How Markets Work

What is the aim of a rational consumer?

To maximise overall utility from consumption choices

What is utility?

The satisfaction or well-being that individuals derive from consuming goods and services

What are consumers choices based on?

Preference and budget constraints

What is profit?

The difference between a firms total revenue and its total costs

What is the aim of rational firms?

To maximise their profits to ensure business sustainability and growth

Why do firms produce goods and services??

To meet consumer demand

What is the main criticism of the assumptions of firms and consumers?

In reality consumers and firms may not always behave rationally due to bounded rationality, cognitive biases, and imperfect information

When do movements along a demand curve occur?

When the quantity demanded changes due to a change in the price of the good or service, while other factors remain constant

What does the law of demand state?

With all else being equal, as the price of a good or service decreases, the quantity demanded increases, and vice versa

When do shits of the demand curve occur?

When factors other than price cause a change in the quantity demanded at every price level

What does a shift in demand show?

A change in overall demand, not just a response to price changes

6 Conditions of Demand

1. Income

2. Consumer Preference

3. Price of Related Goods

4. Tastes and Preferences

5. Population and Demographic

6. Expectation

How does income affect demand?

As consumer income changes, the demand for goods and services can shift

What are normal goods?

A good where it’s demand increases with rising income

What are inferior goods?

A good where it’s demand increases with falling income

What is an example of a normal good?

Luxury Car

What is an example of an inferior good?

Generic Brands

What are complimentary goods?

Goods where a decrease in the price of one good increases the demand for its complementary good

Example of complementary goods

Peanut Butter and Jelly

What are substitute goods?

Goods where the increase in the price of one good increases the demand for its substitute

Example of substitute goods?

Coke and Pepsi

What is diminishing marginal utility?

As a consumer consumes more units of a good or service, the additional utility (satisfaction) derived from each additional unit decreases

How does the law of diminishing marginal utility contribute to the downward sloping demand curve?

As the price decreases, consumers are willing to buy more because the marginal utility of each additional unit exceeds the price

What does PED stand for?

Price Elasticity of Demand

What does YED stand for?

Income Elasticity of Demand

What does XED stand for?

Cross Elasticity of Demand

What does PED measure?

The responsiveness of the quantity demanded to changes in the price of a good 

What does YED measure?

The responsiveness of the quantity demanded to changes in consumer income

What does XED measure?

The responsiveness of the quantity demanded of one good to changes in the price of another 

Equation for PED

(% Change in QD) / (% Change in Price)

Equation for YED

(% Change in QD) / (% Change in Income)

Equation for XED

(% Change in QD of Good A ) / (% Change of price of Good B)

PED value when demand is unitary elastic

PED = 1

PED value when demand is perfectly elastic

PED = Infinite

PED value when demand is perfectly inelastic

PED = 0

PED value when demand is relatively elastic

PED is greater than 1

PED value when demand is relatively inelastic

PED is greater than 0, but less than 1

YED value of inferior goods

YED is less than 0

YED value of normal goods

YED is greater than 0 but less than 1

What is a luxury good?

A good where demand increases significantly with income

YED value of luxury goods

YED is greater than 1

XED value of substitute goods

XED is greater than 0

XED value of complementary goods

XED is less than 0

XED value of unrelated goods

XED = 0

4 Factors influencing elasticities of demand

1. Availability of substitutes

2. Necessity vs Luxury

3. Future predictions for income and expense of the good

4. Habit

3 reasons why elasticities of demand are important for firms (regarding indirect taxes and subsidies)

1. Use elasticities to set prices and predict changes in revenue

2. Elastic demand means price increases total revenue

3. Inelastic demand means price increases raise total revenue

4 reasons why elasticities of demand are important for governments (regarding indirect taxes and subsidies)

1. Uses elasticities to make tax and subsidy decisions

2. Inelastic goods can afford to take on higher taxes

3. Elastic goods would likely see reduced consumption due to taxes

4. Subsidies can encourage consumption of essential goods

4 reasons why elasticities of demand are important for firms (regarding changes in real income and prices of substitutes and complementary goods)

1. YED determines which firms gain when real income rises and which firms are vulnerable in a recession

2. PED affects whether firms can pass on cost increases without losing revenue

3. PED determines the revenue outcome of price cut strategies

4. XED reveals threats and opportunities from rivals’ price changes

2 reasons why elasticities of demand are important for governments (regarding changes in real income and prices of substitutes and complementary goods)

1. PED determines the effectiveness of indirect taxes as a revenue tool and their effectiveness in reducing consumption

2. YED affects the cyclical stability of tax revenues

Equation for Total Revenue

Price x Quantity 

When do movements along a supply curve occur?

