1.2 How markets work

1.2.1 Rational decision making

The underlying assumptions of rational economic decision making:

● Consumers aim to maximise utility: Utility is the satisfaction gained from consuming a product. The rational consumer is called Homo Economicus, who makes decisions by calculating the utility gained from each decision and chooses the one which will give them the most satisfaction.

● Firms aim to maximise profit: Economic theory assumes that firms are run for their owners and shareholders and so aim to maximise profit in order to keep the shareholders happy.

● Governments aim to maximise social welfare: Governments are voted in by the public and work for the public, so should aim to maximise their satisfaction by taking decisions which increase social welfare.

This is the basis for economic thinking, but it is currently being questioned by behavioral economists. Economic agents do not always have the information necessary to act rationally and consumers do not always make calculated decisions.

1.2.2 Demand

Demand is the ability and willingness to buy a particular good at a given price and at a given moment in time.

Movements and shifts of the demand curve:

● A movement along the demand curve, for example from A to B, is caused by a change in the price of the good. A shift of the demand curve, for example D1 to D2, is caused by a change in any of the factors which affect demand, the conditions of demand.

● A movement from A to B is a contraction in demand, the quantity demanded falls because of an increase in price. A movement from A to C is an extension in demand, the quantity demanded rises due to a decrease in price. Movements along the curve are not called increases or decreases- this only occurs when the curve shifts.

● A shift from D1 to D2 is a decrease in demand, because fewer goods are demanded at each and every price. For example, at price P only Q2 goods are demanded rather than Q1 goods. A shift from D1 to D3 is an increase in demand, as more goods are demanded at each and every price. Now, Q3 goods are demanded at price P.

The conditions of demand:

The conditions of demand are the factors which cause the demand curve to shift. A shift to the right is an increase in demand and a shift to the left is a decrease in demand. One way to remember this is the mnemonic PIRATES.

● Population: If population rises, we would expect demand for all products to increase and so the demand curve will shift to the right. This is because the more people there are in the country, the more people who will want a good.

● Income: For most goods, if income increases, demand increases because a person can afford to buy more of the product. If there is a fall in income then the demand would decrease and shift to the left. However, for some goods an increase in income can lead to a fall in demand and vice versa, this is a concept called income elasticity of demand.

● Related goods: If goods are complements or substitutes of each other then a change in the price of another good can cause a shift in the demand curve. Substitutes are where you either buy one good or the other, for example you either buy a pair of Nike trainers or a pair of Adidas trainers. An increase in the price of Nike trainers would lead to a contraction in demand for Nike trainers and an increase in demand of Adidas trainers, as we would expect people to buy them instead. Complements are goods such as DVDs and DVD players where if you have one, you need the other to go with it. If the price of DVD players drops, demand for DVD players would extend and we would expect the demand curve for DVDs to increase. This is linked to the concept of cross elasticity of demand.

Advertising: If a firm carries out a successful advertising campaign, demand is likely to increase. If a competitor firm carries out a successful advertising campaign, demand for the first firm will fall. A successful advertising campaign by Tesco will increase demand for Tesco but reduce demand for Asda.

● Taste/fashion: If something becomes more fashionable, we expect demand to increase and if it becomes less fashionable, then demand will fall.

● Expectations: Expectations of what might happen in the future can have a big impact on the level of demand for some goods. If people expect a shortage of something, or that price will rise in the future, then demand for that product will increase. If people expect that price will fall in the future, demand will decrease.

● Seasons: Some products will find their demand affected by the weather. For example, hot summers cause an increase in demand for sun cream whilst wet summers cause a decrease in demand for umbrellas.

● Government legislation can also have an effect on the demand for goods. Demand for car seats increased after the government made it a legal requirement that young children have to sit in them.

Diminishing marginal utility:

● The demand curve slopes downward, showing the inverse relationship between

price and quantity. This can be explained by the law of diminishing marginal utility.

● In order to explain or predict how people will spend their money, we have to assume that they are going to behave rationally, expecting them to spend it according to what gives them the greatest level of satisfaction or welfare.

