1.2 How Markets Work

What are the underlying assumptions of rational economic decision making?

Underlying assumptions of rational economic decision making=

• consumers aim to maximise utility(economic welfare)

• firms aim to maximise profits

• governments aim to maximise social welfare

How do consumers aim to maximise utility (economic welfare)?

Consumers aim to maximise utility (economic welfare)=

• rational consumer (Homo Economicus) who makes decisions by calculating the utility gained from each decision and chooses the one that will give them the most satisfaction

How do firms aim to maximise profit?

Firms aim to maximise profit=

• Neo-classical theory assumes that the owners of firms want to maximise their reward from ownership and so aim to maximise profit to keep shareholders happy

How do goverments aim to maximise social welfare?

Governments aim to maximise social welfare=

• as goverments are voted in by the public and work for the public, so should maximise their satisfaction by taking decisions which increases social welfare

What is demand?

Demand= quantity of a good/service that consumers are willing and able to buy at a given time in a given time period

What is the law of demand?

Law of demand= there is an inverse relationship between price and quantity demanded

• as prices increases, quantity demanded decreases

• as prices decreases. quantity demanded increases

What is the diagram for the demand curve- when there is a change in price?

When does contraction of demand happen on the demand curve? 

Contraction of demand happens when the price increases

When does extension (expansion) of demand happen on the demand curve?

Extension(expansion) of demand happens when price decreases

Why does the demand curve slope downward?

Demand curve slope downward=

• income effect

• substitution effect

• (law of diminishing marginal utility)

What is the income effect, and how does that affect the demand curve?

Income effect=

• as prices rise, purchasing power of income decreases

• consumers are less able to buy the same quantity of goods & services

• leads to a contraction in demand

What is the substitution effect, and how does that affect the demand curve?

Substitution effect=

• as prices rises, other goods and services become relatively price- competitive 

• consumers switch their consumption towards these alternatives 

• leads to a contraction in demand for original good or service

What is the diagram for the demand curve, when non-price factor affects demand?

What happens as non- price factor affects demand? 

Non- price factor affects demand=

• increase in demand= shift to the right 

• decrease in demand= shift to the left

AT THE SAME PRICE

What are the non-price factors causing shifts in demand curve?

Non-price factors causing shifts in demand curve→

PAC_SIFIC

• Population

• Advertising

• Substitute’s price

• Income

• Fashion/tastes

• Interest rates

• Complement’s price

How does Population (non-price factor) cause shift in demand curve?

Population (non-price factor) causes shifts in demand curve=

• Increase in population, increase in demand (shift to right)

• Decrease in population, decrease in demand (shift to left)

How does Advertising (non-price factor) cause shift in demand curve?

Advertising (non-price factor) causes shift in demand curve=

• Effective advertising, increases willingness to buy, shift to right

• Bad advertising decreases willingness to buy, shift to left

How does Substitute’s price (non-price factor) cause shift in demand curve?

Substitute’s price (non-price factor) causes shift in demand curve=

• if price of substitute good increases, demand for original good increases (shift to right)

• if price of substitute good decreases, demand for original good decreases (shift to left)

How does income (non-price factor) cause shift in demand curve?

Income (non- price factor) causes shift in demand curve=

• For normal goods, as income increases, demand increases (shift to right)

• For normal goods, as income decreases, demand decreases (shift to left)

• For inferior goods, as income increases, demand decreases (shift to left)

• For inferior goods, as income decreases, demand increases (shift to right)

i.o.n.s

What are examples of normal and inferior goods?

Examples of=

• normal goods= luxury cars, designer clothing

• inferior goods= fast food

How does Fashion/tastes (non-price factor) cause shift in demand curve?

Fashion/tastes (non-price factor) causes shift in demand curve=

• if a good becomes more fashionable, demand increases (shift to right)

• if a good becomes less fashionable, demand decreases (shift to left)

How does Interest rates (non-price factor) cause shift in demand curve?

Interest rates (non-price factor) causes shift in demand curve=

• lower interest rates; borrowing cheaper; demand increases for goods bought with loans (shift to right)

• higher interest rates; borrowing more expensive; demand decreases (shift to left)

How does Complement’s price (non-price factor) cause shift in demand curve?

Complement’s price (non-price factor) causes shift in demand curve=

• price of complementary good increases, demand decreases for original good

What is the law of diminishing marginal utility?

