1.2 How Markets Work

Question 1

What are the underlining assumptions of rational economics decisions making:

Answer 1

• consumers aim to maximise utility
• firms aim to maximise profit
• governments aim to maximise social welfare

Question 2

Consumers aim to maximise utility:

Answer 2

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

Question 3

Firms aim to maximise profit:

Answer 3

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

Question 4

Governments aim to maximise social welfare:

Answer 4

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

Question 5

What is demand

Answer 5

The willingness to buy a particular good at a given price and at a given moment in time

Question 6

What are conditions of demand

Answer 6

Factors which cause the demand curve to shift. A way to remember the conditions is the mnemonic PIRATES

Question 7

Population as a Condition of demand

Answer 7

If population rises, we would expect demand for all products to increase and so the demand curve will shift to the right

Question 8

Income as a condition of demand

Answer 8

If income increases for most goods demand increases as a person can afford to buy more of the product.

Question 9

Related goods as conditions of demand

Answer 9

If goods are complements or substitutes of each other then a change in price of another good can cause a shift in the demand curve.

Question 10

Advertising as a condition of demand

Answer 10

If a firm carries out a successful advertising campaign, demand is likely to increase and vice versa.

Question 11

Taste/fashion as a condition of demand

Answer 11

If something becomes more fashionable we expect demand to increase and if it becomes less fashionable, then demand will fall

Question 12

Expectations as conditions of demand

Answer 12

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.

Question 13

Seasons as a condition for demand

Answer 13

Some products will find their demand affected by the weather.

Question 14

Government legislation as a condition effect on the demand of goods

Answer 14

Demand for a car seat increased after the government made it a legal requirement that young children have to sit in them

Question 15

Diminishing marginal utility demand curve is downward sloping

Answer 15

• demand curve slopes downwards showing the inverse relationship between price and quantity. If more of a good is consumed, there is less satisfaction derived from the good. This means consumers are less willing to pay high prices at high quantities

-we assume people are going to behave rationally excepting them to spend it according to what gives them the greatest level of satisfaction or welfare

Question 16

What is total utility compared to marginal utility

Answer 16

total utility represents the satisfaction gained by s customer as a result of their overall consumption of a good whilst marginal utility represents the change is satisfaction resulting in consumption of the next unit of good

Question 17

What does The Law of Diminishing Marginal Utility state

Answer 17

The satisfaction derived from the consumption of an additional unit of a good will decrease as more of a good is consumed assuming all goods remain constant

Question 18

What is elasticity of demand

Answer 18

An attempt to measure the responsiveness of quantity of demand to changes in other variables

Question 19

Difference between price elastic and inelastic

Answer 19

Elastic = relatively responsive
Inelastic = relatively unresponsive

Question 20

What is price elasticity of demand (PED)

Answer 20

The responsiveness of demand to a change in the price of the good

%change in quantity demanded / %change in price

Question 21

Why are most PED values negative

Answer 21

Since a raise in price leads to a fall in output therefore we look at the integer alone disregarding negative signs

Question 22

Unitary elastic PED

Answer 22

Where PED = 1: quantity demanded changes by exactly the same percentage as price. This will be shown as a reciprocal curve

Question 23

Relatively elastic PED

Answer 23

PED > 1: quantity demanded changes by a larger percentage that price so demand is relatively responsive to price. Curve will be more sloping

Question 24

Relatively inelastic PED

Answer 24

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

Question 25

Perfectly elastic PED

Answer 25

PED = infinity : a change in price means that quantity falls to 9 and demand is very responsive to price. This would be a horizontal line.

Question 26

Perfectly inelastic PED

Answer 26

PED = 0 : a change in price has no effect on output so demand is completely unresponsive (vertical line)

Question 27

Factors influencing PED:

Answer 27

-Availability of substitutes
-Time (in short term many goods are inelastic as people may not even notice a price difference)
-necessity
-how large of a % of total expenditure
-addictive

Question 28

Significance of PED on tax

Answer 28

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