Price mechanisms and decision making (Theme 1 CC3)

Signalling Function

Helps to determine where and how resources should be allocated. If prices increase, this signals to producers that demand is high and that they should increase production by shifting resources away from other goods/services.

Allocative efficiency

A state of the economy in which production is in accordance with consumer preferences; in particular, the right amount of every good or service is produced using the right amount of resources.

Incentive Function

Prices give producers the motivation either to increase or decrease the quantity they supply. A rising price gives producers the motive to increase the quantity supplied, as the higher price may allow them to earn higher revenues and higher profits.

Rationing Function

When demand is greater than supply, prices are bid up so that the good/service is rationed out to those who can afford to pay.

Consumer sovereignty

Attributed to the signalling function: Role of consumer as ruler of the market when determining the types of goods and services produced

Quantitative Easing

The introduction of new, digital money into the money supply by a central bank in order to stimulate demand.

Stocks and shares Market

A general term used to describe all transactions involving the buying and selling of stock shares issued by a company.

Stock

Form of debt or IOU issued by companies or governments which has to be repaid at a certain point with a certain rate of interest.

Ordinary Share

A type of share issued in a firm. These shareholders have ownership and voting rights in the firm and the dividend they receive depends on the profits made by the firm.

LTD

Private limited company, do not have to offer their shares to the general public.

Public limited company (PLC)

A limited company, often a large business, with the legal right to sell shares to the general public - share prices are quoted on the national stock exchange such as the London Stock Exchange.

Limited Liability

A form of shareholder ownership in which the owners are liable only up to the amount of their individual investments.

Commodity

A raw, unprocessed material or primary agricultural product that can be bought and sold, such as copper or coffee.

Soft Commodities

Commodities which can be grown, such as coffee, sugar, tea or maize alongside wild, natural occuring products.

Hard commodities

Natural resources that must be mined or extracted, such as gold, rubber, and oil

Foreign Exchange Market

A market for converting the currency of one country into that of another country

fixed exchange rate

An exchange rate policy under which a government commits itself to keep its currency at or around a specific value in terms of another currency or a commodity, such as gold.

floating exchange rate

An exchange rate determined by free market forces of demand and supply.

Portfolio Investment

Investment in a foreign country via the purchase of stocks or bond. Portfolio investors do not exercise managerial control of the foreign operation.

Herding Behaviour

When people do what others are doing instead of relying on their own information in decision-making. It is often referred to in the area of consumer and investor behaviour, as a source of rational or irrational decision making.

Bounded rationality

A set of boundaries or constraints that tend to complicate the rational decision-making process, could be determined by complex choices, imperfect information and a lack of desire to use time or effort to get more information.

Heuristics

Mental shortcuts or "rules of thumb" that often lead to a solution in order to simplify complex tasks and make efficient decision making such as brand loyalty and 'relative' prices.

diminishing marginal utility

Decreasing satisfaction or usefulness as additional units of a product are acquired, eventually marginal utility could turn negative.

Confirmational Bias

The tendency to collect and interpret new evidence as confirmation on one's existing beliefs or theories, rather than seeking other evidence which could potentially discredit our own hypothesis.

Loss aversion

The strong tendency to regard losses as considerably more important than gains of comparable magnitude—and, with this, a tendency to take steps (including risky steps) to avoid possible loss.

Nudge

A feature in the environment that attracts our interest and the decisions we make in order to provoke a response, often trying to make us make a better decision for our health. Examples could be having to walk through the salad bar at Pizza Hut to get to the Pizza.

Reasons why consumers may not behave rationally

Influence of other people's behaviour - "social norms"

The importance of habitual behaviour

Consumer weaknesses at computation

Bubbles

When animal spirits take over and there is overconfidence, leading to a situation in which the price of an asset is often overinflated from its fundamental market value

Methods of nudges

Default settings, simplification, warning consumers.

Choice Architecture

Otherwise known as nudges; A framework setting out different ways in which choices can be presented to consumers, and the impact of that presentation on consumer decision making

Framing

The way a product is presented to us, such as health details on a food product or price information on a product itself)

Types of choices

Default (Opt out schemes such as organ donation), Mandated (Have to decide one way or the other such as recycling), Restricted (Bans on certain consumption decisions such as designated smoking areas)