● Total utility represents the satisfaction gained by a customer as a result of their overall consumption of a good e.g. the satisfaction of eating the whole bar of chocolate, whilst marginal utility represents the change in satisfaction resulting from the consumption of the next unit of a good e.g. the increased satisfaction by eating another bite of chocolate.

● The Law of Diminishing Marginal Utility states that the satisfaction derived from the consumption of an additional unit of a good will decrease as more of a good is consumed, assuming the consumption of all other goods remains constant.

● This explains why the demand curve slopes downwards: if more of a good is consumed, there is less satisfaction derived from the good. This means that consumers are less willing to pay high prices at high quantities since they are gaining less satisfaction.

1.2.3 Price, income and cross elasticities of demand

Elasticity of demand is an attempt to measure the responsiveness of quantity demanded to changes in other variables: its own price, the price of other goods and real income. If a good is elastic, it is relatively responsive and if it is inelastic, it is relatively unresponsive

Price elasticity of demand (PED):

This is the responsiveness of demand to a change in the price of the good.

%change in quantity demanded %change in price

Numerical values:

Most values of PED are negative, since a rise in price leads to a fall in output. Therefore, we look at the integer alone, disregarding the negative sign.

● Unitary elastic PED is where PED=1: quantity demanded changes by exactly the same percentage as price. This would be shown as a reciprocal curve.

● Relatively elastic PED is where PED>1: quantity demanded changes by a larger percentage than price so demand is relatively responsive to price. The curve will be more sloping.

● Relatively inelastic PED is where PED<1: quantity demanded changes by a smaller percentage than price so demand is relatively unresponsive to price. The curve will be steep.

● Perfectly elastic PED is where PED=infinity: a change in price means that quantity falls to 0 and demand is very responsive to price. This would be shown by a horizontal line

● Perfectly inelastic PED is where PED=0: a change in price has no effect on output so demand is completely unresponsive to price. This would be shown by a vertical line.

Factors influencing PED:

● Availability of substitutes: If a product has lots of substitutes (for example instead of buying Coke you could buy Pepsi), people will switch to other products when prices go up. Therefore, PED will be elastic. If there are no substitutes, then the demand curve will be inelastic since even if prices go up, people will have to buy that good if they want it as there are no alternatives.

● Time: The longer the time, the easier it will be for a person to find an alternative product/supplier of the product so the more elastic the good is. In the short term, many goods are inelastic as people may not even notice the price difference.

● Necessity: If you need something, the demand curve will be inelastic because even if the price goes up, you still need to buy it.

● How large of a % of total expenditure: If a good/service represents a very small percentage of a person’s expenditure, a significant increase in price will have a relatively small impact on how much they buy of that product so it will be inelastic e.g. matches.

● Addictive: If a product is addictive, then the demand curve will be inelastic. No matter how high prices are, people will still buy the good to fulfill their addiction.

Significance of PED:

● The price elasticity of demand, along with the price elasticity of supply, determine the effects of the imposition of indirect taxes and subsidies.

● The more elastic the demand curve, the lower the incidence of tax on the consumer. This means that when PED is elastic, a tax will only lead to a small increase in price and the supplier will have to cover the majority of the cost of the tax.

● When demand is inelastic, the tax will be mainly passed onto the consumer. Since consumers are relatively unresponsive to the price of this good, quantity demanded will not fall by a large amount. This means that the tax will be ineffective at reducing output. However, it also means that there is higher tax revenue for the government. The more inelastic the demand curve, the higher the tax revenue for the government.

These effects can be seen on the diagrams: the first diagram shows inelastic demand, as the demand curve is steep. The tax leads to a small fall in output but a large increase in price, with a large consumer burden. The second diagram shows elastic demand, as the demand curve is sloping. Output falls significantly and the producer burden is high. These diagrams also show that revenue generated is higher when demand is inelastic.

● With a subsidy, elastic demand means that the consumer sees a small fall in price whilst the producer gains a lot in extra revenue. The more inelastic demand, the more the price falls. Elastic demand also means there is a large change in output following a subsidy, whilst inelastic demand means that there is little change in output. Therefore, subsidies on goods with inelastic demand are ineffective at increasing output. They are cheaper for the government to impose since output increases by less and so the government have to pay the subsidy on less goods.