Diminishing marginal utility= extra benefit gained from consumption of a good- declines as extra units are consumed

(marginal utility meaning the change in satisfaction)

How does the law of diminishing marginal utility influence the shape of the demand curve?

Law of diminishing marginal utility influence the shape of the demand curve=

Indicates why demand curve slopes downward as 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 quanitities since they are gaining less satisfaction

What is change in quantity demanded?

Change in quantity demanded= change in price → movement ALONG the curve

What is change in demand?

Change in demand= change in non-price factors → SHIFTS curve left or right

What is price(own) elasticity of demand (PED)? 

Price elasticity of demand (PED)= responsiveness of quantity demanded given a change in price

What is the equation for price elasticity of demand?

Price elasticity of demand= % change in quantity demand/ % change in price

What is perfectly inelastic?

Perfectly inelastic= QD doesn’t change as price changes, PED=0

What is relatively inelastic?

Relatively inelastic= QD changes by smaller % than price, PED<1

What is unitary elastic?

Unitary elastic= QD changes by same % as price, PED=1

What is relatively elastic? 

Relatively elastic= QD changes by larger % than price, PED>1

What is perfectly elastic?

Perfectly elastic= QD falls to 0 at any price increase, PED= infinity

What are the factors affecting PED?

Factors affecting PED=

• (no. of) Substitutes

• Percentage of income

• Luxury/necessity

• Addictive/ habit- forming

• Time period

SPLAT

How does the number of substitutes affect PED?

(No. of) substitutes affects PED=

• more substitutes= more price elastic demand

• fewer substitues= more price inelastic demand

How does the percentage of income affect PED?

Percentage of income affects PED=

• larger % of income= more price elastic demand

• smaller % of income= more price inelastic demand

How does luxury/ necessity affect PED?

Luxury/necessity affects PED=

• luxuries= more price elastic demand

• necessities= more price inelastic demand

How does addictive/ habit-forming (goods) affect PED?

Addictive/habit-forming (goods) affects PED=

• addictive goods= more price inelastic demand

• habit-forming goods= more price inelastic demand

How does the time period affect PED?

Time period affect PED=

• short-run= more price inelastic demand

• long-run= more price elastic demand

What is elasticity?

Elasticity= how much the quantity demanded (QD) will be affected by a change in price/ income/ other factor

• responsiveness

What is the diagram for relatively price inelastic?

Diagram for relatively price inelastic=

• steeper demand curve

What is the diagram for relatively price elastic?

Diagram for relatively price elastic=

• less steep demand curve

What is the relationship between price and total revenue, depending on its elasticity of demand?

Relationship between price and total revenue, depending on its elasticity of demand=

• if demand is price elastic, then the effect is opposite

  • price increases→ TR decreases, vice versa

• if demand is price inelastic, then the effect is the same

  • price increases→ TR increases

E.O.I.S

(elastic, opposite, inelastic, same)

What happens to the total revenue if the demand is price elastic?

If the demand is price elastic

1. price increase, total revenue decreases

2. price decrease, total revenue increases

What happens to the total revenue if the demand is price inelastic? 

If the demand is price inelastic

1. price increase, total revenue increases

2. price decrease, total revenue decreases

What’s the diagram for elastic demand between price, Qty and total revenue?

What’s the diagram for inelastic demand between price, Qty and total revenue?

How to calculate total revenue?

Total revenue= price x quantity demanded

What is supply?

Supply= quantity of a good or service producers are willing and able to produce at a given time period 

What is the law of supply?

Law of supply= there is a direct relationship between price and quantity supplied

• as price increases, quantity supplied increases

• as price decreases, quantity supplied decreases

What is the diagram for supply curve when there is a change in price?

Why is there a direct relationship between price and quantity supplied?

There is a direct relationship between price and quantity supplied is= profit motive

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

• if the prices are lower, firms will cut back on any profitable production, supply will decrease

  • to increase production, you will need to use up more resources, which will cost more-will only want to do this if you are going to receive more money → assumes cost of producing a unit increase as output increase (rising marginal costs)

• quantity increases→ costs of production are likely to increase for suppliers, therefore suppliers want a higher price to cover their increased costs of production and maintain their profit margins

What are the costs of production?

Costs of production=

• lower costs of production= firms willing to supply more at the same price

• higher costs of production= firms less willing to supply at same price

What are the non-price factors causing shifts in supply?

