1.2 how markets work

Rational choice theory

A framework for understanding and formally modelling social and economic behaviour based on the assumption that economic agents act rationally

rational definition

in accordance with reason or logic

net benefit

the sum of all the benefits of an outcome minus all the costs. each economic agent maximises a different net benefit

what net benefit does each agent maximise?

* consumers: economic welfare or utility
* firms: profit
* governments: maximise the welfare of their citizens

rational consumers

try to maximise their total utility ( constrained by income)

what makes behaviour rational

it is goal-oriented, reflective and consistent

Homo economicus

RCT uses a hypothetical model of humans who are infinitely rational and immensely intelligent, an emotionless being who can do cost-benefit analysis instantly and is never wrong

utility definition

the satisfaction derived from the use of a good or service

unit of utility

the Util- an ordinal measure used to rank the net benefits of different outcomes

total utility

the total satisfaction an economic agent gains from all the units of a good consumed within a given time period

marginal utility

the total satisfsction an economic agent gains from consuming one extra unit within a given time period

diminishing marginal utility

As more units are consumed , additional units add less to satisfaction than previous units. eventually consuming more units will cut total utility, negative marginal utility!

MAX TU

where MU=0

relationship between MU and TU

MU gives the rate of change of TU

* the rate of change of TU is the gradient of TU, therefore MU is the differential of TU

behavioural economics

economic theory that tries to augment or replace traditional ideas of economic rationality from RCT with decision-making models borrowed from psychology.

what does behavioural economics attempt to explain?

why people make apparently irrational decisions

homo sapiens

most of us are not infinitely rational but rather face “bounded rationality” with people adopting simple, intuitive rules of thumb (heuristics) instead of calculating optimal solutions for every decision they make . futhermore we are open to influences outside of those covered in standard utility theory

failures of RCT

* computational weaknesses: problems recognising and defining the true net benefits of a choice
* habitual behaviour: choices are made automatically based on routine rather than consideration of net benefits
* social/external influences: factors that influence a decision outside the power of an economic agent

behavioural biases

irrational beliefs or behaviours that can unconsciously influence our decision-making process

choice architecture

refers to a scenario in which the environment has been carefully designed to try and influence that decision. it focuses on altering the default option

why is the cognitive decision-making capacity of economic agents not fully rational?

1. economic agents hold limited information
2. have limited time to make decisions
3. limited cognitive power to process every piece of information and consider every possibility

social norms

economic agent’s day to day behaviour in markets is often influenced by prevailing social norms or social customs

heuristics

As economic agents only have bounded rationality, they employ rules of thumb in allocating their scarce resources instead of calculating optimal solutions for every decision they make. they help make quick decisions

herd behaviour

humans are social creatures and economic agents often make decisions based in part on who is around us and the choices they make

commitment contracts

imposition of a penalty, often by oneself should an individual fail to meet a goal

priming

our behaviour is often subconsciously influenced by cues that affect our behaviours and prime us to make certain choices

anchoring

the use of irrelevant information as a reference point for helping to make an estimate of an unknown piece of information

further biases which affect our decisions

* default bias: people carry on behaving as always done
* availability bias: people judge the likelihood or frequency of an event by the ease with which examples and instances easily come to mind
* hindsight bias: see events in the past as having been predictable
* scarcity bias: value something more if it is rare
* ikea effect : place a higher value on an object they assembled themselves

nudge definitioin

any aspect of choice architecture that alters people’s behabiour in a predictable way without forbidding or significantly changing their economic incentives

aim of nudges

improve the rationality of the behaviour of economic agents by:

* influencing choices
* strengthening positive social norms

demand definition

the quantity of a good or service consumers are willing and able to buy at a given price

latent demand

exists when there is willingness, but doesnt take into account whether the consumer has the purchasing power to afford the product

effective demand

the desire to buy a product is backed by the ability to pay for it

market demand

the sum of all consumer’s individual effective demand

the law of demand

The law of demand states that as the price of a good or service increases, the quantity demanded of that good or service will decrease, and vice versa.

demand as a function

.Qd=f( p, k1,k2…)

shift of the demand curve

changes to any other determining factor

movement along demand curve

changes in price

why do we buy more at lower prices?