These effects can also be seen on the diagram. In the first diagram, demand is inelastic and there is a small rise in output but a large fall in price, with little producer gain. In the second diagram, demand is elastic and there is a large rise in output but a small fall in price. They show that the government has to spend more for subsidies on elastic goods.

The shift from S1 to S2 on tax diagrams is a result of the imposition of an indirect tax: this raises the cost of production and shifts supply to the left. The opposite occurs with a subsidy. Diagrammatic analysis of indirect taxation and subsidies is looked at in more detail at the end of this unit.

PED and revenue:

● For an elastic demand curve: A decrease in price leads to an increase in revenue and an increase in price leads to a decrease in revenue.

● For an inelastic demand curve: A decrease in price leads to a decrease in revenue and an increase in price leads to an increase in revenue.

● For a unitary elastic curve, a change in price does not affect total revenue.

Income elasticity of demand (YED):

This is the responsiveness of demand to a change in income.

%change in quantity demanded %change in income.

Numerical values:

(using the fact that output

● An inferior good is when YED<0: a rise in income will lead to a fall in demand for the good. For example, Tesco Value goods are inferior goods.

● A normal good is when YED>0: a rise in income will lead to a rise in demand for the good.

● A luxury good is a type of normal good, when YED>1.

● Goods can also be as elastic or inelastic in income. If the integer is bigger than

one, the good is elastic. If the integer is smaller than one, the good is inelastic and this tends to be necessities.

Significance of YED:

● It is important for businesses to know how their sales will be affected by changes in the income of the population. If the economy is improving and people’s incomes are rising it is vital that a business knows whether this is likely to increase their sales or not.

It may have an impact on the type of goods that a firm produces. During times of prosperity, firms might produce more luxury goods and less inferior goods.

Cross elasticity of demand (XED):

This is the responsiveness of demand for one product (A) to the change in price of another product (B).

%change in quantity demanded of A %change in price of B.

Numerical values:

● Substitutes are where XED>0: an increase in the price of good B will increase demand for good A. For example, Coca Cola and Pepsi are substitutes.

● Complementary goods are where XED<0: an increase in the price of good B will decrease demand for good A. One example is DVDs and DVD players.

● Unrelated goods are where XED=0: a change in the price of good B has no impact on good A.

● The size of the integer represents the strength of the relationship: the larger the number, the stronger the relationship between the two.

Significance of XED:

● Firms need to be aware of their competition and those producing complementary goods. They need to know how price changes by other firms will impact them so they can take appropriate action.

1.2.4 Supply

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

Movements and shifts of the supply curve:

● A movement along the supply curve, for example from A to B, is caused by a change in the price of the good. A shift of the supply curve, for example S1 to S2, is caused by a change in any of the factors which affect supply, the conditions of supply.

● A movement from A to B is a contraction in supply, the quantity supplied falls because of a decrease in price. A movement from A to C is an extension in supply, the quantity supplied rises due to an increase in price. Movements along the curve are not called increases or decreases- this only occurs when the curve shifts.

● A shift from S1 to S2 is a decrease in supply, because fewer goods are supplied at each and every price. For example, at price P only Q2 goods are supplied rather than

Q1 goods. A shift from S1 to S3 is an increase in supply, as more goods are supplied at each and every price. Now, Q3 goods are supplied at price P.

The conditions of supply:

● Costs of production: If a business has in an increase in their costs but their selling price stays the same, they will make less money on what they sell. They will put up their prices in order to avoid making a loss and so less is supplied at each price, meaning the supply curve will shift to the left. If they have a decrease in their costs, then it will shift to the right.

● Price of other goods: Joint supply is where the production of one good automatically causes the production of another goods e.g. the production of beef automatically produces leather. Therefore, if the price of beef rises, farmers will slaughter their cows and so will get more leather, causing a shift to the right and an increase in supply. Competitive supply is where the production of one good prevents the supply of another e.g. if the farmer kills his cows, he can no longer produce the milk. Therefore, the rise in the price of beef may cause a decrease in the supply of milk and a shift to the left.

