition of demand be broken into?
- Quantity
- Products
- Buyers
- Willing to buy
- Able to buy
- Various/given prices
- Ceteris paribus
Define
Notional demand
want is not backed by purchasing power
buyer can’t afford
Effective Demand
Wanting is backed by purchasing power
Why is ceteris paribus part of the definition of demand?
The market is very turbulent for the price mechanism theory to work
Define
Demand Schedule
a table showing the levels of demand for a product at different prices per period of time, ceteris paribus
Define
Demand Curve
A curve showing the levels of demand at different prices, per period of time ceteris paribus
Explain the relationship show by the demand curve
The demand curve is downward sloping, showing an inverse relationship between price and
quantity demanded
What are the factors affecting demand
for a product or service
- Price of a good Itself
- Price of Complements
- Price of substitutes
- Consumers’ disposable income
- Advertising and promotion
- Availability of credit facilities
- Fashion taste and preferences
- Population
- Seasonal demand
- Changes in legislation
What causes movement of the demand curve?
Change of quantity demanded
This is caused by the price of the good itself and no other factor
What causes Expansion of the demand curve?
extenstion
Increase in demand caused by decrease in price of a good
What causes contraction of the demand curve?
A decrease in demand caused by an increase in the price of a good
What causes a shift in the demand curve?
Change in demand
All other factors affecting demand except the price of the good itself
Individual demand curve
The demand curve of an individual buyer.
This can be a consumer firm or government
Horizontal summing for the individual demand curves
The sum of the x axis of individual demand curves are added up to put on the market demand curve for the entire market.
Individual Demand
The amount an individual or single firm will buy at each price
Supply
The amount of goods or services that producers are willing and able to bring onto the market and sell at different prices per period of time Ceteris paribus
Describe the relationship between supply and price
Price and Quantity demaned have a direct relationship
What factors affect movement of the supply curve?
Only the price of the good itself
What factors affect shifts in the supply curve?
change in supply
all factors except the price of the good itself
What causes expansion of the supply curve?
Increase in the price of the good
What causes contraction of the supply curve?
Decrease in the price of the good itself
Define
Equilibrium
State of rest with no tendency to change
State
Law of supply
ceteris paribus more goods will be supplied onto the market at a higher price than at a lower price
State
Law of demand
More goods will be demanded at a lower price
What is excess supply?
Any price above the equilibrium price
What is excess demand?
Any price below the equilibrium price
What is equilibrium price?
The price at which supply is equal to demand because the market is always in equilibrium
When is the market in disequilibrium?
Excess supply (Any point above equilibrium price)
Excess Demand ( any price below equilibrium)
What roles does price play in the market?
Rationing
Incentive
Signalling and the transmission of preferences
What is the invisible hand?
The price mechanism working automatically
How does the price system lead to Rationing
If demand is high and supply is low then prices will be high.
to combat this then suppliers increase the prices to to limit the buyers to only those who can afford to pay high prices
Supply can also be limited to allow goods to remain exclusive allowing them to sell the goods for high prices
How does the price system create Incentive
Low prices, discounts and deals encourage customers to buy more goods, because utility increases when consumers thing they are getting a good deal
Higher prices lead to less demand but can encourage supply to increase as suppliers aim to profit more from expensive goods
How does the price system lead to Signalling and transmission of preferences
Price reflects market conditions
An increase in price signals suppliers to produce more, and if demand falls so does the price of the good, signalling to supplier they need to lower prices, improve the product or produce less
Define
Complement
Joint Demand
A good which is purchased with other goods to satisfy a want
pen + ink
Economic Theory
Complement
A rise in quantity demanded of one good, will lead to an increase in demand for it complements, resulting in an increase in price and quantity bought of the complement
Define
Subsitute
Competitive Demand
A good that can be replaced by another
they satisfy the same want
Economic Theory
Substitute
A rise in price of one good will lead to an increase demand and rise in price of its substitute
Define
Derived demand
when the demand of a good is the result of the demand for another good
Economic Theory
Derived Demand
An increase in demand for a good, will lead to an increase in price and quantity of goods that are in derived demand from it
Define
Joint Demand
Composite Demand
When a good is demanded for two distinct uses
Crude oil and its fractions
Economic Theory
Joint Demand
An increase in demand of a good will lead to a fall in supply, rise in price therefore a fall in quantity demanded of another good in joint demand
Define
Joint Supply
When two or more goods are produced together so that a change in supply of one good, will lead to the same change to the other good in joint suppy
Economic Theory
Joint Supply
An increase in demand for one good in joint supply will lead to an increase in its price. This will lead to an increase in the quantity supplied of the good.