Non-price factors causing shifts in supply=

PINTSWC

• Productivity (output per worker per time period)

• Indirect taxes (tax on production that firms have to pay)

• Number of firms

• Technology

• Subsidy (money grant from government to producers to lower costs of production)

• Weather

• Costs of production

What are the effects of productivity on the supply curve?

Effects of productivity on the supply curve=

• increase in productivity, cost of production decrease, shift curve to right

• decrease in productivity, cost of production increase, shift curve to left

What are the effects of indirect taxes on the supply curve?

Effects of indirect taxes on the supply curve=

• increase in indirect tax, cost of production increase, shift to left

• decrease in indirect tax, cost of production decrease, shift to right

What are the effects of the number of firms on the supply curve?

Effects of the number of firms on the supply curve=

• increase in number of firms in market, shift curve to right

• decrease in number of firms in market, shift curve to left

What are the effects of technology on the supply curve?

Effects of technology on the supply curve=

• improvements in technology, costs of production decrease, shift curve to right

• worsening technology, costs of production increase, shift curve to left

What are the effects of subsidy on the supply curve?

Effects of subsidy on the supply curve=

• increase in subsidy, cost of production decrease, shift curve to right

• decrease in subsidy, cost of production increase, shift curve to left

What are the effects of weather on the supply curve?

Effects of weather on the supply curve=

• good weather conditions allow increase in supply, shift curve to right

• bad weather conditions decrease supply, shift curve to left

What are the effects of the costs of production?

Effects of the costs of production=

e.g →

• transport costs

• labor costs

• oil prices

• raw material prices

• utilities (gas, electricity, water, internet)

• rent

• government regulations (health and safety standards, environmental policies)

• costs of production increase, shift curve to left

• costs of production decrease, shift curve to right

What is the diagram for the supply curve- when non-price factor affects supply?

What are the PES figures always?

PES figures are always positive as the supply curve has an upwards slope

What are the diagrams for the price elasticity of supply?

What are the factors affecting PES?

Factors affecting PES=

PSSST

• Production lag

• Stocks

• Spare capacity

• Substitutability of factors of production

• Time

How does production lag affect PES?

Production lag affect PES=

• longer production lag for a good or service, more price inelastic supply

• shorter production lag for a good or service, more price elastic supply

How do stocks affect PES?

Stocks affect PES=

• larger (higher) level of stocks, more price elastic supply

• lower level of stocks, more price inelastic supply

How does spare capacity affect PES?

Spare capacity affects PES=

• more spare capacity, more price elastic supply

• low spare capacity, more price inelastic supply

How does substitutability of factors of production affect PES?

Substitutability of factors of production affect PES=

• more substitutable factors of production, more price elastic supply

  • e.g business can move more workers and machinery from cars to vans

• less substitutable factors of production, more price inelastic supply

How does time affect PES?

Time affects PES=

• short-run (at least 1 fixed factor of production), more price inelastic supply

• long-run (all factors of production are variable), more price elastic supply as it is easier to increase or decrease production

What is the difference between change in quantity supply and change in supply?

• Change in quantity supplied= change in price so moving along the curve

• change in supply= change in non-price factors so shifts curve left or right

What is equilibrium point?

Equilibrium point= refers to a point at which there are no more forces bringing about change

What is price equilibrium?

Price equilibrium= where supply is equal to demand (allocative efficiency)- this price is a.k.a market clearing as all products supplied to the market are cleared (bought), but no buyers are unable to buy the good

What is disequilibrium?

Disequilibrium= where demand doesn’t equal supply

• even if the market is not at equilibrium, the free market (any place where buyers meet suppliers to exchange goods and services, free from government intervention) has special functions that will always return market back to equilibrium

What is the diagram for price equilibrium?

What is excess demand?

Excess demand (shortage)is where price is below equilibrium e.g. waiting lists

1. Price rises= firms see high demand and consumers are willing to pay more→ upward pressure on prices

2. Signal excess demand to consumers and producers and need for more resources

3. Incentivise firms to increase their output to increase profit (via extension on the supply curve) WHY?→ new firms might enter market, existing firms might invest in more capacity or use existing spare capacity

4. Ration scarce resources by discouraging consumption (via contraction on the demand curve)

5. Allocate scarce resources efficiently

What is excess supply?

