1.2 How Markets Work PDF

[ **1.2.1 Rational decision making**] **Rational decision making:** when a consumer allocates their time, money, and effort to maximise their utilities, whilst firms try to maximise their profits. **Utility:** the satisfaction that the consumer gains from consuming a good or service. **[Evaluatio...

[ **1.2.1 Rational decision making**] **Rational decision making:** when a consumer allocates their time, money, and effort to maximise their utilities, whilst firms try to maximise their profits. **Utility:** the satisfaction that the consumer gains from consuming a good or service. **[Evaluation:]** - Consumers do not always act rationally. - This is because they are **swayed by influencers**, advertisements, and family & friends, or because of **computational difficulties** (they cannot decide the best option for themselves). - To solve this, supermarkets put unit prices to help make decisions (e.g. £0.35/kg). **[1.2.2 Demand]** **Demand:** the quantity of a good or service that consumers are able and willing to buy at a given price during a given period of time. **Demand varies with price**. Generally, the lower the price, the more affordable the good is, and so the consumer's demand increases. This is an **inverse relationship.** At the lower price of P2, a larger quantity of Q2 is demanded. This is an **extension** **of demand**. At the higher price of P3, a lower quantity of Q3 is demanded. This is a **contraction of demand**. Only a **[change in price]** will cause these movements along the demand curve.  A shift from D1 to D2 is an **inward shift in demand**, so a lower quantity of goods is demanded at the same market price of P1. A shift from D1 to D3 is an **outward shift in demand**, so more goods are demanded at the same market price of P1. **[FACTORS INFLUENCING DEMAND (PRICE-FASTICS)]** 1. Price 2. Fashion/trends 3. Advertising 4. Seasonality 5. Taxes 6. Income 7. Complimentary goods prices 8. Substitute goods prices. **Diminishing marginal utility:** the satisfaction gained from consuming on extra unit (marginal) of a good the more it is consumed. - The lower the utility, the lower the price the consumer is willing to pay. **[1.2.3 Price, income, and cross elasticities of demand]** **Price elasticity of demand (PED):** the sensitivity or responsiveness of changes in quantity demanded to a change in price. PED is always going to be negative because of the inverse relationship. \ [\$\$\\mathrm{PED =}\\frac{\\mathrm{\\%\\ change\\ in\\ quantity\\ demanded}}{\\mathrm{\\%\\ change\\ in\\ price}}\$\$]{.math.display}\  1. **Perfectly price elastic:** the good has a demand that falls to zero when price changes. **[PED = ∞]** 2. **Relatively price elastic:** when the percentage change in quantity demanded is greater than the percentage change in price, which means the percentage change in quantity demanded is more responsive to the percentage change in price. **[PED \> 1]** - E.g. if prices go up by 10%, quantity demanded will go up by 30%. 3. **Unit price elastic:** percentage change in quantity demanded is equal to percentage change in price. Exactly proportional. **[PED = 1]** 4. **Relatively price inelastic:** when the percentage change in quantity demanded is less than the percentage change in price, meaning percentage change in quantity demanded is less responsive to the percentage change in price. **[PED \< 1]** - E.g. food, oil. 5. **Perfectly price inelastic: [PED = 0]** **[FACTORS INFLUENCING PED]** 1. **AVAILABILITY OF SUBSTITUTES** - The more substitutes there are, more likely to switch. - Elastic demand. 2. **BRAND LOYALTY** - Stronger brand loyalty, less likely to switch. - Inelastic demand. 3. **LUXURY ITEMS** - Not necessities, so if the price increases, people may not buy them. - Elastic demand. 4. **PROPORTION OF INCOME SPENT** - Higher incomes means spending more money. - Elastic demand. 5. **ADDICTIVE AND HABIT-FORMING GOODS** - As price increases, demand does not decrease. - Inelastic demand. 6. **TIME PERIOD** - In the short run, habits do not change quickly so demand is inelastic. - In the long run, demand is elastic. 7. **NECESSITIES** - Even if the price increases significantly, consumers will still demand the good, because they need it (e.g. milk, electricity). - Inelastic demand. **Total revenue:** quantity sold \* average price of the product. **Total expenditure:** quantity bought \* average price of a product. - Firms can charge **high prices** when **PED is inelastic** so they can increase their **total revenue.** **\ ** **Income elasticity of demand (YED):** the sensitivity or responsiveness of changes in demand to a change in income. Can be either positive or negative. \ [\$\$\\mathrm{YED =}\\frac{\\mathrm{\\%\\ change\\ in\\ demand}}{\\mathrm{\\%\\ change\\ in\\ income}}\\mathrm{\\ }\$\$]{.math.display}\ 1. **Normal goods:** one with a positive income elasticity of demand. - As incomes increase, affordability increases so demand increases. - As incomes decreases, affordability decreases so demand decreases. - When YED \> +1, the goods are **luxury items.