Hence an increase in supply of the other good, and a fall in its price
Define
Elasticity
The measure of the extent to which quantity demanded or supplied responds to a change in the variable which affects it
State
The variables of Elasticity
Price Elasticity of:
PED & PES - supply and demand
XED - complements and substitutes
YED - Consumer’s Income
Define
PED
The responsivness of demand to changes in the price of a good
State
The types of PED
Elastic
Inelastic
Perfectly Elastic
Perfecly Inelastic
Unitary Elastic
Equation
PED
%ΔQ / %ΔP
or
ΔQ|Q / ΔP|P
Describe
Elastic Demand
When a small change in price leads to a large change in quantity demand or when the elasticity ratio >1
What does line abc represent?
The total tax per unit
What does line bc represent?
Tax for producer per unit
What does line ab represent ?
Tax for consumer per unit
What does area ac P0 P2 represents
Total tax paid to the government
Define
Inelastic Demand
When demand is not very responsive to changes in price or when the elasticity ratio 0<x<1
Define
Perfectly inelastic demand
Demand does not vary with change, consumers are willing to pay any price for the good eg. Necessities
Elasticity ration = 0
Define
Perfectly Elastic Demand
There is one price that consumers are willing to pay eg. price controlled goods
Elasticity ratio = infinity
Define
Unitary Elasticity
Change in price is met with a proportional change in demand (revenue remains constant)
Elasticity ratio = 1
State
Factors affecting PED
- Habit forming goods
- Time period
- Percentage of income spent on a good
- Number and availability of substitutes
- Neccessities and Luxuries
- Width of definition (branding)
How do habit forming goods affect PED?
Habit forming goods like addictive substances have inelastic demand as they cant be forgone
Non habit forming goods have elastic demand as they can be forgone
How do time periods affect PED?
In the Short run demand is inelastic as there is no time to look for alternatives
In the Long run demand is elastic as there is more time to deliberate
How does percentage of income affect PED?
If a larger portion of income is spent on a good then demand is elastic
if a smaller percentage of income is spent on a good then demand is inelastic
How does the availability of substitutes affect PED?
If many substitutes are available, then demand is elastic
If substitutes are few, then demand is inelastic
How do necessities and luxuries affect PED?
Necessities have inelastic demand as they are needs
Luxuries have elastic demand as they are wants
How does width of definition affect PED?
branding
Branded goods have inelastic demand
Unbranded goods have elastic demand
State
Economic relevance of PED
- Price determination
- Production planning
- Price discrimination
- Government and Taxes
How is PED used to determine the price of a good?
If demand is elastic, then a lower price will yield a larger revenue
If deman is inelastic, then a higher price will yield a larger revenue
if demand is unitary mantaining price will be the best option as revenue is constant
How does PED help in production planning?
Used to estimate the effect of changes in price,allowing the company to plan on what goods to produce, how many people to hire and the impact on cash flow
How is PED used for price discrimination?
How is PED used by governments and taxes?
Taxes reduce supply and increase prices.
If demand is elastic or supply is inelastic then the tax burden falls on producers
if demand is inelastic or supply is elastic then the tax burden falls on the consumer
Problems with PED
- Hard to draw this graph
- Data collection problems
- Price is affected by numerous factors
Define
YED
Income elasticity of demand
measures the reponsivness of demand to changes in income
When is YED elastic?
When it is highly reposive to changes in income
When is YED inelastic?
