Edexcel Economics (A) A-Level PDF 1.2 How Markets Work

Edexcel Economics (A) A-level Theme 1: Introduction to Markets and Market Failure 1.2 How Markets Work Detailed Notes This work by PMT Education is licensed under https://bit.ly/pmt-cc https://bit.ly/pmt-edu-cc...

Edexcel Economics (A) A-level Theme 1: Introduction to Markets and Market Failure 1.2 How Markets Work Detailed Notes This work by PMT Education is licensed under https://bit.ly/pmt-cc https://bit.ly/pmt-edu-cc CC BY-NC-ND 4.0 https://bit.ly/pmt-cc https://bit.ly/pmt-edu https://bit.ly/pmt-cc  1.2.1 Rational decision making The underlying assumptions of rational economic decision making: Consumers aim to maximise utility: Utility is the satisfaction gained from consuming a product. The rational consumer is called Homo Economicus, who makes decisions by calculating the utility gained from each decision and chooses the one which will give them the most satisfaction. Firms aim to maximise profit: Economic theory assumes that firms are run for their owners and shareholders and so aim to maximise profit in order to keep the shareholders happy. Governments aim to maximise social welfare: Governments are voted in by the public and work for the public, so should aim to maximise their satisfaction by taking decisions which increase social welfare. This is the basis for economic thinking, but it is currently being questioned by behavioral economists. Economic agents do not always have the information necessary to act rationally and consumers do not always make calculated decisions. 1.2.2 Demand Demand is the ability and willingness to buy a particular good at a given price and at a given moment in time. Movements and shifts of the demand curve: A movement along the demand curve, for example from A to B, is caused by a change in the price of the good. A shift of the demand curve, for example D1 to D2, is caused by a change in any of the factors which affect demand, the conditions of demand. A movement from A to B is a contraction in demand, the quantity demanded falls because of an increase in price. A movement from A to C is an extension in demand, the quantity demanded rises due to a decrease in price. Movements along the curve are not called increases or decreases- this only occurs when the curve shifts. A shift from D1 to D2 is a decrease in demand, because fewer goods are demanded at each and every price. For example, at price P only Q2 goods are demanded rather than Q1 goods. A shift from D1 to D3 is an increase in demand, as more goods are demanded at each and every price. Now, Q3 goods are demanded at price P. https://bit.ly/pmt-cc https://bit.ly/pmt-edu https://bit.ly/pmt-cc The conditions of demand: The conditions of demand are the factors which cause the demand curve to shift. A shift to the right is an increase in demand and a shift to the left is a decrease in demand. One way to remember this is the mnemonic PIRATES. Population: If population rises, we would expect demand for all products to increase and so the demand curve will shift to the right. This is because the more people there are in the country, the more people who will want a good. Income: For most goods, if income increases, demand increases because a person can afford to buy more of the product. If there is a fall in income then the demand would decrease and shift to the left. However, for some goods an increase in income can lead to a fall in demand and vice versa, this is a concept called income elasticity of demand. Related goods: If goods are complements or substitutes of each other then a change in the price of another good can cause a shift in the demand curve. Substitutes are where you either buy one good or the other, for example you either buy a pair of Nike trainers or a pair of Adidas trainers. An increase in the price of Nike trainers would lead to a contraction in demand for Nike trainers and an increase in demand of Adidas trainers, as we would expect people to buy them instead. Complements are goods such as DVDs and DVD players where if you have one, you need the other to go with it. If the price of DVD players drops, demand for DVD players would extend and we would expect the demand curve for DVDs to increase. This is linked to the concept of cross elasticity of demand. https://bit.ly/pmt-cc https://bit.ly/pmt-edu https://bit.ly/pmt-cc  Advertising: If a firm carries out a successful advertising campaign, demand is likely to increase. If a competitor firm carries out a successful advertising campaign, demand for the first firm will fall. A successful advertising campaign by Tesco will increase demand for Tesco but reduce demand for Asda. Taste/fashion: If something becomes more fashionable, we expect demand to increase and if it becomes less fashionable, then demand will fall. Expectations: Expectations of what might happen in the future can have a big impact on the level of demand for some goods. If people expect a shortage of something, or that price will rise in the future, then demand for that product will increase. If people expect that price will fall in the future, demand will decrease. Seasons: Some products will find their demand affected by the weather. For example, hot summers cause an increase in demand for sun cream whilst wet summers cause a decrease in demand for umbrellas. Government legislation can also have an effect on the demand for goods. Demand for car seats increased after the government made it a legal requirement that young children have to sit in them. Diminishing marginal utility: The demand curve slopes downward, showing the inverse relationship between price and quantity. This can be explained by the law of diminishing marginal utility. In order to explain or predict how people will spend their money, we have to assume that they are going to behave rationally, expecting them to spend it according to what gives them the greatest level of satisfaction or welfare. Total utility represents the satisfaction gained by a customer as a result of their overall consumption of a good e.g. the satisfaction of eating the whole bar of chocolate, whilst marginal utility represents the change in satisfaction resulting from the consumption of the next unit of a good e.g. the increased satisfaction by eating another bite of chocolate. The Law of Diminishing Marginal Utility states that the satisfaction derived from the consumption of an additional unit of a good will decrease as more of a good is consumed, assuming the consumption of all other goods remains constant. This explains why the demand curve slopes 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. https://bit.ly/pmt-cc https://bit.ly/pmt-edu https://bit.ly/pmt-cc  1.2.3 Price, income and cross elasticities of demand Elasticity of demand is an attempt to measure the responsiveness of quantity demanded to changes in other variables: its own price, the price of other goods and real income. If a good is elastic, it is relatively responsive and if it is inelastic, it is relatively unresponsive Price elasticity of demand (PED): This is the responsiveness of demand to a change in the price of the good. %change in quantity demanded %change in price e.g. If the original price was £5 and 100 were sold and the new price is £3 and 120 are sold, what is the PED? %change in quantity demanded: (20/100)x100=20% %change in price: (-2/5)x100=-40% PED= 20%/-40%= -½ Numerical values: Most values of PED are negative, since a rise in price leads to a fall in output. Therefore, we look at the integer alone, disregarding the negative sign. Unitary elastic PED is where PED=1: quantity demanded changes by exactly the same percentage as price. This would be shown as a reciprocal curve. Relatively elastic PED is where PED>1: quantity demanded changes by a larger percentage than price so demand is relatively responsive to price. The curve will be more sloping. Relatively inelastic PED is where PED1. Goods can also be as elastic or inelastic in income. If the integer is bigger than one, the good is elastic. If the integer is smaller than one, the good is inelastic and this tends to be necessities. Significance of YED: It is important for businesses to know how their sales will be affected by changes in the income of the population. If the economy is improving and people’s incomes are rising it is vital that a business knows whether this is likely to increase their sales or not. https://bit.ly/pmt-cc https://bit.ly/pmt-edu https://bit.ly/pmt-cc  It may have an impact on the type of goods that a firm produces. During times of prosperity, firms might produce more luxury goods and less inferior goods. Cross elasticity of demand (XED): This is the responsiveness of demand for one product (A) to the change in price of another product (B). %change in quantity demanded of A %change in price of B. Numerical values: Substitutes are where XED>0: an increase in the price of good B will increase demand for good A. For example, Coca Cola and Pepsi are substitutes. Complementary goods are where XED1: quantity supplied changes by a larger percentage than price so supply is relatively responsive to price. The curve will be more sloping, starting on the price axis. Relatively inelastic PES is where PES