1.2 How markets work

Question 1

Inductive statement

Answer 1

Collect evidence

Question 2

Deductive statement

Answer 2

Start with a hypothesis

Question 3

Rational choice

Answer 3

involves weighing up costs and benefits and trying to maximise surplus of benefits over costs

Question 4

Utility

Answer 4

measure of satisfaction that we get from purchasing and consuming a G/S

Question 5

Consumer durables

Answer 5

Products that give steady flow of utility over their working life

Question 6

Consumer non-durables

Answer 6

Products that are used up in the act of consumption

Question 7

Demand

Answer 7

Quantity of a G/S that consumers are willing and able to buy at a given price at a given time period

Question 8

Diminishing marginal utility

Answer 8

Marginal utility is change in satisfaction from consuming an extra unit of a G/S. Beyond a point, marginal utility may start to fall

As more of a good is consumed, the additional utility (satisfaction) from each extra unit consumed will fall. Because consumers are assumed to be rational, they will not pay more for a good than the additional utility it provides. Therefore, price and quantity demanded are inversely related.

Question 9

Complement goods

Answer 9

Products used together - joint demand

Question 10

Derived demand

Answer 10

demand that comes from demand for something else. Demand for machinery derived from demand for consumer goods

Question 11

PED

Answer 11

Price elasticity of demand - responsiveness of demand for a product following a change in price

Question 12

Substitute goods

Answer 12

Two alternative products that could be used for the same purpose

Question 13

Competitive supply

Answer 13

Alternative products that a firm can produce with its resources. E.g. potatoes OR carrots

Question 14

Supply

Answer 14

quantity of a G/S that a producer is willing and able to supply onto the market at a given price at a given time period

Question 15

PES

Answer 15

Price elasticity of supply - responsiveness of supply of a product following a change in price

Question 16

Equilibrium

Answer 16

situation where there is no tendency for change

Question 17

Price mechanism

Answer 17

Decisions of consumers and firms interact to determine allocation of resources. Does not ensure equitable distribution of resources and can lead to market failure

Question 18

Consumer surplus

Answer 18

difference between the total amount that consumers are willing and able to pay for a good or service

Question 19

Producer surplus

Answer 19

difference between what producers are willing and able to supply a good for and the price they actually receive

Question 20

Direct tax

Answer 20

tax levied directly on an individual or organisation

Question 21

Indirect tax

Answer 21

tax levied on a good or service

Question 22

Specific tax

Answer 22

Set tax per unit. Parallel shift in supply curve.

Question 23

Ad Valorem tax

Answer 23

Percentage of sales price tax. Non-parallel shift

Question 24

Subsidy

Answer 24

payments by government to suppliers to reduce COP.
Effect: increase supply, decrease market equilibrium price

Question 25

Computational weakness

Answer 25

When consumers find it difficult to calculate probability of something happening when they make purchasing decisions.

Question 26

Habitual consumption

Answer 26

Strong default choices. Repeat choices become automatic as they do not involve much mental effort.

Question 27

Rational choice model

Answer 27

independent choice consistent tastes and preferences complete info optimal choice Continue consuming until marginal benefit = marginal cost

Question 28

Bounded rationality

Answer 28

When consumers have limited attention, knowledge and ability to understand complex decisions

Question 29

Info gaps

Answer 29

Consumers have insufficient knowledge to make optimal decision

Question 30

Explain shape of demand curve

Answer 30

Income Effect: When the price of a good falls, the consumer can maintain the same consumption for less spending. Provided that the good is normal, some of the increase in real income is used to buy more Substitution Effect: When the price of a good falls, ceteris paribus, the product is now relatively cheaper than an alternative and some consumers will switch their spending from an alternative good or service. The more substitutes there are in the market and the lower the cost and inconvenience of switching, the bigger the substitution effect is likely to be.

Question 31

Joint demand

Answer 31

demand for one product is positively related to demand for a related good or service - complements XED = negative

Question 32

Composite demand

Answer 32

Product has more than one use Demand increase leads to supply decrease

Question 33

Determinants of PED

Answer 33

No of substitutes: more substitutes - more price elastic Cost of switching: expense in switching - inelastic Necessity = inelastic Luxury = elastic Higher proportion of income = more elastic More time to respond to price change = more elastic Habitual = inelastic Broad definition of G/S = inelastic

Question 34

Explaining upwards slope of supply

Answer 34

Profit motive: When market price rises following an increase in demand, it then becomes more profitable for businesses to increase their output Production and costs: When output expands, a firm’s production costs tend to rise; therefore, a higher price is needed to cover these extra costs. This may be due to diminishing returns as more factors of production are added to production, but each extra input is less productive than the one before New entrants into the market: Higher prices create an incentive for other businesses to enter the market leading to an expansion of supply

Question 35

Substitute in production

Answer 35

two or more goods that can be produced using the same resources Producing one good prevents sellers from using resources to produce another. Produce one or produce the other, but not both.

Question 36

Joint supply

Answer 36

Joint supply is where an increase or decrease in the supply of one good leads to an increase or decrease in supply of a by-product. cows can be utilized for milk, beef, and hide

Question 37

PES determinants

Answer 37

Spare capacity Stock of finished products/components Factor mobility (flexible labour market) Time period and production speed

Question 38

Increase in demand

Answer 38

Excess demand at existing market price SR rise in price and fall in available stock - signal to producer Profit incentive leads to movement along supply curve

Question 39

Excess demand

Answer 39

Market price below EQ price Results in queuing for G/S and upward pressure on price Higher prices rations demand to those w effective demand Stimulates expansion of supply to respond to high profit

Question 40

Causes of shifts in demand curve

Answer 40

Changes in price of substitutes/complements Changes in real income Changes in distribution of income Changes in consumer tastes or preferences Interest rates Changes in size and age structure of population Seasonal factors

Question 41

Normal goods (necessities and luxury)

Answer 41

Positive income elasticity of demand Necessity: between 0 and 1, income inelastic Luxury: >1

Question 42

Inferior goods

Answer 42

Negative income elasticity of demand

Question 43

Cross price elasticity of demand for substitutes and complements

Answer 43

Substitutes: positive Complements: negative

Question 44

Price mechanism functions

Answer 44

Signalling: adjusts to demonstrate where resources are required. If prices rising due to high demand, it is a signal to expand production to meet rising demand. If there is excess supply, price mechanism will eliminate surplus allowing market price to fall. Incentives: Higher prices act as incentive to raise output due to changing nature of needs and wants. Demand weaker in recession, supply contracts as producers cut back on output. Rationing: when demand outstrips supply. Shortage, prices are big up and only those who are willing and able to pay will buy.

Question 45

Impact of indirect tax on consumers and suppliers

Answer 45

PED > 1, indirect tax absorbed mostly by supplier PED < 1, indirect tax absorbed mostly by consumer

Question 46

Rational decisions require?

Answer 46

Time Info Ability to process info

Question 47

Bounded rationality

Answer 47

Due to lack of time, info and ability to process info. habitual behaviour/consumer inertia people influenced by behaviour of others consumer weakness at computation

Question 48

Determinants of demand

Answer 48

Changes in age structure Changes in income Advertising Changes in tastes/preferences

Question 49

XED

Answer 49

Cross elasticity of demand Responsiveness of demand for one good to changes in price of another good. Substitutes have positive XED. Complements have negative XED.