When demand is unreposive to changes in income
Describe
Normal goods
These are goods with positive YEDs, showing a positive relationship
As income increases so does demand
Describe
Necessity goods
Type of normal good
YED is positive but 0> x>+1
quantity demanded is unlikely to change even with changes in income
Describe
Superior goods
luxury
Type of normal good
PED ratio of >+1
Income rises, more proportionate increase in demand
Describe
Inferior goods
YED ratio is negative
As income increases demand decreases
Graph
Elastic YED
Small change in income big change in demand
YED>1
Graph
Inelastic YED
Big change in income small change in demand
YED 0>x>1
Graph
Perfectly Elastic YED
Demand can vary at the same income
YED = infinity
Graph
Perfectly Inelastic YED
Demand is constant irrespective of changes in income
YED = 0
Graphy
Unitary YED
Change in demand is proportionate to change in income
YED = 1
Relevance YED
Determine what types of goods to stock
Normal goods during economic booms and inferior goods during hardships to ensure money is always being made.
Products in the primary sector have inelastic YED in the secondary sector they have elastic YED
Used so that the government knows when to make changes for income tax
Define
XED
Cross elasticity of demand
A numerical measure of the responsiveness of demand of one product to changes in price of another related product
What does a negative XED represent?
Goods that are complements
What does a positive XED represent?
Goods that are substitutes
How is the closeness between substitutes and complements observed?
If the two goods being compared have an Elastic XED then they are close substitutes or complements of each other as the price of Good A drastically affects demand for good B
If the XED is inelastic then they are weak complements or substitutes as the change in price of one does not highly affect demand for another.
Economic relevance of XED
Allows a business to estimate the effects of changes in price of their competitors on their own goods
Allows businesses to estimate effects of changes of price of complements on their own goods
Allows the company to estimate the effects on customers expenditure using special deals and promotions (make complements cheaper to draw in customers, increase price of the goods itself)
Define
PES
Price elasticity of supply
A numerical measure of the responsiveness of supply to changes in price of the product itself, ceteris paribus
Why is PES positive?
Price and supply have a direct relationship
Why does a price increase for PES always favoured?
Price and Quantity supplied have a positive correlation between price and quantity supplied, price increases will always lead to more revenue
State
Factors affecting PES
- The number of producers
- The existence of spare capacity
- Ease of storing stocks
- The time period
- Factor mobility
- Length of the production period
Economic relevance of PES
If demand increases for a good, the the good with inelastic demand will have larger increase in price than the one with elastic demand.
This knowledge informs supplier with goods with inelastic demand to raise prices more sharply in response to surges in demand
How does the number of producers impact PES?
If there are many producers then the PES will be elastic as it is easier to increase output to the market
If there are few then it will be inelastic as it is difficult to supplement during shortages
How does spare capacity affect PES?
If there is spare capacity then is is easy to increase output with increases in price, so it is elastic
If there is no spare capacity then PES will be inelastic
How does ease of storing stocks affect PES ?
If it is easier to store stocks then PES will be elastic, as stocks can be kept and sold later
If it is difficult to store stocks then PES will be inelastic eg. Agriculture and seats in stadiums
How does time period affect PES?
In the short run PES is inelastic as there is not time to increase productivity
In the long run PES is elastic as there is time to improve factors of production and be more efficient
How does factor mobility affect PES?
Easy elastic
Hard inelastic
How does length of production period affect PES?
If the length of production is short then PES will be elastic as it is easy to increase output eg. manufacturing
if the length of production is long then PES will be inelastic as it is difficult to increase output with changes in the market
Define
Consumer Surplus
The difference between what consumers are willing to pay and what they actually pay
It is a measure of the welfare consumers receive
What area represents consumer surplus?
The area below the demand curve and equilibrium price
What is the consumer surplus when PED is perfectly elastic
ZERO as consumers are only willing to pay one price
What is consumer surplus when PED is perfectly inelastic?
Infinity as consumers are willing to pay any price for the good
Relate consumer surplus to PED?
The more elastic demand is the less the consumer surplus because buyers are only willing to pay lower prices
Relate price and consumer surplus
As price increases consumer surplus decreases and the greater the change in price the greater the change in consumer surplus
Economic relevance of Consumer surplus
Used to analyse the impact of government intervention in any market
Define
Producer surplus
Measure of producer welfare
The difference between the price that consumers are willing and able to provide a good or service to the market, and the price they actually receive
Relate Price and producer surplus
The greater the price, the greater the producer surplus as there is more incentive to supply
What area represents producer surplus?
The area underneath the supply curve and equilibrium price
Relate demand to economic welfare?
If demand increases both consumer and producer surplus increase
Relate supply to economic welfare
If supply increases (shift right) both consumer and producer surplus increases