When the quantity supplied changes in response to a change in the price of the good or service, while other factors remain constant

When do shifts on a supply curve occur?

When factors other than price level cause a change in the quantity supplied at every price level

What does a shift in supply indicate?

A change in overall supply, not just a response to price changes 

Acronym for the conditions of supply

PINTSWC

7 factors of supply

1. Productivity

2. Indirect Taxes

3. Number of firms

4. Technology

5. Subsidies

6. Weather

7. Costs of Production

What does PES measure?

The responsiveness of the quantity supplied of a good to changes in price

Equation for Elasticity of supply

(% Change in QS) / (% Change in Price)

How to find a percentage change?

(New - Old) / Old

Value of PES when supply is perfectly elastic

PES is infinity

Value of PES when supply is perfectly inelastic

PES = 0

Value of PES when supply is relatively elastic

PES is greater than 1

Value of PES when supply is relatively inelastic

PES is more than one and less than 0

What is meant by perfectly elastic?

When even a slight change in price causes an infinite change in the quantity supplied

When does perfect elasticity of supply occur?

This is rare and usually occurs in markets where producers can instantly adjust production without costs

What is meant by perfectly inelastic?

When quantity supplied does not respond to price changes because producers are unable or unwilling to adjust supply in response to price fluctuations

What is meant by relatively elastic?

This is when a percentage change in price results in a larger percentage change in the quantity supplied.

When supply is relatively elastic how can producers respond to price changes

Adjusting production

What is meant by relatively inelastic?

This is when a percentage change in price results in a smaller percentage change in the quantity supplied because producers have limited flexibility to adjust supply quickly

4 factors that influence price elasticity of supply

1. Time Horizon

2. Resource Availability

3. Production Technology

4. Perishability

How does time horizon influence price elasticity of supply in the short run?

Supply may be less elastic as it takes time to adjust production capacity

How does time horizon influence price elasticity of supply in the long run?

Supply can be more elastic as firms can make capital investments to expand capacity 

How does perishability influence price elasticity of supply?

Goods with short shelf lives tend to have more elastic supply in the short run, as producers can quickly adjust to changing demand 

What is supply likely to be in the short run?

Less elastic

What is meant by production technology?

The ease with which production can be scaled up or down influences elasticity

What is meant by resource availability?

The ease with which production can be scaled up or down influences elasticity,

What is the short run?

A period during which some factors of production, such as plant capacity or labour, are fixed and cannot be adjusted

What is the long run?

A period during which all factors of production can be adjusted 

3 functions of the price mechanism to allocate resources

1. Rationing function

2. Incentive function

3. Signalling function

Explain rationing function

Prices act as a rationing mechanism to allocate scarce resources among competing uses

How does rationing function work?

When demand exceeds supply, prices rise, discourage some consumers from buying, and ensure that goods are allocated to those willing to pay the highest prices

Explain incentive function

Prices provide incentives for producers to allocate resources efficiently

How does incentive function affect higher prices?

Higher prices indicate increased demand, motivating producers to produce more of a particular good or service

How does incentive function affect lower prices?

Lower prices signal decreased demand, encouraging producers to reallocate resources to more profitable uses

Explain signalling function

Prices convey information about changing market conditions, allowing consumers and producers to make informed decisions.

How does incentive function affect rising prices?

Rising prices may signal potential shortages, prompting consumers to conserve and producers to increase supply

How does incentive function affect falling prices?

Falling prices may indicate oversupply, prompting consumers to buy more and producers to cut back on production

How are prices determined in local markets?

By supply and demand conditions within a specific geographic area

What local factors influence prices in local markets?

Weather or local preferences

What are national markets?

National markets cover an entire country and consider supply and demand at a broader scale

What impacts prices in national markets?

National policies and regulations such as taxes and trade policies

What are global markets?

Global markets involve international trade and can be influenced by factors like currency exchange rates, global supply chains, and geopolitical events

Explain prices in global markets

Prices in global markets are interconnected and can impact local and national markets

What are market forces?

The factors of demand and supply that influence price and quantity in a free market. 

When do market forces raise prices?

In the case of excess demand

When do market forces lower prices?

In the case of excess supply

What do market forces lowering prices lead to?

An extension in demand and a contraction in supply, restoring equilibrium

What do market forces rising prices lead to?

Causing a contraction in demand and an extension of supply, restoring equilibrium

What is consumer surplus?

The difference between what consumers are willing to pay (their maximum price) 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

Impacts of an increase in demand on consumer surplus

Increase in consumer surplus as more people benefit from lower prices