● Weather: For some goods, particularly agricultural goods, the supply is dependent on weather e.g. if the weather is good, more wheat will be produced so the curve will shift to the right. If the weather is bad, the producers won’t be able to supply as much wheat and so it will shift to the left.

Technology: If new technology is introduced then it will lead to a fall in production costs as there is higher productive efficiency. This will encourage firms to lower prices or produce more goods for the same price and so the curve will shift to the right. During war or natural disasters, companies may have to use less efficient technology so the supply curve will shift to the left as they produce less at each price.

● Goals of the supplier: If a supplier is motivated by helping society and providing a service, they may increase supply even when that doesn’t provide extra profit.

● Government legislation: If the government passes laws that mean more cars have to have catalytic converters, supply of cars with catalytic converters will increase. High levels of regulation may increase costs and so decrease supply.

● Taxes and subsidies: A tax decreases supply and a subsidy increases supply by affecting the costs of production.

● Producer cartels: Some firms or countries come together in order to decrease supply and therefore increase the price of their good to increase profit.

• The supply curve slopes upward because higher prices incentivize firms to produce more, aiming to maximize profits.

• Lower prices lead firms to reduce unprofitable production, decreasing supply.

• Higher prices attract new firms into the market, increasing overall output.

• Expanding production requires using additional resources, which raises costs. Firms will only incur these higher costs if they can charge higher prices (rising marginal cost).

1.2.5 Elasticity of supply

Price elasticity of supply (PES):

This is the responsiveness of supply to a change in price of the good.

%change in quantity supplied %change in price

Numerical values:

● Unitary elastic PES is where PES=1: quantity supplied changes by exactly the same percentage as price. This would be shown as a curve which starts in the origin, is steeper than an elastic curve but more sloping than an inelastic curve.

● Relatively elastic PES is where PES>1: quantity supplied changes by a larger percentage than price so supply is relatively responsive to price. The curve will be more sloping, starting on the price axis.

● Relatively inelastic PES is where PES<1: quantity supplied changes by a smaller percentage than price so supply is relatively unresponsive to price. The curve will be steep, starting on the quantity line axis.

● Perfectly elastic PES is where PES=infinity: a change in prices means that quantity supplied falls to 0 and supply is very responsive to price. This would be shown by a horizontal line.

● Perfectly inelastic PES is where PES=0: a change in price has no effect on output so demand is completely unresponsive to price. This would be shown by a vertical line.

The diagram shows the curves with different elasticities. S1 shows a unitary elastic supply curve, S2 shows a relatively elastic supply curve and S3 shows a relatively inelastic supply curve.

Factors affecting PES:

● Time: This will have an impact on the amount of a good that can be supplied at any price. In the immediate term, no matter how high the price is, a supplier can only sell the amount of product they have so supply is perfectly inelastic. In economics, the short term is the period of time when at least one factor of production is fixed

and the long term is when all factors of production are variable. In the short term, they could sell more products but will still be restricted by the factors of production, meaning it will still be relatively inelastic. In the long term, they can increase production and all factors are variable and therefore the supply curve will be elastic. The longer the period of time the supplier has to make a change and increase production, the more elastic the curve will be.

● Stocks: If a business has a stockpile of goods, when the price goes up, they will simply decide to use up some or all of their stockpiles and therefore supply will be more elastic.

● Working below full capacity: If a business is working below full capacity (e.g. they are producing 50 goods but could produce 100) and there is an increase in price, they can easily respond by producing to their full capacity so the supply curve will be more elastic.

● Availability of factors of production: For example, labour may need particular skills or training so cannot be instantly increased. If wages of a doctor rise by a large amount, it would still take years before there would be an increase in the number of doctors so it is inelastic.

● Ease of entry into the market: Large costs of start-up equipment could make it difficult to increase supply, which makes it inelastic. Trade unions or professional associations can restrict entry.

● Availability of substitutes: If a good has a lot of producer substitutes, it will have high elasticity. One model of car is a substitute for another model of car as producers can easily switch between the two meaning suppliers can alter the pattern of production if price rises or falls so supply will change.