* income effect: real value of income rises
* substitution effect: consumers will find cheaper products more attractivr at a higher price
* diminishing marginal utility: willingness to pay falls

determinants of demand

* price of good
* consumer income ( exception of inferior goods)
* prices of other g/s ( subsitutes and complements)
* consumer tastes or fashion
* other factors ( population changes, advertising, competition in market)

veblen goods

have a ‘snob effect’where people consume more of certain products as their price increased this is ‘conspicuous consumption’ AKA paying for clout

veblen goods related effects

* common law of business balance: low price indicates producers may have reduced quality
* hot-hand fallacy: previous price increases suggest future price increases

giffen goods

tend to be very basic necessities. when the price of these goods rise, it represents a large fall in the PP of a consumers income, so they cut down on more luxury items and double down on the very basic necessities

joint demand

where the demand for two goods are interdependant. they are generally strong compliments for each other

two part pricing

where companies charge a lump sum price at the initial purchase, and then a per unit charge for future/complementary purchases. eg gilette and disposable razor blades

derived demand

where demand for a good or factor of production is based on the quantity traded of an intermediate good or service. eg cars and tyres

derived demand for labour

the demand for labour is derived from the quantity demanded for a firm’s output. if demand for a firms output increases, the firm will demand more labour and hire more staff

marginal revenue product theory

states that demand for labour depends upon the productivity of a worker and the marginal revenue of the goods sold. marginal revenue product= marginal physical product x marginal revenue

supply

the quantity of a g/s which a producer is willing and able to produce and sell at a given price

market supply

the sum of all producers individual supply

law of supply

The principle that as the price of a good increases, the quantity supplied by producers also increases, and as the price of a good decreases, the quantity supplied by producers decreases.

supply as a function

Qs=f(p, k1,k2)

why do firms sell more at higher prices, less at lower prices?

* profit motive
* production and costs: higher price needed to cover extra costs of production when output expands
* new entrants coming into the market: higher prices create an incentive for this, increased total supply

determinants of supply

* price of good (p)
* costs of production
* level of technology
* gov policy ( taxes,subsidies,regulations)
* prices of substitutes in production
* entry of new producers into the market : more people willing to sell for a given price
* shocks to factors of production
* other factors ( expectations, pop.changes, weather)

joint supply

when two goods are produced together from the same origin/ raw material . usually arises because producing a good, creates a by-product

price market mechanism

the means by which millions of decisions taken by consumers and businesses interact to determine the allocation of scarce resources between competing uses

market equilibrium

the point at which demand is equal to supply

market clearing price

the price that is charged at the market equilibrium , at this price all products made are sold

solution to excess supply

firms would need to lower price to get rid of excess products.

solution to excess demand

to improve profitability firms could raise price, thus reducing excess demand

the price mechanism plays 3 important functions in a market

* rationing function: prices ration scarce resources when demand outstrips supply
* excess demand leads to a rise in price due to the scarcity of the product. this leads to rationing of the product as fewer people are willing to pay for it. decreased Qd, increase p
* incentive function: through their choices, consumers send information to producers about their changing nature of needs and want
* higher prices act as a motivator for producers to increase supply, increase qs due to an increased p
* signalling function: where prices adjust to demonstrate where resources are required
* signals push market towards equilibrium

consumer surplus

a measure of the welfare people gain from consuming g/s

CS= WTP-P

indicated by the area under the demand curve and above the market price

changes in market prices CS

* higher supply costs lead to a rise in market price and fall in consumer surplus
* increase in market demand causes consumer surplus to increase

producer surplus

a measure of producer welfare that people gain from the sale of a good

PS= P-WTS

indicated by the area above the supply curve and below the market price

changes in market price PS

* higher supply costs leads to a rise in market price and a fall in consumer surplus
* an increase in market demand causes producer surplus to increases

relevance of CS&PS

important concepts in examining societies welfare

allocative efficieny

occurs where total satisfaction is maximised in the consumption and production of g/s

disequilibrium

the total level of welfare is not maximised, though one party may be better off than at equilibrium