** E.g. foreign holidays. 2. **Inferior goods:** one with a negative income elasticity of demand. - As incomes increase, affordability increases so demand decreases. - As incomes decrease, affordability decreases so demand increases. - E.g. Tesco own brand goods. **Income elastic:** % change in demand \> % change in income. - Changes in demand are **more responsive** to changes in income. - E.g. foreign holidays, tourism. **Income inelastic:** % change in demand \< % change in income - Changes in demand are **less responsive** to changes in income. - Income has gone up so consumption increases, but not as much. - E.g. go to Hawaii rather than a staycation in Brighton. **[EVALUATION OF YED:]** 1. **CHANGES IN DEMAND DEPEND ON THE QUALITY OF THE GOOD** - When income increases, people always tend to buy better quality goods as they can afford more. E.g. Osweegos vs Yeezys. 2. **NOT EVERYONE CONSUMES THE GOOD** - For those who do not consume the product, **regardless of income, YED will be 0**. - E.g. lactose intolerant people would not consume chocolate, so if income were to change, YED would be 0. **Cross price elasticity of demand (XED):** the sensitivity or responsiveness of changes in demand for good 'A' to a change in price of good 'B'. \ [\$\$\\mathrm{XED =}\\frac{\\mathrm{\\%\\ change\\ in\\ demand\\ of\\ good\\ A}}{\\mathrm{\\%\\ change\\ in\\ price\\ of\\ good\\ B}}\$\$]{.math.display}\ 1. **Substitute goods:** those with a positive XED. - If the price of 'good B' increases, the demand of 'good A' increases. - Positive gradient. - E.g. if the price of the iPhone increases, the demand for Samsung increases. 2. **Complimentary goods:** those with a negative XED. - If the price of 'good B' increases, the demand of 'good A' decreases. - Negative gradient. - E.g. if the price of fuel increases, the demand for fuel driven cars decreases. **[EVALUATION OF XED:]** 1. **DEPENDS ON THE STRENGTH OF THE RELATIONSHIP** - How much demand changes for good A change **depends on the strength of the relationship** of good A and good B. 2. **STRONG SUBSTITUTES** - Any value that is positive are substitute goods. - If XED value is +2 then it is a strong substitute because XED\>1. - If XED is +0.5 then it is a weak substitute as XED\< 1. 3. **COMPLIMENTARY GOODS** - Any value that is negative are complimentary goods. - If XED value is -2 then it is a strong complimentary good because XED\1. 4. **TIME PERIOD** - Consumer tastes and preferences generally do not adjust/change to price changes immediately. - In the short run a price increase of good B will not significantly affect the demand of good A. **[1.2.4 Supply]** **Supply:** the willingness of a producer to sell a product at a given price. - There is a positive relationship between the price of a good and the quantity supplied. - When price increases, quantity supplied increases. - When prices are high, companies are more likely to supply more as they can **maximise revenue** (price \* supply). This is a positive price elasticity of supply. At the lower price of P2, a lower quantity of Q2 is supplied. This is a **contraction of supply**.. At the higher price of P3, a larger quantity of Q3 is supplied. This is an **extension** **of supply**. Only a **[change in price]** will cause these movements along the demand curve.  A shift from S1 to S2 is an **inward shift in supply**, so a lower quantity of goods is supplied at the same market price of P1. A shift from S1 to D3 is an **outward shift in supply**, so more goods are supplied at the same market price of P1. **[CONDITIONS OF SUPPLY (PRICE-TACOWS)]** 1. **PRICE:** Causes a movement along the supply curve. 2. **TAXES:** Indirect taxes: corporation tax, VAT, so **supply decreases.** 3. **ADVANCEMENTS IN TECHNOLOGY:** able to produce more, so can **supply increases**. 4. **COST OF PRODUCTION:** a low cost of production means **supply increases**. 5. **OTHER FIRMS (COMPETITION):** greater competition means **supply increases**. 6. **WEATHER:** if there is a good harvest for agricultural producers, **supply increases**. 