Edexcel A-level Economics Theme 1 - 1.2 How Markets Work

A complete set of 77 vocabulary flashcards covering Edexcel A-level Economics Theme 1 - 1.2 How markets work, including demand, supply, elasticities, equilibrium, the price mechanism, economic surpluses, taxes, and subsidies.

Utility

The theoretical measure of satisfaction, value, or pleasure a consumer gets from consuming a good or service.

Rational Decision Making for Consumers

Where consumers allocate their expenditure on goods and services to maximize utility.

Rational Decision Making for Producers

Where producers allocate their resources to maximize profits.

Rational Decision Making for Governments

Where governments aim to maximize social welfare (meeting basic needs and achieving a minimum standard of well-being).

Demand

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

Demand Curve

A curve that slopes downward because price and quantity have an inverse (negative) relationship.

Movement Along the Demand Curve

A change caused solely by a change in price, leading to either an expansion (quantity demanded goes up) or a contraction (quantity demanded goes down).

Shift in Demand (PIRATES)

A shift in the demand curve caused by non-price factors: Population, Indirect Tax, Related goods, Advertisement, Trends, Expectation, and Seasonality.

Rationality Assumption in Consumer Spending

The economic assumption that consumers will behave rationally, spending their money according to what yields the greatest level of satisfaction (utility).

Marginal Utility

The additional satisfaction that a consumer gains from consuming one additional unit of a product.

Law of Diminishing Marginal Utility

The economic principle stating that the utility gained from consuming an additional unit of a good decreases as more of that good is consumed (ceteris paribus for other goods), meaning consumers will only buy more if the price falls.

Income Effect

When the price of a good drops, a consumer's effective purchasing power rises; they feel richer because they spend less on that item and consequently demand more.

Substitution Effect

When an item becomes cheaper, it appears more attractive compared to more expensive alternatives, leading consumers to demand more of it.

Three Reasons Why the Demand Curve Slopes Downwards

The Law of Diminishing Marginal Utility, the income effect, and the substitution effect.

Percentage Change Formula

$$\left(\frac{\text{New value} - \text{Old value}}{\text{Old value}}\right) \times 100$$

Price Elasticity of Demand (PED)

A measure of the responsiveness of the change in quantity demanded to a change in price.

Price Elasticity of Demand Formula

$$\frac{\%\Delta \text{quantity demanded}}{\%\Delta \text{price}}$$

Unitary Price Elasticity of Demand

A situation where the percentage change in quantity demanded equals the percentage change in price ($PED = 1$).

Price Inelastic Demand

A situation where quantity demanded is relatively unresponsive to a change in price ($PED < 1$).

Perfectly Price Inelastic Demand

A situation where quantity demanded does not change at all with price changes ($PED = 0$), represented by a vertical demand curve.

Price Elastic Demand

A situation where quantity demanded is relatively responsive to a change in price ($PED > 1$).

Perfectly Price Elastic Demand

A situation where buyers will purchase all they can obtain at a given price but none at a higher price ($PED = \infty$), represented by a horizontal demand curve.

Factors Influencing PED

The four main determinants: availability of substitutes, addictiveness of the product, time period, and necessity.

Availability of Substitutes (Impact on PED)

A high availability of substitutes results in an elastic $PED$ because consumers are incentivized to switch to lower-priced alternatives.

Addictiveness of Product (Impact on PED)

Addictive products have an inelastic $PED$ due to habitual consumption, causing consumers to behave irrationally.

Time Period (Impact on PED)

In the short term, consumers are less responsive to price increases (inelastic $PED$); in the long term, consumers adjust and find substitutes (elastic $PED$).

Necessity (Impact on PED)

Necessities have an inelastic $PED$ because consumers must still buy them even when prices rise (e.g., petrol, diesel, water).

Significance of PED

It determines the economic incidence and effects of the imposition of indirect taxes and subsidies.

Impact of PED on Indirect Tax Incidence

When demand is elastic, the producer tax burden is higher than consumer burden; when demand is inelastic, the producer tax burden is lower than consumer burden.

Impact of PED on Subsidies

When demand is elastic, the producer gain is higher than consumer gain; when demand is inelastic, the producer gain is lower than consumer gain.

Total Revenue

$$\text{Price} \times \text{Quantity}$$

Income Elasticity of Demand (YED)

A measure of how responsive the change in quantity demanded is to a change in consumer income, used to classify types of goods.

Income Elasticity of Demand Formula

$$\left(\frac{\%QD}{\%Y}\right) \times 100$$

Normal / Necessity Good (YED)

A good with positive $YED$ between $0$ and $1$ ($0 < YED < 1$), meaning demand is income inelastic and relatively less responsive to changes in income.

Luxury Good (YED)

A good with $YED > 1$, meaning demand is income elastic and relatively more responsive to a change in income.

Inferior Good (YED)

A good with $YED < 0$, meaning quantity demanded decreases as consumer income increases.

Factors Influencing YED

Any factors in an economy that alter the wages or salaries of workers.

Significance of YED

Guides firms on which goods to produce to maximize profits (e.g., shifting toward luxury goods in times of economic prosperity).

Cross Price Elasticity of Demand (XED)

Reveals how responsive the change in quantity demanded for Good A is to a change in the price of Good B.

