1.2 how markets work

• What is the aim of consumers in rational economic decision making?

  To maximise utility
• Who is referred to as Homo Economicus?

  The rational consumer who calculates utility from decisions
• What do firms aim to maximise according to economic theory?

  Profit
• Why do governments aim to maximise social welfare?

  They are elected by the public and work for their satisfaction
• What is being questioned by behavioral economists regarding rational decision making?

  Economic agents do not always have the necessary information to act rationally
• What is demand defined as?

  The ability and willingness to buy a good at a given price
• What causes a movement along the demand curve?

  A change in the price of the good
• What is a shift of the demand curve caused by?

  A change in any of the factors affecting demand
• What does a contraction in demand indicate?

  The quantity demanded falls due to an increase in price
• What does an extension in demand indicate?

  The quantity demanded rises due to a decrease in price
• What does a shift from D1 to D2 represent?

  A decrease in demand

  
• What does a shift from D1 to D3 represent?

  An increase in demand

  
• What are the conditions of demand that cause the demand curve to shift?

  • Population
  • Income
  • Related goods
  • Advertising
  • Taste/fashion
  • Expectations
  • Seasons
  • Government legislation
• How does population affect demand?

  If population rises, demand for all products is expected to increase
• What happens to demand when income increases for most goods?

  Demand increases because people can afford to buy more
• What is income elasticity of demand?

  The concept that an increase in income can lead to a fall in demand for some goods
• How do related goods affect demand?

  A change in the price of one good can shift the demand curve for its complements or substitutes
• What happens to demand for substitutes when the price of one increases?

  Demand for the other substitute increases
• What happens to demand for complements when the price of one decreases?

  Demand for the other complement increases
• How does advertising affect demand?

  A successful advertising campaign can increase demand for a firm’s products
• How do taste and fashion influence demand?

  If something becomes more fashionable, demand is expected to increase
• How do expectations affect demand?

  Expectations of future shortages or price increases can increase current demand
• How do seasons affect demand?

  Weather can affect demand for certain products, like sun cream in hot summers
• How can government legislation affect demand?

  Legal requirements can increase demand for certain goods, like car seats for children
• What does the law of diminishing marginal utility explain about the demand curve?

  It explains why the demand curve slopes downward due to decreasing satisfaction from additional units

  
• What is total utility?

  The satisfaction gained from overall consumption of a good
• What is marginal utility?

  The change in satisfaction from consuming an additional unit of a good
• What does the Law of Diminishing Marginal Utility state?

  The satisfaction from consuming an additional unit decreases as more is consumed
• Why are consumers less willing to pay high prices at high quantities?

  Because they gain less satisfaction from additional units consumed
• What is elasticity of demand?

  It measures the responsiveness of quantity demanded to changes in other variables
• What does price elasticity of demand (PED) measure?

  The responsiveness of demand to a change in the price of the good
• How do you calculate PED?

  PED = % change in quantity demanded / % change in price
• If the original price was £5 and 100 were sold, and the new price is £3 with 120 sold, what is the PED?

  PED = 20% / -40% = -½
• What does unitary elastic PED mean?

  PED = 1, quantity demanded changes by the same percentage as price
• What does relatively elastic PED indicate?

  PED > 1, quantity demanded changes by a larger percentage than price
• What does relatively inelastic PED indicate?

  PED < 1, quantity demanded changes by a smaller percentage than price
• What does perfectly elastic PED mean?

  PED = infinity, a change in price causes quantity demanded to fall to 0
• What does perfectly inelastic PED mean?

  PED = 0, a change in price has no effect on quantity demanded
• What factors influence PED?

  Availability of substitutes
• How does the availability of substitutes affect PED?

  If substitutes are available, demand is more elastic