How Markets Work Flashcards Preview

Economics - Introduction to markets and market failure > How Markets Work > Flashcards

Flashcards in How Markets Work Deck (79):
1

What two assumptions are made by Neo-classical analysis about the way firms and consumers behave?

1) Consumers act rationally by trying to maximise their utility.
2) Firms act rationally by aiming to maximise their profits.

2

Define demand.

Demand refers to the quantity of a product demanded by consumers at a given price over a certain period of time.
Demand means that consumers are both willing and able to purchase a product.

3

What does the shape of the demand curve reveal?

The demand curve is downwards sloping showing that a fall in price would lead to an extension of demand, whereas a rise in price would lead to an contraction of demand.

4

What is the substitution effect?

The substitution effect explains that when there is a rise in price, a consumer who's income has remained constant will choose to switch their spending to a similar product or substitute of a lower price to the original product.

5

What is the income effect?

The income effect is where a rise in price leads to a fall in real incomes because consumer's money can no longer buy as much, their purchasing power falls. With normal goods, the quantity demanded will fall when there is a fall in real incomes.

6

What causes a movement along the demand curve?
Explain the two scenarios.

Movement along the demand curve are brought about by a change in the price of the product itself.
A rise in the price of the product would bring about a contraction of demand which is shown by a movement up the demand curve.
A fall in price would bring about an extension of demand which is shown by a movement down the demand curve.

7

What factors may cause a change in the quantity of a product demanded other than price? (5)

1) Real incomes
2) Size or age of the population.
3) Tastes, fashions or preferences
4) Prices of substitutes or compliments
5) Interest rates

8

Explain how real incomes may affect quantity demanded.

An increase in real incomes would lead to an increase in demand for a product, shown by a rightward shift of the demand curve.
A decrease in real incomes would lead to decrease in demand for a product, shown by a leftward shift of the demand curve.

9

Explain how the size or age of the population may affect demand.

An increase in the size of the population would lead to an increase in the demand of most goods and services.
An ageing population would cause an increase in demand for certain goods and services, such as sheltered accommodation and a fall in demand for others, e.g. clothes for teenagers.

10

Explain how tastes and fashions may affect demand.

The demand for goods and services can rise and fall as they come into and go out of fashion.

11

Explain how the prices of substitutes and compliments can affect demand.

A change in the price of substitute good can affect the demand for other goods, for example a rise in the price of beef may cause an increase in demand for s substitute such as lamb.
A rise in the price of a compliment good, e,g. petrol made lead to a fall in demand for cars.

12

Explain how interest rates may affect demand?

Interest rates affect the cost of borrowing money. For example, a rise in interest rates, would increase the cost of borrowing money for mortgages and may lead to a fall in demand for homes.

13

What is total utility?

Total utility is the amount of satisfaction gained from the total amount of a product consumed.

14

What is marginal utility?

Marginal utility is the change in utility from consuming an extra unit of the product.

15

Explain the law of diminishing marginal utility.

The law of diminishing marginal utility states that, as a person consumes more and more of a product, the consumers' total utility increases but marginal utility decreases.
People are prepared to pay less for each additional unit as their consumption increases, with the result that there will be an inverse relationship between the quantity demanded and the price.

16

Define price elasticity of demand.

Price elasticity of demand is a measure of the responsiveness or sensitivity of the demand for a product to change in the products price.

17

How can PED be calculated?

PED = % change in QD/ % change in price.

18

Explain price inelastic demand.
What is the value of PED when demand is price inelastic?

Demand is price inelastic when a proportional or percentage change in price leads to a proportionally smaller change in the demand for the product.
When demand is price inelastic, the value of PED is between 0 and -1.

19

Explain price elastic demand.
What is the value of PED when demand is price elastic?

Demand is price elastic when a proportional or percentage change in price leads to a proportionally larger change in demand for the product. When demand is price elastic, the value of PED will be greater than -1.

20

Explain unitary elasticity.
What is the value of PED when demand is unit elastic.

Demand is unit elastic when a percentage or proportional change in the price of the product leads to the same proportional or percentage change in price.
When demand is unit elastic, the value of PED will be equal to 1 and the demand curve will be a rectangular hyperbola.

21

Explain perfectly inelastic demand.
What is the value of PED when demand is perfectly inelastic?

Demand is perfectly inelastic when a proportional or percentage change in the price of the product does not bring about a change in the demand for the product.
When demand is perfectly price inelastic, the value of PED will be 0 and the demand curve will be a straight line vertically upwards.