examples of disequilibrium

* excess demand: CS grows but not as much as PS falls, DWL
* excess supply: PS grows , not as much as CS falls, DWL

elasticity theory

looks at the responsiveness of one variable to a change in another

PED

the responsiveness of quantity demanded to a given change in price. %change Qd/%chsnge P

why is PED always negative

demand is downward sloping

types of PED

* price elastic: PED>1. if PED is infinity, perfectly elastic
* price inelastic: PED

factors determining PED

* availability of close substitutes
* branding
* luxury or necessity
* proportion of income spent on product
* whether the purchase can be postponed
* time period under consideration

importance of PED to firms

* sales forecasting
* life cycle of product
* effects of marketing
* pricing policy

revenue

the total income a firm generates from selling its output

changes in revenue influenced by PED

* if PED is elastic a rise in price will cause revenue to fall
* if inelastic a rise in price will cause revenue to rise

when is total revenue maximised?

when PED is unitary

YED

the responsiveness of quantity demanded to a given change in real income. %change Qd/ %change Y

different types of YED

* +ve: qd increases as real income rises. normal goods
* +ve and >1: qd increases by proportionally more than real income. luxury goods aka superior goods
* +ve and

factors determining YED

* necessity or lucury
* level of income of consumer
* \

relevance of YED to firms

* standards of living: as standards increase we expect to see an increase in demand for luxury and movement away from inferior goods
* economic cycle: firms will identify the state of the economy e.g. recession and produce g/s to meet the demand of consumers

XED

the responsiveness of quantity demanded of one g/s to a change in price of another. %change qdx/ %changeQdy

different types of XED

* +ve: increase in price of once product causes an increase in demand for the other
* substitutes (competitive demand)
* the higher the value the greater the substitues
* -ve: increase in price of one product causes decrease of demand in the other
* complements (joint demand)
* the higher the value the closer the complements
* 0: increase in price causes no change in demand for the other
* unrelated

relevance of XED to firms

* substitues: a lower price for rival products means fewer sales of your product
* firms will try to differentiate their product
* complements: firms might be able to increase their profits through encouraging complementary purchases as complements have joint demand

PES

the responsiveness of quantity supplied to a given change in price.

why is pes always positive

supply is upward sloping

different types of PES

* >1: change in Q proportionally greater than change in P. if infinity, perfectly elastic
*

factors determining PES

* level of spare capacity
* stock levels
* time period under consideration

limitations of elasticity analysis

* problems with inaccurate or incomplete data collection
* consumer sensitivity changes over time
* elasicity of demand varies by region/time
* not all businesses wish to maximise revenue

indirect taxes

tax levied on expenditure on goods or services. reduce supply by increasing CoP

specific taxes

a fixed tax per unit of the good or service produced. shifts supply curve inwards and maintains gradient

Ad Valorem taxes

a % tax of the unit cost of a good. pivots the supply curve inwards and increases gradient.

why would a government implement an indirect tax

* raise tax revenue to fund gov spending
* change level of demand and pattern of demand for different g/s
* flexible-easy to change

economic incidence (or burden)

indicates the extent to which someone is made worse off by the tax ie the amount they pay

incidence of tax and PED

* elastic: producers pay most of the tax
* inelastic: consumers pay most
* perfectly elastic: producers pay all
* perfectly inelastic: consumers pay all

limitations of indirect tax

* can be regressive: poor individuals pay a greater proportion of their income
* inflation
* gov failure: if set too high, creates an incentive to avoid taxes through boot legging and smuggling
* can be ineffective: if demand is inelastic
* uncertain gov revenue: if a market is volatile
* loss of economic welfare: fall in CS and PS

subsidies

government support, usually financial, to suppliers that cover some of their costs. increase supply by reducing CoP

types of subsidy

* guaranteed payment on the factor cost of a product
* input subsidies: costs of inputs used in production
* government grants to cover losses: keep output high for benefit of consumers and workers
* Bail-outs: brink of bankrupcy
* start up assistance: cheap loans for new businesses

why would a government want to implement a subsidy

* keep prices down and control inflation
* encourage consumption of merit goods and services
* reduce the cost of capital investment projects
* subsidies to slow down the long term decline of an industry
* boost Qd for industries during a recession