Cross Price Elasticity of Demand Formula

$$\left(\frac{\% QD \text{ of Good A}}{\% \text{Price of Good B}}\right) \times 100$$

Complementary Goods (XED)

Goods in joint demand with $XED < 0$ (e.g., Gin & Tonic); a fall in the price of one raises demand for the other, with more negative values indicating stronger complementary ties.

Substitute Goods (XED)

Goods in competitive demand with $XED > 0$ (e.g., Coke & Pepsi); a rise in the price of one raises demand for the other, with higher positive values indicating stronger substitutability.

Unrelated Goods (XED)

Goods with $XED = 0$ (e.g., potatoes & cars), indicating no economic relationship between the products.

Significance of XED

Allows firms seeking to maximize revenue to adjust their pricing strategies for substitute and complementary goods.

Supply

The ability and willingness to provide a good or service at a particular price at a given moment in time.

Supply Curve

An upward sloping curve reflecting a direct relationship between price and quantity supplied.

Movement Along the Supply Curve

A change caused solely by price, resulting in an expansion when price increases or a contraction when price decreases.

Shift in Supply (PINTSWC)

A shift in the supply curve caused by non-price factors: Productivity, Investment, Number of firms, Technology, Subsidy / Tax, Weather, and Costs of production.

Law of Supply

The economic principle stating that when price increases (ceteris paribus), producers will increase quantity supplied, and vice versa.

Law of Diminishing Returns

Adding more of one factor of production (e.g., labor) while holding others constant (e.g., land or equipment) eventually yields lower per-unit output gains, driving up production costs and requiring higher selling prices.

Reasons Why the Supply Curve Slopes Upwards

The profit incentive (Law of Supply) and the Law of Diminishing Returns.

Price Elasticity of Supply (PES)

The responsiveness of supply to changes in price, calculated as $PES = \frac{\%QS}{\%P}$.

Unitary Elastic Supply

A condition where the percentage change in quantity supplied equals the percentage change in price ($PES = 1$).

Relatively Elastic Supply

A condition where quantity supplied is proportionally more responsive to changes in price ($PES > 1$).

Perfectly Elastic Supply

A condition where producers will supply an infinite quantity at a given market price, represented by a horizontal supply curve.

Relatively Inelastic Supply

A condition where quantity supplied is proportionally less responsive to changes in price ($PES < 1$).

Perfectly Inelastic Supply

A condition where quantity supplied does not respond to price changes at all ($PES = 0$), represented by a vertical supply curve.

Factors Affecting PES

Mobility of factors of production, availability of raw materials, ability to store goods, and time period.

Mobility of Factors of Production (Impact on PES)

If producers can switch resources between products quickly and easily, $PES$ will be higher (more elastic).

Availability of Raw Materials (Impact on PES)

If raw materials are scarce, $PES$ will be low (inelastic); if they are abundant, $PES$ will be higher.

Ability to Store Goods (Impact on PES)

If products can be stored easily as inventory, $PES$ will be higher (more elastic).

Time Period (Impact on PES)

In the short run, supply is relatively inelastic because altering production takes time; in the long run, all factors of production can be varied, making supply elastic.

Equilibrium Price

The market clearing price where quantity demanded equals quantity supplied ($QD = QS$) at the intersection of the demand and supply curves.

Excess Supply

A market condition occurring when the quantity supplied exceeds the quantity demanded ($QS > QD$) at the current market price, creating a surplus.

Excess Demand

A market condition occurring when the quantity demanded exceeds the quantity supplied ($QD > QS$) at the current market price, creating a shortage.

Adam Smith's Invisible Hand

The concept describing how the price mechanism functions automatically in a free market to allocate scarce resources.

Price Mechanism

The interaction of market forces (demand and supply) to determine market clearing prices and allocate resources, resolving what, how, and for whom to produce.

Rationing Function of the Price Mechanism

The mechanism by which rising prices allocate scarce resources to those who can afford them, while falling prices clear surpluses so more consumers can purchase.

Signalling Function of the Price Mechanism

The mechanism by which prices provide information to producers and consumers regarding where resources are required (rising prices) and where they are not (falling prices).

Incentive Function of the Price Mechanism

The mechanism where higher prices encourage producers to allocate resources toward a market to maximize profits, while lower prices incentivize reallocation away to new markets.

Consumer Surplus

The difference between what consumers are willing to pay for a good and what they actually pay, represented graphically by the area beneath the demand curve and above the market price.

Producer Surplus

The difference between the market price firms receive and the price at which they are willing to supply, represented graphically by the area above the supply curve and below the market price.

Specific Tax

A fixed tax levied per unit of output regardless of the good's value (e.g., excise duties), causing a parallel upward shift in the supply curve.

Ad Valorem Tax

A tax levied as a percentage of the price of a good or service; the absolute tax increases as price rises, making the new supply curve steeper than the original.

Deadweight Loss (Welfare Loss)

The loss of total economic welfare to society when a market fails to operate in competitive equilibrium.

Indirect Taxes

Taxes levied on the purchase of goods and services (encompassing specific and ad valorem taxes), represented graphically by an inward shift of the supply curve.

Subsidy

A government grant paid to producers that lowers production costs and incentivizes an increase in output, shown graphically by an outward shift of the supply curve.