22

Explain perfectly elastic demand.
What will be the value of PED when demand is perfectly elastic?

When the demand for a product is perfectly elastic a percentage or proportional change in the price of the product will lead to demand falling to zero or rising to infinity.
When demand is perfectly elastic the value of PED is infinity and the demand curve will be a straight, horizontal line.

23

What are the determinants of the price elasticity of demand? (6)

1) Availability of substitutes
2) Proportion of income spent on the product
3) Nature of the product
4) Durability of the product
5) Length of time under consideration
6) Width of market definition

24

Explain how availability of substitutes can affect PED.

The more substitutes a product has, the greater the incentive will be to switch spending when the price of that product increases and the more elastic the demand will tend to be.

25

Explain how the proportion of income spent on the product can affect PED.

If only a small percentage of income is spent on the product, the demand for that product tends to be more price inelastic.

26

Explain how the nature of the product can affect PED.

If the product is addictive, e.g. alcohol and tobacco, then the demand for the product will be more price inelastic.

27

Explain how durability of the product effects PED.

If the product is long-lasting and hard wearing such as furniture, then the demand for the product will tend to be more price elastic because it is easier for consumers to postpone the purchase.
However demand for non-durable goods such as petrol and mil tends to be price inelastic because these must be regularly replaced.

28

Explain how length of time under consideration effects PED.

It usually takes time for consumers to change their spending patterns as a result of a price change. Consequently demand tends to be more price inelastic in the short run than in the long run.

29

Explain how the width of market definition effects PED.

If a product is broadly defined, for example fruit, demand is likely to be inelastic. However the demand for a particular type of fruit will tend to be more price elastic.

30

What is total revenue and how is it calculated?

Total revenue is the value of goods and services sold by a firm and is calculated by multiplying the price of the product by the quantity of the product sold.

31

What are the five key relationships between PED and total revenue?

1) When demand is price inelastic, a price change causes total revenue to change in the same direction.
2) When demand is price elastic, a price change causes total revue to change in the opposite direction.
3) When demand is unit elastic, a price change causes total revenue to remain unchanged.
4) When demand is perfectly inelastic, a price change causes total revenue to change in the same direction by the same proportion.
5) When demand is perfectly elastic, a price rise causes total revenue to fall to zero.

32

What is the significance of PED to firms?

If firms are aware that the demand for their product is price inelastic, then to increase total revenue, they can increase the price.

If they know that the demand for their product is price elastic then they can increase total revenue by reducing the price.

33

What is the significance of PED to the government?

If the government wishes to raise tax revenue, then it will place indirect taxes on products which have price inelastic demand, such as alcohol or tobacco.

The government may therefore also tax products, the demand for which is price elastic, in the knowledge that producers will bear the greatest burden of the tax.

34

What is cross price elasticity of demand (XED)?

Cross price elasticity of demand is a measure of the responsiveness of the demand for product X to a change in the price of product Y.

35

How can XED be measured?

XED = % change in QD of product Y / %c change in price of product X

36

For XED, what does a positive sign indicated?
What does a negative sign indicate?

A positive sign indicates that the products are substitutes, e.g. arise in the price of one product will cause an increase in demand for the other product.

A negative sign indicates that the products are compliments, e.g. a rise in the price of one product will lead to a fall in demand of the other product.

37

Why is XED valuable to businesses?
(3)

1) Knowledge of XED is helpful to businesses in setting the price of their products.
2) If the firm is selling a product with a close substitute, then it would know that demand for this product would fall if they were to increase it's price.
3) Firms also know that complimentary goods command high prices, e.g. ink cartridges command high prices compared to the actual printer because a certain type of cartridge is required for each particular printer.

38

Define income elasticity of demand.

Income elasticity of demand is a measure of the responsiveness or sensitivity of the demand for a product to a change in real income.

39

How can YED be measured?

YED = percentage change in quantity demanded/percentage change in real income.

40

Why is the sign very significant for YED?

For YED the sign is very significant because a positive sign indicates that the product is a normal good, i.e a rise in real income will lead to a rise in demand for the product.

41

What is income inelastic demand?
What is the value of YED?

Demand is said to be income inelastic when a percentage or proportional change in real income leads to a proportionally smaller change in the demand for the product.
When the value of YED is between 0 and +1, demand is income inelastic.

