1.2 How markets work

Question 1

What is the rational consumer?

Answer 1

Consumers are assumed to make rational decisions. This means consumers will allocate their income to maximise their utility or satisfaction from the goods or services they purchase. Utility is the amount of satisfaction obtained from consuming a good or service. Economist believe this could be measured.

Question 2

What is the rational producer?

Answer 2

Firms will use their resources to maximise their profits for the good and services produced. This involves producing at the level of output where total revenue exceeds total cost by the largest amount.

Question 3

What is rational decision making based on?

Answer 3

Perfect market information. Computational and judgemental skills. The ability to take decisions free from the influence and behaviour of others. Sufficient time to make decisions.

Question 4

What is the marginal?

Answer 4

Marginal – is the change in a variable caused by an increase of one unit of another variable.

For example – The marginal cost of an ice cream is the additional cost of making one additional ice cream i.e. the cost of the final ice cream produced.

Question 5

What is marginal utility?

Answer 5

Marginal utility – the satisfaction gained by a consumer consuming an additional unit of a good or service. We assume that rational consumers will only consume a good or service only if the perceived satisfaction is greater than or equal to the price.

Question 6

What is the law of diminishing marginal utility?

Answer 6

States that for each additional unit of a good that’s consumed, the marginal utility decreases.

E.g. for each additional burger eaten gives a consumer less satisfaction than the previous.

Question 7

What is demand?

Answer 7

The willingness and ability to purchase a good and a service at the given price in a given time period.

Question 8

What is the law of demand?

Answer 8

States that for most products as the price of a good or service falls, the quantity demanded increases.

Question 9

What causes a shift in demand?

Answer 9

Anything accept price will cause a shift in demand.

Examples of what causes a shift in demand: Income, Price of other goods (substitutes and complementary), Introduction of a new product, Fashion, Tastes/preferences, Advertising, Weather, Demographics.

Question 10

What are factors that can affect demand?

Answer 10

Substitute goods, Complementary goods, Derived demand, Composite demand.

Question 11

What are substitute goods?

Answer 11

Goods which are alternatives to each other e.g. beef and lamb.

Question 12

What are complementary goods?

Answer 12

Goods often used together e.g. strawberries and cream.

Question 13

What is derived demand?

Answer 13

Demand for a good or factor of production used in making another good or service e.g. demand for fencing will affect demand for wood.

Question 14

What is composite demand?

Answer 14

Goods with more than one use such as oil e.g. demand for oil can lead in changes of demand curve for plastics.

Question 15

What are normal goods?

Answer 15

(e.g. DVDs) are those that people demand more of if their real income increases.

Question 16

What are inferior goods?

Answer 16

(e.g. cheap clothing) are those that people demand less of if their real income increases.

Question 17

What are exceptions to law of demand?

Answer 17

Speculative demand. Goods for which consumers see price as an indicator. Veblen goods. A giffen good.

Question 18

What is speculative demand?

Answer 18

If the price of a good such as housing or shares start to rise people may speculate that it may rise further.

Question 19

What does it mean when there are goods for which consumers see price as an indicator?

Answer 19

Potential buyers may demand more as a goods price rises, believing that a high price means high quality.

Question 20

What are Veblen goods?

Answer 20

Some firms try to sell their goods based on the fact that they cost more than those of their competitors e.g. Ferrari cars as a sign of wealth.

Question 21

What is a giffen good?

Answer 21

A low-income, non-luxury product. Demand for Giffen goods rises when the price rises and falls when the price falls e.g. bread, rice and wheat.

Question 22

What is price elasticity of demand (PED)?

Answer 22

This shows how demand changes with price. This looks at the sensitivity of the quantity demanded for a good or service when there is a change in its price. Products will either be: Elastic, Inelastic.

Question 23

What does it mean if a product is inelastic in terms of price elasticity of demand?

