Edexcel Economics 1.2

Rational consumers

They make choices with the aim of maximising utility (satisfaction or benefit) from purchasing and consuming goods and services using a limited amount of income.

Rational choice model assumptions (4)

1. Consumers choose independently

2. A consumer has fixed and consistent tastes and preferences

3. Consumers gather complete and perfect information

4. Consumers make optimal choices given their preference

Total utility

The total satisfaction from a given level of consumption.

Marginal utility

The change in satisfaction from consuming an extra unit.

Diminishing marginal utility

The theory believes the marginal utility of extra units decline as more is consumed.

Rational economic theory

The theory suggests the maximum price you are willing to pay for a product is equal to the marginal utility you get from consuming it.

Demand

The quantity of a good or service that consumers are willing and able to buy at a given price in a given time period.

Effective demand

When a desire to buy a product is backed up by an ability to pay.

Derived demand

Demand for a good or service that arises from the demand for another related good or service.

Income effect

Is when the price of a good falls, the consumer can maintain the same consumption for less expenditure, increasing real income. Usually, some of the extra income is used to buy more.

Substitution effect

Is when the price of a good falls, the product is now relatively cheaper than an alternative and some consumers will switch to the cheaper good.

Causes of shifts in the demand curve

Due to changes in anything that might affect the demand for a good other than price of the good.

1. Changing price of substitutes and complements

2. The effects of advertising and marketing

3. Changes in the real income of consumers

4. Seasonal factor for some goods

Joint demand

is when demand for one product is positively related to demand for a related good.

Composite demand

Is when goods have more than one use, and so an increase in the demand for one product leads to a fall in supply of the other.

Price elasticity of demand(PED) - Definition and formula

Measures the responsiveness of quantity demanded after a change in the good’s own price.

PED = Percentage change in quantity demanded / Percentage change in price

Factors affecting price elasticity of demand (4)

1. Number of close substitutes - The more substitutes there are the more price elastic the good is.

2. Cost of switching between products - There may be costs involved in switching, making the good more inelastic.

3. Whether it is a necessity or a luxury - necessities tend to have price inelastic demand and luxury good have a more price elastic demand.

4. Proportion of a consumer’s income spending on the good - Products that take up a high proportion of income will be more price elastic demand

Firms can use PED to predict: (3)

1. Effect of a change in price on total revenue

2. Effect of a change of an indirect tax on price and quantity demanded and also whether the business is able to pass on some or all of the tax onto the consumer

3. Price volatility in a market following a change in supply

Income elasticity of demand(YED) - Definition and formula

Measures the responsiveness of demand following a change in real income.

YED = Percentage change in quantity demanded / Percentage change in income

Normal good

They have a positive income elasticity of demand so as consumers’ income rises, more is demanded at each price.

Luxury goods

They have an income elasticity of more than 1.

Inferior goods

They have a negative income elasticity of demand meaning that demand falls as income rises. If a consumer has enough money to buy the superior goods, they will usually buy it.

Cross price elasticity (XED) - Definition and formula

measures the responsiveness of demand of Good X following a change in price of Good Y.

XED = %change in demand for Good X / %change in price for Good Y

Substitutes

They have a positive cross price elasticity of demand. An increase in the price of one product will lead to a rise in demand for its substitute, as consumers swap away from the more expensive good.

Complements

When there is a strong complementary relationship, cross price elasticity of demand will be negative. An increase in price of good T will lead to a fall in demand for good S.

Unrelated products

They have cross price elasticity equal to zero.

Supply

the quantity of a good or service producers are willing and able to supply in a given time period.

Law of supply

As the price of a good or service rises, the quantity supplied increases because of profit incentives.

Causes for a shift in supply (5)

1. Changes in costs of production

2. Changes in technology

3. Government taxes and subsidies and regulations

4. Changes in climate in agricultural industries

5. Changes in prices of a substitute in production

Price elasticity of supply (PES) - Definition and formula

Measures the relationship between change in quantity supplied and a change in market price.

PES = %change in quantity supplied / %change in price

Factors affecting price elasticity of supply (4)

1. Spare production capacity

2. Stocks of finished products and components

3. Time period and production speeds

4. Complexity of the production process

Equilibrium

Where market supply and demand are balanced

The price mechanism

How decisions taken by consumers and businesses interact to determine the allocation of scarce resources between competing uses.

Invisible hand

A theory made by Adam Smith in which the firm produce in self-interest in a free market economy.

Signalling function

If prices are rising because of high demand from consumers, this is a signal to suppliers to expand production to meet the higher demand. If there is excess supply in a market, the price mechanism will help to eliminate a surplus of a good by allowing the market price to fall.

Incentives function

How changes in market prices motivate consumers and producers to alter their behaviour. Higher prices incentivise producers to increase supply, while lower prices encourage consumers to increase demand.

Rationing function

Prices ration scarce resources when demand outstrips supply. When there is a shortage, price is raised so only those who can afford will buy.

Consumer surplus

The difference between the maximum that consumers are willing to pay for a good or service and the total amount that they actually do pay.

It is represented by the area underneath the demand curve and above the market price.

Producer surplus

The difference the price producers are willing and able to supply a product for and the price they get in the market. Producer surplus is shown by the area above the supply curve and below the price.

Indirect tax

A tax imposed by the government that increases the supply costs faced by producers. The amount of the tax is always shown by the vertical distance between the two supply curves.

Specific tax

A set tax per unit. For example £1 tax per unit.

Ad valorem tax

A percentage tax. For example 20% on total price.

Subsidy

Any form of government support offered to producers and consumers. It does not have to be repaid. A subsidy paid to producers cause an outward shift of the supply curve, leading to a lower equilibrium price and an increase in the quantity sold. It reduces costs of production.

Justifications for a subsidy (4)

1. Helping poorer families with food and child care

2. Encourage output and investment in certain sectors

3. Reduce the cost of training and employing workers

4. Higher income distribution - lower unemployment