Theme 1.2 - How markets work

Question 1

1.2.1 - What are the two underlying assumptions made by rational economic decision making?

Answer 1

1) Consumers aim to maximise utility (happiness, satisfaction)
2) Firms/businesses aim to maximise profit

Question 2

1.2.1 - What is the neoclassical view on consumer behaviour?

Answer 2

1) Production and consumption are determined through the calculation of cost and benefit at the margin
2) Consumers optimise their purchasing power by equating the marginal utility per pound spent
3) Market failures can be corrected through taxation and subsidies

Question 3

1.2.1 - What assumptions are made by the neoclassical model of behaviour?

Answer 3

• Homo Economicus - a selfish and utility maximising, unboundedly rational agent
• Consumers choose indecently
• Consumers have fixed tastes
• Consumers gather complete information on alternative choices
• Consumers always make optimal choices given their preferences

Question 4

1.2.1 - What is a criticism of the unbounded rationality assumption

Answer 4

Herbert Simon

• incapable of gathering complete information on alternative choices
• limited attention span
• computational capacity

George A.Akerlof
- Asymmetric information - when sellers have more information about the product than buyers

Daniel Kahneman

• People reason poorly and act intuitively
• Tend to choose the most popular because its popular
• Tend to copy behaviours and think the group has superior information

Question 5

1.2.1 - What are some of the behavioural models?

Answer 5

• Limited computational capacity - satisfice rather than maximise
• Social networks
• Act reciprocally
• Lack self-control and tend to be present-biased
• Loss averse
• Attached to existing default choices
• Inequity aversion (do not like unequal outcomes)

Question 6

1.2.2 - What are the conditions of demand?

Answer 6

Any changes to any of these can cause shift in demand

• Population
• Advertisement
• Substitute goods
• Income
• Interest rate
• Fashion
• Expectation
• Complementary goods

Question 7

1.2.2 - What is derived demand?

Answer 7

Demand that comes from something else/a demand for a commodity, service etc. which is a consequence of the demand for something else eg sugar and tea or cars and petrol

Question 8

1.2.2 - What is diminishing marginal utility and how does it influence the shape of the demand curve?

Answer 8

As more of a good is brought, the satisfaction that comes from the good decreases.
Causes demand to fall - shift to the left

Question 9

1.2.3 - What is price elasticity of demand?

Answer 9

When the price of a good rises, the quantity demanded will fall
- measures the responsiveness of consumers to price change
Formula
PED= %change in quantity demanded/%change in price

Question 10

1.2.3 - What are the determinants of PED?

Answer 10

• Closeness of substitute goods
• Proportion of income spent on the good
• Habitual consumption (addiction)
• Whether the purchase can be delayed
• Necessity or luxury
• The time period
• Width of market definition
• Cost of substituting

Question 11

1.2.3 - What is income elasticity of demand?

Answer 11

Responsiveness of demand when income changes
Formula
YED = %change in quantity demanded/%change in income