Economics - 1.2

What does rational decision making mean?

Rational decision making is when economic agents are able to consider the outcome of their choices and recognise the net benefits of each one. Rational agents will select the choice which presents the highest benefits

Consumers try to maximise their utility

Producers try to maximise their profit

The government try to maximise their welfare

What is the definition of utility

The amount of satisfaction gained from consuming a good or service

What is marginal utility

The additional satisfaction gained from each unit of consumption

What is diminishing marginal utility

As more units of a good is consumed, additional units will provide less additional satisfaction

What is the equation for profit

Total revenue - Total costs

Why might consumers and other economic agents not make rational decisions

Peer pressure

Habits

Emotions

Altruism

Herd mentality

What is demand

Demand is the amount of a good or service that consumers are willing and able to buy at a given time

What is the law of demand

When the price of a good rises, the quantity demanded will fall

Income effect

When the price of a good increases, the real income falls, meaning purchasing power decreases. People therefore feel poorer, and buy less, so quantity demanded decreases

What is the substitution effect

The price of a good is more expensive relative to another good and the consumer switches to the cheaper good

Demand curves

Price only moves along the demand curve, it does not shift demand. 

An increase in price is a contraction and and decrease is an extension

Factors that effect demand

Population

Advertising

Substitutes

Income

Fashion and trends

Interest rates

Complimentory goods

Why does a demand curve slope downwards

• The Law of Diminishing Marginal Utility helps to explain the reason why the demand curve is downward sloping

  • When the first unit is purchased, the utility is high and consumers are willing to pay a higher price

  • When subsequent units are purchased, each one offers less utility and the willingness of the consumer to pay the initial price decreases

  • Lowering the price makes it a more attractive proposition for the consumer to keep consuming additional units

  • This is one reason why firms offer discounts such as '50% off the second item.'

What is PED

The responsiveness to quantity demanded of a good given a change in price

Interpreting PED values

<1 - inelastic

0 - perfectly inelastic

0-1 - relatively elastic

1 - Unitary

>1 - Perfectly elastic

Factors effecting PED

Availability of substitutes

Addictiveness of the product

Time period

Percentage of income

What is YED

Responsiveness to quantity demanded of a good given a change in income

Interpreting YED values

<0 - Inferior good - As income increases, demand decreases.

0-1 - Normal necessity good - As income increases, demand increases. Income is inelastic

>1 - Normal luxury - As income increases, demand increases. Income is elastic

What is XED

Responsiveness of quantity demanded of Good A, given a change in price of Good B

YED graphs

What are the types of goods

Substitutes - Positive relationship between price of other good and quantity demanded of main good

Complimentary good - Negative relationship between price of other good and quantity demanded of main good

Interpreting XED Values

<1 -inelastic

>1 - elastic

0 - No relation in goods

XED graphs

What is supply

Supply is the amount of a good or service that consumers are willing and able to pay for at a given time

Law of supply

As price increases, quantity supplied will also increases

Reasons for the law of supply

Firms want to maximise profit

Higher prices gives firms an incentive to produce more

Cost of production goes up eg wages, capital cost, raw materials 

Higher prices attracts more entrants

Why do lower prices reduce the quantity supplied

• Reduces profit and therefore reduced incentive to produce

• Reduced the number of possible entrants into the market

Factors effecting the supply curve

Productivity

Indirect tax

No of firms

Technology

Subsidy

Weather

Cost of production

Price elasticity of supply

The responsiveness of quantity supplied given a change in price

Factors effecting price elasticity of supply

Production log - If production takes long then PES is inelastic

Stocks - If stock levels are high, then firms can easily increase output, so PES is high

Spare capacity - If a firms has a lot of spare capacity, then it can easily increase output, so PES is high

Substitutability of FOP’s - How easily resources can be switched from use to another - PES increases

Time period - In the short run, supply is inelastic, however in the long run, firms invest in factors of production so PES is elastic

What is equilibrium

This is when supply meets demand, meaning there is no excess demand or supply

AKA. The market clearing price

When the price is above the equilibrium price

1) Consumers are less willing and able to spend

2) Producers are unable to sell all they are willing anf able to supply at the current price

3) There is excess supply (which worsens the basic economic problem)

When the price is below the equilibrium price

1) Consumers are unable to obtain all they demand and are willing to pay a higher price

2) Producers are unwilling o supply at the current price being offered by the market. They are willing to accept a higher price.