42

What is income elastic demand?
What is the value of YED?

Income elastic demand is when a percentage or proportional rise in real income leads to a proportionally larger rise in demand for the product.
When the value of YED is greater than +1, demand is income inelastic.

43

What does a negative value of YED indicated?

A negative sign indicates that the good is an inferior good, i.e. a rise in real incomes will lead to a fall in demand for the product. This is sometimes because consumers are now able to afford a more expensive and high quality item.

44

What is the significance of YED for firms?

Knowledge of YED can help with investment decisions. For example, if firms know that the demand for their product is income inelastic, then they know that demand for their product will increase significantly during times of rapid growth but fall significantly during recession.

45

What is the significance of YED for the government?

If the government wishes to maximise its tax revenue during an economic boom, then it will place indirect taxes on products it knows the demand for which is income elastic.

46

What is supply?

Supply refers to the amount supplied by producers at a given price over a certain period of time.

47

What can be said about the shape of the supply curve?
Explain why this is the case.

The supply curve is upward sloping from left to right, meaning that as price rises, the quantity supplied will increase.

When the price rises, it become more profitable for producers to supply a product and so they have an incentive to increase production.
When there is a fall in price, it becomes less profitable for producers to supply a product and so they make the decision to cut production and or exit the market.

48

What are movement along the supply curve caused by?

Movements along the supply curve are caused by price changes, a rise in price will cause an extension of supply and a movement up the supply curve. A fall in price will cause a contraction of supply and a movement down the supply curve.

49

What factors may cause a shift in the supply curve? (6)

1) Costs of production
2) Productivity of the workforce
3) Indirect taxes
4) Technology
5) Subsidies
6) Discoveries of new technology

50

Explain how costs of production and productivity of the workforce may affect supply?

An increase in the costs of production, such as increase in electricity costs, will lead to a decrease in supply and a leftward shift of the supply curve.

If there is a rise in productivity there will be an increase in supply shown by a rightward shift of the supply curve.

51

Explain how indirect taxes and technology may affect supply?

In indirect tax raises the cost of supply leading to a decrease in in supply, shown by a leftward shift of the supply curve.

New innovation and technology will usually lead to a rise in productivity bringing about an increase in supply shown by a rightward shift of the supply curve.

52

Explain how subsidies and discoveries of new resources may affect supply.

Subsidies are grants made to producers from the government which effectively lead to a reduction in the costs of production bringing about an increase in supply.
If, for example a country discovers new oil reserves, there will be a rise in the supply of oil.

53

Define PES.

Price elasticity of supply is a measure of the sensitivity or responsiveness of the supply for a product to a change in the price of the product.

54

How is PES measured?

What is significant about the value of PES and why is this the case?

PES = Percentage change in quantity supplied / percentage change in price
PES will always have a positive value because price and quantity always move in the same direction, as the supply curve is upwards sloping.

55

What is price inelastic supply?
What is the value of PES when supply is price inelastic?

Supply is said to be price inelastic when a percentage or proportional change in price of the product leads to a proportionally smaller change in the supply of the product.
When supply is price inelastic, the value of PES will be between 0 and 1.

56

What is price elastic supply?
What is the value of PES when supply is price elastic?

Supply is said to be price elastic, when a percentage or proportional change in price leads to a proportionally greater change in the supply of the product.
When supply is price inelastic, the value of PES will be greater than 1.

57

What is unit elastic supply?
What is the value of PES when supply is unit elastic?

Supply is said to be unit elastic when a percentage or proportional change in the price of the product leads to a change in supply which is proportionally equal.
When supply is unit elastic, the value of PES will be equal to 1 and the supply curve will be a straight line drawn through the origin.

58

What is perfectly inelastic supply?
What is the value of PES when supply is perfectly price inelastic?

Supply is said to be perfectly price inelastic when a percentage or proportional change in the price of the product has no affect on the quantity supplied.
When supply is perfectly price inelastic, the value of PES will be 0 and the supply curve will be a straight line vertically upwards.

59

What is perfectly elastic supply?

Supply is said to be perfectly elastic when an infinite amount could be supplied at a given price.
When supply is perfectly elastic the value of PES would be infinity and the supply curve would be horizontal.

60

What factors may affect PES? (5)

1) Time
2) Stocks
3) Spare Capacity
4) Availability and cost of switching resources from one use to another.
5) Perishability of a product

61

Explain how time may affect PES.

