1.2 How Markets Work

Question 1

Consumers act rationally by aiming to maximise their…

Answer 1

Utility

Question 2

Firms act rationally by aiming to maximise…

Answer 2

Profits

Question 3

Demand

Answer 3

The quantity of good or service that consumers are able and willing to buy at a given price during a given period of time.

Question 4

A movement along the demand curve is caused by a change in…

Answer 4

Price

Question 5

What causes a shift in the demand curve?

Answer 5

A shift in the demand curve occurs when any factor other than price changes, leading to a change in demand at every price level.

Question 6

Factors that can cause demand curve to shift

Answer 6

One way to remember this is the mnenomic PIRATES.

Population: the more people that are in the country, the more people who will want a good.

Income: For most goods, if income increases, the month increase the because a person can afford to buy more of the product. If there is a full income, then the demand would decrease and shift to the left.

Relatated goods: if goods are compliments or substitutes of each other then a change in the price of another good can cause a shift in the demand curve.

Advertising: If a firm carries out a successful advertising campaign, demand is likely to increase. If a competitor firm carries out the successful advertising campaign, demand for the firm will fall.

Taste/fashion: If something becomes more fashionable, we expect demand to increase.

Expectations: expectations of what might happen in the future can have a big impact on the level of demand for some goods.

Seasons: some products will find that the amount affected by the weather. Eg. Increase in sunscreen during summer.

Question 7

Total utility

Answer 7

Represent the total satisfaction gained from the total amount of a product consumed.

Question 8

Marginal utility

Answer 8

Represents the change in utility from consuming an additional unit of the product.

Question 9

The law of diminishing marginal utility

Answer 9

As a person consumes more and more of a product, the marginal utility (extra satisfaction or benefit) falls.

This explains why the demand curve slops 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.

Question 10

How does the law of diminishing marginal utility influence the shape of the demand curve?

Answer 10

This explains why the demand curve slops 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.

Question 11

Price elasticity of demand (PED)

Answer 11

A measure of the responsiveness of quantity demanded of a product to change in price.

Question 12

Formula for PED

Answer 12

PED = % change in quantity demanded / % change in price

Question 13

Numerical values (PED)

Answer 13

• Unitary elastic PED is where PED = 1: quantity demanded changes by exactly the same percentage as price.
• Relatively elastic PED is where PED>1 quantity demanded changes by larger percentage than price so the amount is relatively responsive to price.
• Relatively inelastic PED is where PED<1: quantity demanded changes by smaller percentage than price to the demand is relatively unresponsive to price.
• Perfectly elastic PED is where PED = infinity: a change in price means that quantity falls to 0 and the demand is very responsive to price.
• Perfectly inelastic PED is where PED = 0: a changing price has no effect on output so the amount is completely unresponsive to price.

Question 14

Factors influencing price elasticity of demand

Answer 14

• Availability of substitutes: if a product has a lot of substitutes, 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.
• Nature of the product: if the product is addictive, then the demand tends to be inelastic. No matter how high prices are, people will still buy the good to fulfill their addiction.
• Proportion of income spend on a product: if only a small percentage of income is spent on a product such as salt then the demand tends to be inelastic, whereas if a high percentage of income is spent on the product, then the demand tends to be elastic, eg. Exotic holidays and works of art by famous artists.

Question 15

Significance of PED (for firms)

Answer 15

• If firms know that the demand for the product is priced inelastic then they can increase total revenue by increasing price.
• if farms know that demand is price elastic, then they can increase total revenue by reducing price.

Question 16

Significance of PED (for consumers)

Answer 16

• If demand is price inelastic then firms may raise prices (to increase their total revenue) but this would reduce the real income of consumers.

Question 17

Significance of PED (for the government)

Answer 17

• if the government wishes to maximise its tax revenue then it will place indirect taxes on those products who’s demand is price inelastic.
• The government may also tax products and services whose demand is price elastic, so that produces bear a higher proportion of the tax burden. However, this could make the business unprofitable.

Question 18

Cross elasticity of demand

Answer 18

the responsiveness of quantity demanded of one product (A) to a change the price of another product (B)

Question 19

Cross elasticity of demand formula

Answer 19

XED = % change in quantity demanded of products A / % change in price of product B

Question 20

Numercial values (XED)

Answer 20

• Substitutes are where XED>0
• Complementary goods are where XED<0
• Unrelated goods are where XED=0

Question 21

Significance of XED

Answer 21

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

Question 22

Income elasticity of demand (YED)

Answer 22

The responsiveness of quantity demanded of a product to a change in real income.

