1.2 : how markets work

This set covers key economic concepts including rational decision making, demand and supply mechanics, various elasticities (PED, YED, XED), market equilibrium, and taxation based on the lecture notes provided.

Rational economic decision making

The principle that rational agents will select the choice that presents the highest benefits.

Consumer Aim

To maximise utility (satisfaction) by comparing the marginal utility per unit of cost across goods and services.

Marginal utility

The extra utility gained from the consumption of an additional unit of a product.

Firm Aim

To maximise profits by making production and pricing decisions that maximise the total revenue.

Demand

The amount that consumers are willing and able to buy at a given price.

Effective demand

A want backed up with the ability to pay.

The law of demand

The inverse relationship between price and quantity demanded; as price increases, quantity demanded falls.

Income effect

When the price of a good rises, real income and purchasing power fall, making people feel poorer and buy less.

Substitution effect

When the price of a good becomes more expensive relative to another, causing the consumer to switch to a cheaper good.

Contraction in demand

A movement along the demand curve caused by a price increase.

Extension in demand

A movement along the demand curve caused by a price decrease.

factors affecting demand

PASIFIC: Population, Advertising, Substitute goods, Interest rates, Fashion/trends, Income, and Complementary goods.

Elasticity

Measures the responsiveness of a change in quantity demanded to a change in a given variable like price, income, or other goods.

Inelastic PED

A condition where the Price Elasticity of Demand is less than one ($PED < 1$).

Unitary PED

A condition where the Price Elasticity of Demand is equal to one ($PED = 1$).

Elastic PED

A condition where the Price Elasticity of Demand is greater than one ($PED > 1$).

factors affecting the price elasticity of demand

SPLAT:: Substitutes, Percentage of income, Luxury/necessity, Addictive, and Time period.

Normal good

A type of good where the Income Elasticity of Demand (YED) has a positive sign.

Inferior good

A type of good where the Income Elasticity of Demand (YED) has a negative sign.

XED (Cross price elasticity)

Measures the responsiveness of a change in quantity demanded of one good when there is a change in price of another good.

Strong substitute

A substitute good that is elastic, with a Cross price elasticity ($XED$) greater than $0$.

Supply

The amount that sellers are willing and able to sell at any given price.

factors affecting supply

PINTSWC : Productivity, Indirect tax, Number of firms, Technology, Subsidy, Weather, and Cost of production.

Market

Any place that brings buyers and sellers together to agree on a trade price.

Equilibrium

The point where demand meets supply, creating a market clearing price with no excess supply or demand.

Disequilibrium

A state where demand is not equal to supply, resulting in excess supply or excess demand.

The price mechanism

The interaction of demand and supply in a free market that determines prices to allocate scarce resources.

four functions of the price mechanism

The four functions of the price mechanism: Signal, Incentive, Rationing, and Allocative efficiency.

Consumer surplus

The difference between the price consumers are willing to pay and the price they actually pay; located below the demand curve and above the price line.

Producer surplus

The difference between the price the producer is willing to charge and the price they actually receive; located above the supply curve and below the price line.

Direct tax

Tax paid directly to the government, such as income tax or corporation tax.

Indirect tax

A tax on goods and services, categorized into specific tax and ad valorem tax.

Specific tax

A fixed amount of tax paid on every unit sold.