Answer 23

A product that is not very price sensitive. If there is a change in price you will not see a significant change in demand (price elasticity between 0 and -1) e.g. cigarettes.

Question 24

What does it mean if a product is elastic in terms of price elasticity of demand?

Answer 24

A product that is highly price sensitive. If the price changes you will see a significant change in demand (price elasticity beyond -1) e.g. a holiday package.

Question 25

How do you calculate price elasticity of demand (PED)?

Answer 25

% change in demand / % change in price.

Question 26

What is perfectly elastic demand?

Answer 26

Has PED of infinity. Any increase in the price means the demand will fall to zero. Consumers are willing to buy all they can obtain at the current price, but none at a higher price. ## Footnote (lots of substitutes)

Question 27

What is perfectly inelastic demand?

Answer 27

Has a PED of zero and any change in price will have no effect on the quantity demanded. ## Footnote (products with no substitute. E.g. salt)

Question 28

What is unitary elasticity of demand?

Answer 28

A good has unit elasticity if the size of the percentage change in price is equal to the size of the percentage change in quantity demanded. PED is always -1.

Question 29

What does a steeper gradient mean on a PED graph?

Answer 29

The steeper the gradient the more inelastic. ## Footnote (like an elastic band, it doesn't stretch far over the graph if it is inelastic)

Question 30

What is supply?

Answer 30

Supply is the amount of a good or a service producers offer for sale to the market at each price level.

Question 31

How does supply work in a market with businesses?

Answer 31

Businesses have to consider how much of a good is profitable and worthwhile to produce given the market price. As they decide the quantity to supply, they weigh up the cost to produce the good (land, labour, capital and the cost of these.)

Question 32

What is the law of supply?

Answer 32

The law of supply states that as price increases the quantity supplies will increase. Firms are assumed to want to maximise their profits and so a higher price gives an incentive for firms to increase production.

Question 33

What is a movement along the supply curve caused by?

Answer 33

A change in price.

Question 34

What is a shift in the supply curve caused by?

Answer 34

Anything other than price. ## Footnote For example: Wage rates, Tech improvements, Subsidies, Changes to raw material prices.

Question 35

What is joint supply?

Answer 35

Where production of one good or service involves or interrelates to the production of another (or several others). ## Footnote E.g. increased refinement of crude oil to make petrol will also increase the supply of butane.

Question 36

What is the definition for Price elasticity of supply (PES)?

Answer 36

PES – Is the measurement of how the quantity supplied of a good responds to its change in price.

Question 37

What is the PES formula?

Answer 37

% Change in Quantity supplied divided by % Change in Price.

Question 38

Why might supply be elastic?

Answer 38

Supply could be elastic because – There is spare capacity in the factory. There are stocks available. In the long run, capital can be varied. If it is easy to employ more factors of production.

Question 39

Why might supply be inelastic?

Answer 39

Supply could be inelastic because: Firms operating close to full capacity. Capital if fixed in the short run – e.g. firms do not have time to build a bigger factory. It is difficult to employ factors of production – e.g. if skilled labour is needed. With agricultural products, supply is inelastic in the short run, because it takes at least 6 months to grow crops.

Question 40

What are factors that might affect price elasticity of supply?

Answer 40

Time – more elastic the longer the time period. Availability of stock and stockpiling – if stocks are high then they are able to increase supply. Ease of switching between alternative production. Availability of spare capacity – can increase production quickly. Number of firms in the market and ease of entering the market.

Question 41

What is the price mechanism?

Answer 41

The price mechanism - Changes to demand and supply leads to changes in price and to the quantity bought and sold.

Question 42

What are the functions of price?

Answer 42

The signalling function, The incentive function, The rationing function, The allocation function.

Question 43

What is the signalling function of price?

Answer 43

Price provides information to buyers and sellers. It acts as a signalling device. ## Footnote E.g. price increase is a signal that demand is high.

Question 44

What is the incentive function of price?