Question 23

Income elasticity of demand formula

Answer 23

YED = % change in quantity demanded / % change in real income

Question 24

Numerical values (YED)

Answer 24

• An inferior good is when YED<0
• A normal good is when YED>0
• A **luxury good* is a type of normal good when YED>1

Question 25

Significance of YED (for firms)

Answer 25

- If firms know that demand for their product is income elastic then they know that demand and total revenue will increase significantly during periods of rapid economic growth but fall significantly during recessions.

Question 26

Total revenue

Answer 26

The value of goods sold by a firm and is calculated by multiplying price by quantity.

Question 27

Supply

Answer 27

The quantity of a good or service that producers are willing and able to supply at a given price during a given period of time.

Question 28

A movement along the supply curve is caused by…

Answer 28

A change in price

Question 29

Factors that can cause supply to shift

Answer 29

**PINTSWC** - **P**roductivity: Increased productivity (eg. more output per worker) reduces production costs, leading to an outward shift in supply curve. - **I**ndirect taxes: Indirect taxes increase production costs, causing an inward shift in the supply curve. - **N**umber of firms: More firms in the market generally lead to an outward shift in the supply curve, as more firms can produce more. - **T**echnology: Advancements in technology can reduce production costs and increase efficiency, leading to an outward shift in the supply curve. - **S**ubsidies: government subsidies to lower production costs can encourage firms to supply more, causing an outward shift in the supply curve. - **W**eather: For agricultural product, favourable weather conditions can increase supply, while unfavourable conditions can lead to a supply shortage and an inward shift in the supply curve. - **C**osts of production: if the cost of production increases, funds will be less willing to supply, resulting in an inward shift in the supply curve. Conversely, lower production costs encourage more supply, shifting the curve outward.

Question 30

The supply curve is sloping upwards because…

Answer 30

If prices are higher, firms will increase production to take advantage of the high profits.

Question 31

Price elasticity of supply

Answer 31

A measure of responsiveness of quantity supplied for a product to a change in its price.

Question 32

PES formula

Answer 32

PES = % change in quantity supplied / % change in price

Question 33

PES numerical values

Answer 33

- **Unitary elastic PES** is where **PES=1**: quantity supplied changes by exactly the same percentage as price. - **Relatively elastic PES** is where **PES>1**: quantity supplied changes by a larger percentage than price. - **Relatively inelastic PES** is where **PES<1**: quantity supplied changes by a smaller percentage than price. - **Perfectly elastic PES** is where **PES=infinity**: a change in prices means that quantity supplied falls to 0 and is very responsive to price change. 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 supply is completely unresponsive to price.

Question 34

Factors that influence price elasticity of supply

Answer 34

**Time**: It is often difficult to change supply quickly in response to a price change, making supply very inelastic in the short run. However, in the long run, supply is likely more elastic because all resources are variable. **Stocks**: if stocks of finished goods are available, then supply would be relatively elastic because manufacturers will be able to respond quickly to a price change.

Question 35

Short run

Answer 35

A time period in which there is at least one fixed factor of production.

Question 36

Long run

Answer 36

A time period in which all factors of production can be varied.

Question 37

Consumer surplus

Answer 37

The difference between the price consumer is willing to pay and the price they actually pay.

Question 38

Producer surplus

Answer 38

The difference between the price the supplier is willing to produce their product at and the price they actually produce at, set by price mechanism.

Question 39

Indirect tax

Answer 39

a tax levied on expenditure or consumption, not directly on income or wealth.

Question 40

Ad valorem tax

Answer 40

a tax levied as a percentage of the value of a good or service.

Question 41

Specific taxes

Answer 41

a tax levied as a fixed amount per unit of a good or service, regardless of its price or value.

Question 42

Impacts of a tax

Answer 42

- When demand is inelastic, the consumer bears a much more larger proportion of the tax burden, whereas, the producer bears a much more smaller part of the tax burden. - When demand is elastic, the producer bears a much larger proportion of the tax burden, whereas the consumer bears a much smaller part of the tax burden.

Question 43

Incidence of tax

Answer 43

Relates to how the burden of a tax is distributed between different groups. eg. producers and consumers.

Question 44

Subsidy

Answer 44

A subsidy is a grant from the government that has the effect of reducing costs of production.

Question 45

Alternative views of consumer

Answer 45

- **Influences of other people**: People act individually to maximise their own benefits but sometimes individuals are influenced by social norms, known as bias. ‘Herding behaviour’ occurs when an individual copies the actions of a large group. - **The importance of habitual behaviour**: Most people have habits and these habits reduce the amount of time it takes to do something, because consumers no longer have to consciously think about their actions. - **Difficulty in computation**: Many consumers aren’t willing or able to make comparisons between prices and so they will buy more expensive goods than needed. -**Information gaps**