Excess supply (surplus) is where price is above equilibrium e.g empty restaurant tables

1. Price falls= firms realise they’re not selling what they are producing→ downward pressure on prices

2. Signal excess supply to consumers and producers and need for less resources

3. Incentivise firms to decrease their output to increase output (via a contraction on supply curve) WHY?→ firms leave the market if they can’t compete at lower prices or existing firms decrease production capacity

4. Ration scarce resources by encouraging consumption (via an extension on demand curve)

5. Allocate scarce resources efficiently

What are the different microeconomic equilibrium shifts?

What are the three functions of the price mechanism?

3 functions of the price mechanism=

• rationing function

• signalling function

• incentive function

What is the rationing function of the price mechanism?

Rationing function of the price mechanism= when changes in price lead to more or less being produced, so increasing or limiting the quantity demanded by buyers

What is the signalling function of the price mechanism?

Signalling function of the price mechanism= when changes in price give information to buyers and sellers which influence their decisons to buy and sell

What is the incentive function of the price mechansim?

Incentive function of the price mechanism= when changes in price encourage buyers and sellers to change the quantity they buy and sell. A rise in price encourages buyers to buy less and sellers to produce more; and vice versa

What is the price mechanism in the context of local market?

Price mechanism in the context of local market= coronavirus pandemic disrupted supply chains across the planet, and many countries have blocked M to prevent spread of virus e.g. British supermarkets, less M from other countries means there are fewer goods on supermarket shelves. As demand for food is high, but supply is low, price of food rises to ration off excess demand so consumers who value the food most highly buy them → e.g of rationing function

What is the price mechanism in the context of national market?

Price mechanism in the context of national market=

• price of housing differs across the UK (high in the south and low in the north). As population of London is high relative to the rest of the UK, house prices will increase through rationing function i.e to ration off excess demand and only provide houses to those who value them the most.

• High house prices in London also offer incentive for firms to allocate resources to more house production, as there’s more profit to be made → e.g. of incentive function

What is the price mechanism in context of global market?

Price mechanism in context of global market= In 1973, the organisation for petroleum exporting countries (OPEC) procalimed restricted oil supply on a high scale, due to geopoltical factors regarding America and the Middle East. This sent price of oil at record- breaking levels across the planet, as oil was an invaluable resource to countries → e.g. of rationing function as disequilibrium of supply and demand meant high prices deterred consumers who didn’t value oil highly, which left market open only to those consumers who did. By increasing price of oil, market returned to equilibrium state

What is consumer surplus?

Consumer surplus= difference between the price consumers are willing and able to pay for a good or service and the price they actually pay

What is producer surplus?

Producer surplus= difference between the price producers are willing and able to supply a good or service for and the price they actually receive

What is society surplus? 

Society surplus= consumer surplus + producer surplus 

• insert pic 

What happens to the consumer surplus and the producer surplus when the price increases, due to shift in supply curve?

What happens to the consumer surplus and the producer surplus, when the price increases, due to shift in demand curve?

What is Income elasticity of demand (YED)?

Income elasticity of demand (YED)=

responsiveness of demand to a change in income

What is the equation for YED?

Equation for YED=

percentage change in quantity demanded/ percentage change in income

Why do normal (luxury) goods have a postive sign when YED>0?

Normal (luxury) goods have a positive sign when YED>0=

• as income increases, demand increases

• as income decreases, demand decreases

Why do inferior goods have a negative sign when YED<0?

Inferior goods have a negative sign when YED<0=

• as income increases, demand decreases

• as income decreases, demand increases

How does the income elasticity differ when it is a normal good?

For a normal good=

• if YED>1, demand is income elastic, so normal luxury

• if YED<1, demand is income inelastic, so normal necessity

How does the income elasticity differ when it is an inferior good?

For an inferior good=

• if YED>1, demand is income elastic

• if YED<1, demand is income inelastic

What is a normal luxury good?

Normal luxury good=

as income rises, demand for these goods increases significantly. People buy a lot more when they get richer e.g. designer clothes

What is a normal necessity good?

Normal necessity good=

as income rises, demand for these goods increases slightly. People already buy these, so getting richer doesn’t change deamnd much e.g basic food items

What is an inferior good?

Inferior good=

as income rises, demand for these goods fall. People switch to better alternatives when they can afford them e.g. store- brand products