How Markets Work

• rational decision making


  describes choices that are logical and consistent and maximize value (consumers want to maximize utility and producers want to maximize profit)
• Utility


  Ability or capacity of a good or service to be useful and give satisfaction to someone.
• Demand


  the quantity of a good or service that consumers are willing and able to buy at any given price in a given time period
• Law of Demand


  quantity demanded varies inversely with price
• extension of demand


  the increase in quantity demanded due to a fall in price

  
• contraction of demand


  the fall in the quantity demanded due to a rise in price

  
• the income effect


  the change in consumption that results when a price increase causes real income to decline

  consumers can buy less with a given budget
• the substitution effect


  the change in the quantity demanded of a good that results from a change in price, making the good more or less expensive relative to other goods that are substitutes ( depends on closeness of substitutes )
• Shifting the Demand Curve


  things that determine buyers' demand for a good, other than the good's price (non-price determinants) (shift right=increase; shift left=decrease)

  
• Conditions of demand


  changes in income

  fashion/tastes/preferences

  advertising and branding

  population size/demographic change

  external shocks

  seasonality

  market expectations

  price of complements

  price of substitutes
• Marginal utility


  the extra usefulness or satisfaction a person gets from acquiring or using one more unit of a product, customers are willing to pay a price less than or equal to their marginal utility
• Diminishing marginal utility


  the principle that our additional satisfaction, or our marginal utility, tends to go down as more and more units are consumed, the additional satisfaction obtained from the consumption of the next unit will go down as we consume more units

  
• Derived demand


  demand for a good when it is required in the making of another
• veblen goods


  are goods that have snob value and are bought to display wealth rather than utility. Their demand curve slopes upwards from left to right, as the higher the price the greater the quantity demanded, reverse economic logic, more expensive they are the more effectively they claim their status
• Supply


  quantity that producers are willing and able to sell at any given price in a given time period
• law of supply


  supply has a direct relationship with price because the higher the price the more opportunity for profit
• extension of supply


  When there is an increase in supply because the market price has risen.

  
• contraction of supply


  When the amount offered for sale is reduced because the price level has fallen.

  
• shifting the supply curve


  non-price determinants shift the supply curve (shift right=increase; shift left=decrease)

  
• conditions of supply


  cost of production

  external shock

  new technology

  indirect taxes (increases cost of production)

  subsidies
• equlibrium price


  The quantity consumers are willing and able to buy is exactly equal to the quantity firms are willing and able to sell. here there is no excess supply causing surplus and no excess demand causing shortage
• When market price is above equilibrium price


  producers supply more and consumers demand less so there is a surplus, market price will fall. there will be a contraction of supply and extension of demand until equilibrium price and quantity is reached

  
• when market price is below equilibrium price


  consumers demand more and producers supply less so there is a shortage, which causes the market price to rise. there is an extension of supply and contraction of demand until equilibrium price is reached
• increase in demand

  a rightward shift in the demand curve representing a willingness on the part of buyers to demand more of a good or service at any price. equilibrium price will increase and so will equilibrium quantity

  
• decrease in demand


  a leftward shift in the demand curve representing a decrease in the willingness of buyers to demand an item at any price. equilibrium price will fall as will equilibrium quantity

  
• increase in supply

  a rightward shift in the supply curve indicating a willingness of business firms to produce more of an item at any given price. equilibrium price will fall and equilibrium quantity will rise

  
• decrease in supply


  a leftward shift of the supply curve indicating a decrease in the quantity suppliers are willing to produce at any price. equilibrium price will rise and equilibrium quantity will fall
• the price mechanism


  forces of supply and demand determine the price of commodities, therefore influencing how scare resources are allocated to their highest value use
• rationing


  A system of allocating scarce goods and services using criteria other than price, when demand is greater than supply prices rise and the good is rationed so that only those who can afford to pay the higher prices get it
• incentivising


  when price rises it creates an incentive for firms to produce more to meet demand, if it falls it creates an incentive to leave the market
• signalling


  long term impact, changes in curves signals for producers and consumers to enter or leave the market
• consumer surplus


  The difference between the maximum amount a person is willing to pay for a good and its current market price.

  
• producer surplus


  the difference between the lowest price a firm would be willing to accept for a good or service and the price it actually receives

  
• elasticity


  a measure of responsiveness to a change in another variable
• PED


  the responsiveness of the quantity demanded to a change in price
• price elastic demand

  % change in QD> % change in P
• price inelastic demand


  %change in QD< % change in P
• unit elastic demand


  % change in QD=% change in P
• PED determinants


  ease of substitution

  luxury or necessity

  frequency of purchase

  proportion of income
• elasticity is effected by...


  time period

  width of market definition