1.2 how markets work

law of demand

states ceteris paribus( all other things being the same)

if price increases then quantity demanded falls

law of dimishing marginal utility

as you use or consume more of something you will get less satisfaction from that thing

the demand curve

downwards sloping curve because the law of dimishing marginal utility,shows the inverse relationship between price and quantity demanded.

what does a shift in price do to the demand curve

movement - either a contraction(moves up the curve) or a extension(moves down the curve)

factors the cause a shift in demand curve

• Population

• Advertising

• Substitutes

• Interest rates

• Fashion trends

• Income

• Compliments

increase in population affect on demand curve

shift to right

increase in advertisment affect on demand curve

shift to right

increase in price of a substitute affect on demand curve

shift to right, as consumers switch to the relatively cheaper alternative.

increase in interest rates affect on demand curve

shift to left, as borrowing costs increase and consumer spending decreases.

product in fashion trends affect on demand curve

shift to right, as consumers desire more trendy products.

increase in income affect on demand curve

shift to right, as consumers have more purchasing power and can buy more goods.

increase in price of compliment affect on demand curve

shift to left, as higher prices for complementary goods decrease the quantity demanded.

demand

the quantity of a good or service that consumers are willing and able to purchase at various prices over a given period.

rational decision making

the process of making choices that result in the optimal level of benefit or utility for the individual. It involves weighing the costs and benefits of different options.

AD - aggregate demand

sum of all individuals demand

PED

price elasticity of demand - the responsiveness of demand to a change in price

elastic

percentage change in quantity demanded is greater than percentage change in price

inelastic

percentage change in quantity demanded is less than percentage change in price.

formula for PED

Percentage change in quantity demanded /percentage change in price.

what happens if PED is negative

usually the coefficient of PED is negative but economists ignore that sign

price elastic goods

• very responsive to price changes

• many substitutes

• unnecessary

price inelastic goods

• less responsiveness to demand changes

• tend to be:

  • highly branded

  • innovative

  • necessity

  • few substitutes

  • habit forming

inelastic demand curve

elastic demand curve

if PED is 0

perfectly inelastic - price has no affect on demand at all

if PED is 0-1

relatively inelastic - price has a small effect on demand

if PED is 1

unitary - changes are the same

if PED is 1 - infinity

relatively elastic - price has large effect on demand

if PED is infinity

perfectly elastic - any increase in price kills demand

factors affecting PED

• S - substitutes

• P-proportion of income

• L - luxury

• A - addiction

• T - Time

supply

the quantity of a good or service that suppliers are willing and able to supply to the market at a given price at given period of time

supply curve

movements along the supply curve

expansions and contraction, happen when there is a change in price of the product

factors causing the supply curve to shift

P - productivity

I - indirect taxes

N - no of firms

T - technology

S - subsidies

W - weather

C - costs of production

increase in productivity affect on supply

shift to right

increase in indirect taxes affect on supply

shift left

increase in no of firms affect on supply

shift to right

increase in technology affect on supply

shift right

increase in subsidies affect on supply

shift right

increase in weather affect on supply

shift left

increase in costs of production affect on supply

shift left

YED

income elasticity of demand - responsiveness of demand to a change in income

formula for YED

percentage change in demand/percentage change in income

normal good

demand rises with average income rate e.g heinz beans

positive YED (0-1)

inferior good

demand rises as income falls

negative YED

luxury goods

demand rises more than proportionate to a change in income

positive YED > 1

XED

cross price elasticity of demand - the responsivess of demand for good A to a change in price of good B

formula for XED

percentage change in demand of good A/percentage change in price of good B

what does it mean when XED is negative

the goods are compliments

a fall in price of good B would lead to a rise in demand of good A

what does it mean when XED is positive

goods are substitutes

a fall in price of good B would mean a fall in demand of good A

if XED 0>1

weak relationship

if XED = 0

no relationship

if XED is >1

strong relationship

PES

price elasticity of supply - the responsiveness of quantity supplied of a good given a change in price

formula for PES

percentage change in quantity supplied/percentage change in price

if PES is >1

relatively elastic

if PES is 0-1

relatively inelastic

if PES =1

unitary

if PES = infinity

perfectly elastic

if PES = 0

perfectly inelastic

factors that affect PES

• Barriers to entry

• Resources

• Inventory

• Time

• Spare capacity

equilibrium

a situation in which price has reached a level where quantity supplied equals quantity demanded

equilibrium price

the price that balances quantity demanded and quantity supplied

equilibrium quantity

the quantity demanded and quantity supplied at equilibrium price

surplus

when the price is set above equilibrium price causing the quantity supplied to exceed the quantity demanded causing a surplus of products

shortage

when the price is set below equilibrium price and the quantity demanded exceeds quantity supplied causing a shortage of products

consumer surplus

difference between what they are willing to pay and what they do pay

producer surplus

difference between the price a firm receives and the price they would be willing to sell at

what happens to consumer and producer surplus if demand shifts right

they increase

functions of price

• rationing

• signalling

• incentive

• allocative

rationing

to control the distribution of scarce goods

increasing price- reduce demand for those who arent willing or able to buy it

signalling

prices provide important information to market participants

incentive

create incentives for market participants to change their actions

allocative

acts to divert resources to where returns can be maximised

indirect taxes

taxes on expenditure

e.g. VAT, excise duties

2 types of indirect taxes

• specific

• ad valorem

ad valorem

puts a tax on a good depending on its value

usually expressed as a percentage

consumer incidence

burden on consumer

producer incidence

burden on producer

specific tax

fixed amount of tax placed on a particular good

subsidy

the government pays part of the costs of production to firms

homo economics

rational man

why dont we act like the rational man

• influence of others

• habitual behaviour

• consumer weakness in computation

• inertia

influence of others

• conformity

• unwilling to change the bias

• herding behaviour

habitual behaviour

• easier

• limits consumers considering alternatives

• addictions

• buying products at eye level

consumer weakness at computation

• arent willing or able to look at alternatives

• poor at self control

inertia

tendency to do nothing/remain unchanged