3) There is a shortage in the market and this drives up the market price, leading to excess demand

What is allocative efficiency

Where resources are distributed to produce the combination of good most desired by society

What is disequilibrium

A situation in the market where supply is no longer equal to demand

What causes disequilibrium in the market?

• Price change

• Change in demand and supply

Excess demand

Quantity demanded is greater than quantity supplied

This causes a shortage in the market

Sellers realise they can raise prices

Sellers gradually raise prices, which leads to a decrease in quantity demanded, as buyers are less willing to pay higher prices.

This also leads to an increase in quantity supplied as buyers are more incentivised to supply at higher prices

This will gradually clear excess demand

Excess supply

Quantity supplied is greater than quantity demanded

Sellers will gradually lower prices

This causes a contraction in quantity supplied as sellers are less incentivised to produce supply

This also causes an increase in demand as buyers are more willing and able to pay lower prices

This gradually clears excess supply

What is the price mechanism

The interaction of demand and supply in a free market

Functions of a price mechanism

Signals - Rapid increase in sales, stock levels fall

Incentives - Maximise profit - raise price. Higher prices incentivises producers to allocate more FOPs to produce

Rationing - Prices increase over time, excess will be cleared

Allocative efficiency - Supply = Demand

Evaluation of the price mechanism

Sometimes governments fail to allocate resources efficiently

Inequality - Rationing by price means that markets are favouring the rich

Imperfect information - if consumers or producers don’t have oerfect information prices may send incorrect signals

Time lag - Prices may not adjust immediately, they may adjust slowly in response to production lag

Consumer surplus

This difference between the price that the consumer is willing and able to pay and the price they actually pay

This is the area below the demand curve and above the price line

Higher surplus means that more consumers are willing to pay above the new market price

Producer surplus

The difference between the price the producer is willing to sell at and the price they actually sell at

This is the above the supply curve but below the price line

Community surplus

The total benefit the society receives from an economic transaction

What does disequilibrium cause

Consumer and producer surplus to decrease

What does an increase in demand and supply do the consumer and producer surplus

Increases it

Types of tax

Specific tax - A set tax per unit of a product

Ad valorem tax - Percentages such as VAT, which is added to the unit price

Incidence of tax

The share/burden of tax to be paid

Specific tax

How does PED of good impact the distribution of incidence of tax

If a good is more elastic, then the producer burden is higher

If the good is more inelastic, the the consumer burden is higher

Subsidy

Payment from the government to the producers to lower cost of production

Advantages of subsidy

Decreases COP

Increases output

Increases consumption of merit goods

Why might consumers not make rational decisions

• The influence of other people's behaviour

• The importance of habitual behaviour

• Consumer weakness in computation

The influence of other people’s behaviour

Peer pressure often lead consumers to make not rational decisions

Producers often influence consumer behaviour to make purchases through advertising, influencer culture,

This results in emotional decisions

The importance of habitual behaviour

Consumers rely on habits to make purchasing decisions

Rule of thumb - where the consumer makes a quick estimation of benefits without gathering much information

Sellers recognise habitual behaviour and exploit it

Consumer inertia

The tendency of some consumers to continue buying a product even when a superior option exists

Consumer weakness up at computation

The wider the range of choice the harder it is for a consumer to gather information and compute which one offers the highest net benefits

To exploit this producers may place objects at eye level to make computation easy