1.2 How markets work

• How do consumers act rationally

  1. Respond to signals + Incentives
  2. Aim to maximize utility
  3. Easy access to information
• Irrational behavior

  Herd mentality

  Risk-averse

  Emotional decision making
• Demand

  The total amount of goods consumers are willing to buy at a given price in a period of time
• Diminishing marginal utility

  Consumers are willing to pay less for each consecutive unit
• Non-Price shifts in demand

  Population

  Income

  Related goods (compliments/substitutes)

  Advertisement

  Trends

  Expectations

  Seasonality
• Elasticity of demand

  Sensitivity of quantitative demand to a change in price
• PED formula

  (% change in Demand / % change in price)
• PED values

  1.0 < Elastic

  1.0 > Inelastic

  1.0 = Unitary elastic
• Factors affecting PED

  • Availability of substitutes
  • cost of switching
  • Degree of necessity
  • Time frame
  • Brand loyalty
  • Habit framing products
• Supply

  The quantity of goods or services producers are willing to produce at a given period of time.
• Diminishing marginal returns

  Decreasing productive output, and increasing unit costs.
• Non- price factors affecting supply

  Productivity

  Indirect taxes

  Number of producers

  Technology

  Subsidies

  Weather

  Costs of production
• PES

  Measures the sensitivity of quantity supplied to a change in price
• Elastic or Inelastic

  Spare production capacity- elastic supply

  Perishable goods- inelastic

  Factor of mobility- Elastic

  Long time period of production- Elastic
• Excess demand or Supply

  Due to Market disequilibrium
• Excess supple & Demand

  Excess Supply- Above equilibrium

  Excess Demand- Below Equilibrium
• Price mechanism

  How free markets dictate prices and further conditions for change
• Impact of price changes

  Reallocation

  Signaling

  Incentives

  Rationing
• Increase in demand for price change

  Signalling- Signals excess demand and need for more resources

  Incentives- Incentives for firms to increase output to increase profits

  Rationing- Ration resources by decreasing consumption
• Consumer surplus

  The difference between the price the consumers are willing and able to pay for goods and the price they do pay
• Producer surplus

  Difference between the price producers are willing to supply a good for and the price they actually receive