Elasticity of supply is likely to vary over time;. In the short run it is difficult to change supply in response to a price change, making supply price inelastic.
However, in the long run supply is likely to be more elastic because all factors of production are variable in quantity.

62

Explain how stocks and spare capacity may affect PES.

If stocks of finished goods are available, supply will be relatively price elastic because manufacturers will be able to respond quickly to a price change.
If there is spare capacity in a firm such as under-utilised machinery then supply is likely to be more elastic.

63

Explain how availability and cost of switching resources from one use to another may affect supply.

If resources such as labour, have specific skills or machines are highly specific, or it is expensive to re-allocate resources from one use to another, then supply will be relatively price inelastic.

64

Explain how the perishability of a product may affect supply.

Some products cannot be stockpiled, e.g. fruit and vegetables due to their perishability. These products are typically inelastic in their supply.

65

How is the equilibrium price and output of a product determined?

The equilibrium price and output of a product is determined by the interaction of the forces of supply and demand in the market. When the quantity supplied is equal to the quantity demanded, equilibrium is said to exist. The equilibrium price and quantity will not change unless there is a change in one for the conditions of demand or supply.

66

What may cause a change in the equilibrium price?

A change in equilibrium price can be caused either by a change in one or more of the conditions of demand, causing the demand curve to shift. Or by a change in one or more of the conditions of supply causing the supply curve to shift.

67

What would be the effect of an increase or decrease in demand on equilibrium price and quantity?

An increase in demand would cause a rightward shift in the demand curve, a rise in price and an increase in the quantity.
A decrease in demand would cause a leftward shift if the demand curve, a fall in price and a decrease in the quantity.

68

What would be the effect of an increase or decrease in supply on equilibrium price and quantity?

An increase in supply would cause a rightward shift of the supply curve, a fall in price and an increase in quantity.
A decrease in supply would cause a leftward shift of the supply curve, a rise in price and a decrease in quantity.

69

What are the key functions of the price mechanism? (4)

1) As a rationing device - market forces will ensure that the amount demanded is exactly equal to the amount supplied.
2) As an incentive - the prospect of making a profit acts as an incentive to firms to produce goods and sevrices.
3) As a signalling device - to producers to increase or decrease the quantity supplied.
4) To determine changes in wants - a change in demand will be reflected by a change in price.

70

What is a market?

A market refers to all those buyers and sellers involved in the buying and selling of goods and services and making exchanges with each other to determine price. Markets may be local, national or global.

71

What is consumer surplus?

Consumer surplus is the difference between how much someone is willing to pay and how much they actually pay, i.e. the market price. The consumer surplus is the area under the demand curve and above the market price.

72

What is producer surplus?

Producer surplus is the difference between how much firms are willing to supply at each price and the market price. Producer surplus is the area between the supply curve and the market price.

73

What factors may affect consumer surplus? (2)

1) The gradient of the demand curve, the steeper it is, the greater the consumer surplus will be.
2) Changes in the conditions of demand, an increase in demand will increase consumer surplus.

74

What factors may affect producer surplus?

1) The gradient of the supply curve, the steeper it is, the greater the producer surplus will be.
2) Changes in the conditions of supply, an increase in supply will lead to an increase in producer surplus.

75

What are indirect taxes?
What are the two types of indirect tax?

Indirect taxes are taxes on expenditure and include taxes such as VAT, excise duties and taxes on gambling. These taxes cause an increase in the costs of supply and so shift the supply curve to the left.
1) Specific tax
2) Ad valorem tax

76

What is an Ad valorem tax?
What is a specific tax?

Ad valorem taxes are a percentage of the price of a good or service and will cause the supply curve to shift to the left.
Specific taxes is a set amount of tax on each unit consumed, the effect of a specific tax is to shift the supply curve to the left, parallel to the original curve.

77

What is a subsidy>

A subsidy is money granted by the government to producers, in order to make production costs cheaper. This results in an increase in supply, shown by a rightward shift of the supply curve.

78

Give five reasons why consumers may not behave rationally. (5)

1) Influence of other people's behaviour
2) Habitual behaviour
3) Inertia - consumers may not make the effort to change because of an information overload, the complexity of the information available or the amount of choice available.
4) Consumer weakness at computation - people are easily influenced by recent events.

79

What is behavioural economics and what are its implications?

Behavioural economics applies psychological insights into human behaviour to explain economic decision making.
Policy makers must focus more on the psychology of behaviour when devising policy.