Answer 44

It acts as an incentive to firms. Higher prices allows firms to produce more goods/services and encourages increased production and sales by providing higher profits.

Question 45

What is the rationing function of price?

Answer 45

It acts to ration scarce resources. ## Footnote E.g. if there’s high demand for a good or service and supply is limited, then the price will be high. Therefore, supply of the good will be restricted to consumers that can afford to pay a high price. The opposite will happen to goods in low demand but high supply.

Question 46

What is the allocation function of price?

Answer 46

Used to allocate the resources used to produce goods and services. ## Footnote E.g. it directs resources away from markets where prices are high and there is excess supply.

Question 47

What is market equilibrium?

Answer 47

When the quantity demanded equals, the quantity supplied in a market for a particular product, the market is in a state of equilibrium.

Question 48

What is equilibrium price?

Answer 48

Equilibrium price also known as the market clearing price. The price that balances quantity supplied and quantity demanded.

Question 49

What is equilibrium quantity?

Answer 49

Equilibrium quantity aka the market clearing quantity. The quantity supplied and quantity demanded at the equilibrium price.

Question 50

What is disequilibrium?

Answer 50

A situation within the market when supply does not equal demanded.

Question 51

What is cross price elasticity of demand (XED)?

Answer 51

XED measures how the quantity demanded of one good responds to a change in the price of another good.

Question 52

What is the XED formula?

Answer 52

XED = % change in quantity demanded of good A divided by % change in price of good B.

Question 53

What is the XED of substitute goods?

Answer 53

If two goods are substitutes their XED will be positive. ## Footnote A result between 0 and 1 is inelastic, showing less correlation between goods. A result greater than 1 is elastic and shows a higher level of correlation between the goods.

Question 54

What is the XED of complementary goods?

Answer 54

If they are complementary the XED will be negative.

Question 55

What is income elasticity of demand (YED)?

Answer 55

YED – measures how much the demand for a good changes with the change of real income.

Question 56

What is a normal good in terms of YED and what is its income elasticity?

Answer 56

A good where demand increases (at each price level) as income rises. Positive income elasticity.

Question 57

What is a luxury good in terms of YED and what is its income elasticity?

Answer 57

When income rises, a good that will have demand (at each price level) rising at a faster rate than income. Income elasticity >+1.

Question 58

What is a necessity good in terms of YED and what is its income elasticity?

Answer 58

Are products and services that consumers will buy regardless of the changes in their income levels. Income elasticity >0 and <+1.

Question 59

What is a inferior good in terms of YED and what is its income elasticity?

Answer 59

as income rises, demand falls (at every price level). Negative income elasticity.

Question 60

What is the YED formula?

Answer 60

YED = % change in quantity demanded divided by % change in income.

Question 61

What happens to normal necessities when incomes are falling?

Answer 61

When incomes are falling, demand for normal and necessary goods, to a lesser extent, will fall.

Question 62

What is the income elasticity of normal necessity goods?

Answer 62

Have a low but positive income elasticity. YED – 0 to 1, inelastic.

Question 63

What is the income elasticity normal luxuries?

Answer 63

These products have a high and positive income elasticity. YED >1, Elastic.

Question 64

What is the income elasticity of inferior goods?

Answer 64

Have a negative YED, YED<0.

Question 65

What are factors affecting PED?

Answer 65

Necessity or luxury, Addiction and habit, Substitutes, Brand loyalty, Proportion of income, Time period.

Question 66

Will a necessity or a luxury good be more elastic?

Answer 66

A luxury good is more elastic because it is not needed. People need necessity goods so will have to pay a higher price if needed making it inelastic.

Question 67

Is an addictive good likely to be more elastic or inelastic?

Answer 67

Demand for addictive products (cigarettes) is likely to be more inelastic.

Question 68

Is a good with many substitutes likely to be elastic or inelastic?

Answer 68

The more substitutes, the more elastic as people can just buy cheaper alternatives.