7. **SUBSIDIES:** increased subsidies means **supply increases**. **[\ ]** **[1.2.5 Elasticity of supply]** **Price elasticity of supply (PES):** the sensitivity or responsiveness of changes in quantity supplied to a change in price. All about if the firm can supply immediately or not. PES is [always positive] because there is a positive relationship between P and Q, when prices increase, quantity supplied increases. \ [\$\$\\mathrm{PES =}\\frac{\\mathrm{\\%\\ change\\ in\\ quantity\\ supplied}}{\\mathrm{\\%\\ change\\ in\\ price}}\$\$]{.math.display}\ 1. **Perfectly price elastic:** **[PES = ∞]** 2. **Relatively price elastic:** when the percentage change in quantity supplied is greater than the percentage in price. This means the percentage change in quantity supplied is more responsive to the percentage change in price. **[PES \> 1]** 3. **Unit price elastic:** the percentage change in quantity supplied is equal to the percentage change in price. Exactly proportional. **[PES = 1]** 4. **Relatively price inelastic:** when the percentage change in quantity supplied is less than the percentage change in price. This means the percentage change in quantity supplied is less than the percentage change in price. **[PES \< 1]** 5. **Perfectly price inelastic: [PES = 0]** **[FACTORS INFLUENCING PES:]** 1. **AVAILABILITY** **OF** **RESOURCES** - If there is spare capacity and factors of production are available, then supply is price elastic. - Producers can supply immediately. 2. **AVAILABILITY** **OF** **STOCK** - If there is a stock of goods available, then supply is price elastic. - Producers can supply immediately. - E.g. buffer stock. 3. **PERISHABILITY** - If good can expire quickly supply is price inelastic. - Producer cannot supply immediately. - E.g. strawberries expire within a week or so. 4. **STATE OF THE ECONOMY** - In a recession, there will be spare capacity and therefore supply will be price elastic. - Producers can supply immediately. 5. **TIME** **PERIOD** - In short run PES is inelastic. - In the long run PES is elastic. **[1.2.6 Price determination]** **Equilibrium price:** the balance between demands and supply (D = S), leading to a stable market price.  - If the price level increases from Pe to P1, there is a surplus where supply is more than demand, excess supply as S \> D. - If the price level decreases from Pe to P2, there is a shortage where demand is more than supply, excess demand as D \> S. The equilibrium price (PeQe) is the **[market clearing price]**. This is when there is no surplus and no shortage. The surplus is irradicated by the **[price mechanism]**. **[EXAMPLES OF DEMAND & SUPPLY SHIFTS]** 1. **INCOMES RISE & THE GOOD IS IN FASHION** Demand increases. When demand shifts outward from D to D1, there is an extension of supply from Qe to Q1. Prices rises from Pe to P1 and quantity also increases from Qe to Q1. 2. **INCOMES FALL & THE GOOD IS IN FASHION**  Demand decreases. When demand shifts inward from D to D1, there is a contraction of supply from Qe to Q1. Prices falls from Pe to P1 as quantity falls from Qe to Q1. 3. **TECHNOLOGY IMPROVES & COST OF PRODUCTION FALLS** Supply increases. When supply shifts outward from S to S1, there is an extension of demand from Qe to Q1. Price falls from Pe to P1as quantity rises from Qe to Q1. 4. **TECHNOLOGY WORSENS & COST OF PRODUCTION RISES** Supply decreases. When supply shifts inward from S to S1, there is a contraction of demand from Qe to Q1. Price rises from Pe to P1as quantity falls from Qe to Q1. **[1.2.7 Price mechanism]** **Price mechanism:** the interaction between demand and supply and how price is determined. **[THE ROLE OF THE PRICE MECHANISM]** [To eliminate the surplus] by allowing the price to fall from P1 to Pe. This is through an extension in demand and a contraction in supply. [To eliminate the shortage] by allowing the price to rise from P2 to Pe. This is through a contraction in demand and an extension in supply. **[FUNCTIONS OF PRICE MECHANISM]** 1. **RATIONING SCARCE RESOURCES** - If there is high demand for a good or service and its supply is limited, the price will be high. - Supply of the good will be allocated to those who can afford / willing to pay the most. - E.g. Housing (highest offer on a house gets it). 2. **INCENTIVE TO FIRMS** - When economic agents respond to a change in price. - When **price increases** there is less incentive for consumers to demand and there is greater incentive for firms to supply as they can increase their revenue. - When **price decreases** there is greater incentive for consumers to demand and there is less incentive for firms to supply as they are not gaining high revenue. 3. **SIGNALLING** - When there is an indication from one economic agent to another to respond to changes in demand or supply. - E.g. a price increase is a signal to producers that demand is high, this will encourage them to increase production.**[\ ]** **[1.2.8 Consumer and producer surplus]** **Consumer surplus:** the difference between how much the person is willing to pay and how much they actually pay. **Producer surplus:** the difference between how much the person is willing to sell for and how much they actually sell for / receive.  **[AFFECT OF DEMAND & SUPPLY SHIFTS ON CONSUMER + PRODUCER SURPLUS]** 1. **INCOMES INCREASE & DEMAND SHIFTS RIGHT** Consumer surplus changes from ePex to fP1y. Producer surplus changes from ePe0 to 0P1f. Demand shifts to the right, so there is an extension supply from e to f. Therefore, the producer surplus increases by area ePeP1f. 2. **INCOMES FALL & DEMAND SHIFTS TO THE LEFT** Consumer surplus changes from ePex to fP1y. Producer surplus changes from ePe0 to 0P1f. Demand shifts left, so there is a contraction in supply from e to f. Therefore, producer surplus decreases by area ePeP1f. 3. **TECHNOLOGY IMPROVES & SUPPLY SHIFTS TO THE RIGHT**  Consumer surplus changes from ePex to fP1x. Producer surplus changes from ePey to 0P1f. Supply shifts right, so there is an extension in demand from e to f. Therefore, consumer surplus increases by area ePeP1f. 4. **TECHNOLOGY WORSENS & SUPPLY SHIFTS TO THE LEFT** Consumer surplus changes from ePex to fP1x. Producer surplus changes from ePe0 to yP1f. Supply shifts left, so there is a contraction in demand from e to f. Therefore, consumer surplus decreases by area ePeP1f. **[1.2.9 Indirect taxes and subsidies]** **Tax:** (or levy) a compulsory charge by the government on consumers and producers. Can be a direct tax or indirect tax. **Direct tax:** a tax levied directly on a consumer's incomes or a producer's profit. - E.g. income tax and corporation tax. **Indirect tax:** a tax on the expenditure of goods and services. Can be a specific tax or an ad-valorem tax. **Specific tax:** a tax on the amount per unit of a good. - E.g. customs duty. **fg:** size of tax implemented. **P1fgP2:** total area of tax. **P1fhPe:** area of consumer incidence (tax paid by consumer). **PehgP2:** area of producer incidence (tax paid by producer). Tax causes and increase in price from Pe to P1, leading to a contraction in demand from e to f, so supply shifts from S to S1. **Ad-valorem tax:** a tax as a percentage on the price of the good. - E.g. value added tax (VAT). **fg:** size of tax implemented. **P1fgP2:** total area of tax. **P1fhPe:** area of consumer incidence (tax paid by consumer). **PehgP2:** area of producer incidence (tax paid by producer). Tax causes and increase in price from Pe to P1, leading to a contraction in demand from e to f, so supply shifts from S to S1. **[\ ]** **[ECONOMIC EFFECTS OF INDIRECT TAXES]** **Indirect taxes affect producers** and that is why the supply curve shifts to the left. The main reasons supply shift to the left: [**CPIDSU** ] **C**ost of Production **P**roducer surplus **I**nvestment **D**ividends **S**hares Price **U**nemployment - **C**ost of production increases, so supply curve shifts inwards from S to S1. - **P**roducer surplus decreases from ePe0 to YP1f. - **I**nvestment decreases, so there is more demand for the company's goods. - **D**ividends into the company decrease, existing shareholders get more dividends. - **S**hare price decreases because there is lower demand for company shares. - **U**nemployment increases because less labour is demanded to meet the fall in demand. **Subsidies:** grants given by the government to firms, usually designed to encourage production or consumption of a good. - E.g. council housing is given for lower than market prices.  **fg:** size of subsidy. **P2fgP1:** total area of subsidy. **P2fhPe:** producer incidence of subsidy. **PehgP1:** consumer incidence of subsidy. The subsidy causes a fall in price from Pe to P2, leading to an extension in demand for e to g and thereby an outward shift in supply from S to S1. **[ECONOMIC EFFECTS OF SUBSIDIES (CPIDSU)]** - **C**ost of production decreases, so supply curve shifts outwards from S to S1. - **P**roducer surplus increases from ePey to 0P1f. - **I**nvestment increases, so there is more demand for the company's goods. - **D**ividends into the company increase, existing shareholders get more dividends. - **S**hare price increases because there is greater demand for shares. - **U**nemployment reduces because more labour is demanded to meet the increase in demand. **[1.2.10 Alternative views of consumer behaviour]** In economics it is assumed that consumers act **rationally** to maximise their satisfaction, given their income (in order to get value for money). However, sometimes they do not do this, perhaps because of the following reasons: 1. **INFLUENCE OF OTHER BEHAVIOURS** - Consumers buy 'trendy' products. - Consumers want to copy influencers on social media. - Consumers are swayed by influence of others (social norms). 2. **HABITUAL BEHAVIOURS** - Consumers may exhibit inertia; and/or brand loyalty. - Firms exploit habitual behaviours of consumers by putting high profit goods at eye level in supermarkets to influence consumers to always buy them. - Consumers buy the same products every time (e.g. same brand of hand soap / washing detergent or go to the same hairdressers). 3. **WEAKNESS AT COMPUTATION** - Consumers are unable to calculate the best buys due to asymmetric information. - Consumers are unable to work out if they are getting value for their money. - Consumers are not willing to make comparisons between prices and different offers.