How markets work 1.2

underlying assumptions of rational economic decision making

• consumers aim to maximise utility- utility is the satisfaction gained from consuming a product

• Firms aim to profit maximise- to keep shareholders happy

• Governments aim to maximise social welfare- governments are voted in by the public and work for the public

Demand

the ability and willingness to buy a particular good at a given price and at a given moment

movements and shifts along the demand curve

• change in price or qty of the good

conditions of demand

• population- demand would increase

• income- if income increases demand increase as they can afford to buy more

• related goods- complements or substitutes

• advertising

• seasons

• taste

Diminishing marginal utility

• the satisfaction derived from the consumption of an additional unit of good will decrease as more of a good is consumed

• demand slopes downwards, if more of a good is consumed, there is less satisfaction derived from the good, consumers are less willing to pay high prices at high quantities since they are gaining less satisfaction

elasticity of demand

• An attempt to measure the responsiveness of quantity demanded to changes in price

PED formular

% change in qty demanded/ % change in price

value of unitary

PED=1

• a change in price does not affect total revenue

value of relative elastic PED

PED>1

relatively inelastic PED

PED<1

perfectly elastic PED

infinity

• A decrease in price leads to an increase in revenue

• An increase in price leads to a decrease in revenue

perfectly inelastic PED

0

• A decrease in price leads to a decrease in revenue

• An increase in price leads to an increase in revenue

Factors affecting PED

• substitutes

• time - st, lt

• necessity

• income

• addictive

Significance of PED

• Determine the effects of the imposition of direct taxes and subsidies

• more elastic demand is = the lower the incidence of tax on the consumer

• more inelastic demand= tax is passed onto consumer, higher tax revenue to government

inelastic demand on diagram (subsidy)

elastic demand on diagram (subsidy)

inelastic demand diagram (tax)

Shift from S1 to S2 is a result of the imposition of indirect tax

Income elasticity of demand

• the responsiveness of demand to a change in income

YED formular

% change in qty demanded/ % change in income

value of an inferior good

• YED<0

• a rise in income will lead to a fall in demand for the good

Value of a normal good

YED>0

• a ride in income will lead to a rise in demand for good

value of luxury good

YED>1

Significance of YED

• Important for businesses to know if their sales will be affected by changes in the income for the population

• Impact the of good that a firm produces

Cross elasticity of demand

the responsiveness of demand for one good to a change in price for another

• % change in qty demanded of A/ % change in price of B

Substitutes

• XED>0

• An increase in the price of good B will increase demand for good A

Complementary

• XED<0

• An increase in the price of good B will decrease demand for good A

Unrelated goods

XED=0

• change in the price of good B has no impact on good A

Significance of XED

• Firms need to be aware on their competition and how changes by other firms will impact them

Supply

• The willingness to provide a good or service at a particular price at a given moment

Movement of supply

• caused by a change in the price of a good

Shift in supply

The amount of goods being supplied

Conditions of supply

• cost of production 

• Price of other goods

• Weather

• Technology

• subsidies ad tax

Why is supply upward sloping

• If prices are higher, firms will increase production to take advantage of the high profits they can make

• Higher prices will encourage new firms to enter

Price elasticity of supply

• The responsiveness of supply to a change in price of the good

• % change in qty supplied/ % change in price

Factors affecting PES

• Time

• Stocks

• Availability of factors of production

• Availability of substitutes

Price determinism

• The equilibrium point is the point in which there are no forces bringing about change

• supply is equal to demand

Excess demand

• if price is set below equilibrium there is excess demand

• will lead to a contraction in demand

Excess Supply

• If price is set higher than the equilibrium there is excess supply

• firms have unsold goods

Price mechanism

• Allocates resources

• Price is determined by the interactions of demand and supply

• Adam smith described the invisible hand

Rationing

• the price system is a way of rationing goods because when price increases some people may not be able to afford the product

• limiting resources for those who can afford them and value them the most highly

Signalling

• Where resources should be used

• Price indicates to suppliers and consumers that market conditions have changed so they should change the qty bought and sold 

Incentive

• Acts as an incentive for people to work hard

• more money more goods they can buy

Consumer surplus

• the difference between what consumers are willing to pay and what they actually pay

• (top part of diagram)

Producer surplus

• The difference between the price that the supplier is willing to produce their product at and the price they actually produce at

• ( bottom part of diagram)

CS and PS diagram

• show economic gain from buying and selling of goods

Indirect taxes

tax on expenditure where the person who is ultimately charged the tax is not the person responsible for paying the sum to the government

• ad valorem

• specific tax

Ad valorem

• where the tax payable increases in proportion to the good

• VAT 

Specific tax

• where an amount is added to the price

• excise duties

Impacts of tax

• increase in the cost of production

• consumer sees higher prices and sufferes from a tax burden

• producer sees a rise in costs and a fall in output

CB and PB of tax

CB and PB ad valorem

Incidence of tax

• the tax burden on the tax payer

Subsidies 

• A grant given by the government and is the opposite of a tax

• An extra payment to encourage production/ consumption of a good/ service

Subsidy on a diagram

• increase in supply

• producer sees a fall in production costs

• rise in output

• total shaded area is gov spending

consumer behaviour

• aim to maximise utility

• companies aim to maximise profit

• governments aim to maximise welfare of citizens

• influences of other people

• influence of habitual behaviour

• consumer weakness at computation- consumers arent willing or able to make comaprisons between prices and so they will buy more expensive goods than needed