Question 69

Is a brand with a high brand loyalty likely to be more elastic or inelastic?

Answer 69

Brands with higher brand loyalty are more inelastic as people are willing to pay more for the brand.

Question 70

Are products costing a large proportion of income likely to be more elastic or inelastic?

Answer 70

Products costing a large % of income are more elastic as they will cost a lot more if there is a % price increase.

Question 71

Are products likely to be more elastic or inelastic in the short run?

Answer 71

Short run – more inelastic as people haven't had time to switch to an alternative. , long run – more elastic as they have more time to find alternatives.

Question 72

What is consumer surplus?

Answer 72

The difference between the price a consumer is willing to pay for a good/service and the price that they actually pay.

Question 73

What is producer surplus?

Answer 73

If a producer receives more for a good and service than the price they are willing to accept, the extra earnings are known as the producer surplus.

Question 74

What does the combined sum of the producer and consumer surpluses represent?

Answer 74

The combined sum of the surpluses represent the net welfare that society as a whole gains from the production and consumption of this good or service. It can be argued that efficient allocation is achieved when this is maximised.

Question 75

Will a shift in supply affect consumer or producer surplus?

Answer 75

A shift in supply will increase producer surplus.

Question 76

Will a shift in demand affect consumer or producer surplus?

Answer 76

A shift in demand will increase consumer surplus.

Question 77

What is a subsidy?

Answer 77

Subsidies – a sum of money given by the government or a public body to encourage the production of a good or service. A subsidy will help an industry or business keep the price of a commodity or service low and affordable for consumers.

Question 78

What are direct taxes?

Answer 78

Taxes that are levied on individuals or entities directly by the government. For example: Income tax Corporate tax Capital gains Property tax

Question 79

What are indirect taxes?

Answer 79

Are those collected by an intermediary (marketplaces etc) from the end consumer. i.e. the tax is payed by the seller.

Question 80

What does it mean to shift the burden of the tax?

Answer 80

With an indirect tax, the supplier may be able to pass on some or all of this tax onto the consumer through a higher price. This is known as shifting the burden of the tax. The ability of businesses to do this depends on the PED and PES.

Question 81

Who pays the burden of the tax on an elastic product?

Answer 81

If demand is elastic the producer must absorb most of the tax and accept a lower profit margin on each unit sold.

Question 82

Who pays the burden of the tax on an inelastic product?

Answer 82

The producer is able to pass on most of the tax to the consumer by increasing price without losing much in the way of sales.

Question 83

What is specific tax?

Answer 83

Where the tax per unit is a fixed amount. For example, the tax per packet of 20 cigarettes.

Question 84

What are Ad valorem taxes?

Answer 84

Where the tax is percentage of the cost of supply. For example, VAT is levied at the standard rate of 20%.

Question 85

What is the difference between traditional and behavioural economics?

Answer 85

Traditional economics makes the assumption that: Economic agents are utility ‘maximisers’. Economic agents are rational. However behavioural economist challenge these assumptions: Behavioural economics recognises that humans are unlikely to always act rationally in the face of every decision that they make.

Question 86

Why may people not be able to make rational decisions?

Answer 86

The time available to make a decision is limited. Imperfect information where economic agents may have too much/too little information. Information available may be incorrect. Information may be presented in a way that excludes some people and is meaningful for others. E.g. technical or legal jargon. There may be cost involved in acquiring information that deter people from doing so e.g. house surveys etc. Unable to calculate the cost of alternatives.

Question 87

What is bound rationality?

Answer 87

Idea that people may try to behave rationally but their ability to do so is severely restricted for three main reasons. The human mind has limited ability to process and evaluate information. The available information is incomplete and often unreliable (and rapidly out of date). Time available to make decisions is limited. Therefore even with the best intentions, individuals end up ‘satisficing’ (pursue a course of action that will satisfy the minimum requirements to achieve a goal) or accepting sub-optimal outcomes

Question 88

What is bounded self-control?

Answer 88

When individuals have good intentions but lack the self discipline to see them through. E.g. regular gym attendance.

Question 89

What are behaviour biases?

Answer 89

Behavioural economist believe that individuals are influenced by biases which affect their decision making

Question 90

What are some examples of behaviour biases?

Answer 90

Rule of thumb Anchoring Availability biases social norms Herd mentality Altruism and fairness

Question 91

What is the behaviour bias - rule of thumb?

Answer 91

Rule of thumb are ‘thinking shortcuts’ individuals use to make decisions, given the problems of bounded rationality. E.g. may choose the same drink everywhere.

Question 92

What is the behaviour bias - anchoring?

Answer 92

Anchoring – placing too much emphasis on one piece of information. E.g. a consumer choosing car insurance may only focus on price.

Question 93

What is the behaviour bias - availability bias?

Answer 93

Availability bias – when people make judgements about the probability of events by recalling recent instances, it comes to mind easily. E.g. recalling a friend who lost their savings in a recession therefore discouraging personal saving.

Question 94

What is the behaviour bias - social norms?

Answer 94

Social norms – an individual's behaviours can be influenced by the behaviour of their social group. E.g. people being influences to drink or smoke due to their social group.

Question 95

What is the behaviour bias - Herd mentality?

Answer 95

Herd mentality – many consumer decisions are influenced by what other people are doing. Whether it’s the fear of missing out or whether others want to be part of a larger collective.

Question 96

What is the behaviour bias - altruism and fairness?

Answer 96

Altruism and fairness – mean that people are motivated to ‘do the right thing’. E.g. giving to charity.

Question 97

How can behavioural economics theory help governments and agencies?

Answer 97

Behavioural economics theory can: Help governments and other agencies devise policies that more effectively influence economic decisions. This enables them to better influence the decisions of individuals and firms.

Question 98

What is choice architecture?

Answer 98

Choice architecture refers to how choices may be influenced by the way they are presented to the decision maker.

Question 99

What are some examples of choice architecture?

Answer 99

Framing Nudges Default choices Mandated choices Restricted choice

Question 100

What is the choice architecture - framing?

Answer 100

Framing – influences choices by the way words and numbers are used. E.g. less than £3 a day sounds more palatable than £1000 a year.

Question 101

What is the choice architecture - nudges?

Answer 101

Nudges – aims to influence consumer behaviour via the use of gentle suggestions and positive reinforcements. E.g. the ‘five-a-day’ campaign to encourage greater consumption of fruit and veg.

Question 102

What is the choice architecture - default choices?

Answer 102

Default choices – sets socially desirable choices as the default option, making it an effort to choose otherwise. E.g. The default choice of pension enrolment is to opt in so they make it an effort to opt out.

Question 103

What is the choice architecture - mandated choices?

Answer 103

Mandated choice – where people are required by law to make a choice.

Question 104

What is the choice architecture - restricted choice?

Answer 104

Restricted choice – occurs when peoples choices are restricted. E.g. people are restricted to certain schools in the area.

Question 105

What are advantages of subsidies?

Answer 105

Lower costs for consumers – beneficial where a significant portion of income may go toward basic needs. Support for emerging industries with the capital they need to grow and become competitive. Encourage research and development – Incentive for advancements in technology – leads to broader societal benefits, increase in efficiency and quality. Protect domestic industries can help protect local industries from international competition by lowering production costs, thus encouraging the growth of domestic businesses.

Question 106

What are disadvantages of subsidies?

Answer 106

Significant cost to the government, potentially leading to higher taxes or reduced spending in other areas. Inefficient allocation of resources might lead to the overproduction of subsidised goods and services, potentially resulting in waste or environmental damage. Overdependence on subsidies can cause firms to become complacent, can remove incentive to become more efficient or self-sustaining – reduce quality. Can disproportionately benefit larger businesses or wealthy individuals rather than the intended target groups, exacerbating inequality.