1.2 How markets work

• Underlying assumptions of rational economic decision making:

  • Consumers aim to maximise utility, which is the satisfaction gained from consuming a product
  • Firms aim to maximise profit to keep shareholders happy
  • Governments aim to maximise social welfare by taking decisions that increase public satisfaction
• Behavioral economists question the assumption of rational decision making due to lack of necessary information and consumers not always making calculated decisions
• Demand is the ability and willingness to buy a particular good at a given price and moment in time
• Movements and shifts of the demand curve:

  • A movement along the demand curve is caused by a change in the price of the good
  • A shift of the demand curve is caused by a change in factors affecting demand, known as conditions of demand
• Factors affecting demand curve shifts:

  • Population increase leads to increased demand
  • Income increase generally leads to increased demand
  • Related goods like substitutes or complements can cause shifts
  • Advertising can increase demand
  • Taste/fashion changes can affect demand
  • Expectations of future events can impact demand
  • Seasons and weather can affect demand
  • Government legislation can influence demand
• Diminishing marginal utility:

  • Demand curve slopes downward due to the law of diminishing marginal utility
  • Total utility represents overall satisfaction from consumption, while marginal utility is the change in satisfaction from consuming the next unit
  • Law of Diminishing Marginal Utility states that satisfaction decreases as more of a good is consumed
• Price elasticity of demand (PED):

  • Measures the responsiveness of demand to changes in price
  • Unitary elastic PED is where quantity demanded changes by the same percentage as price
  • Relatively elastic PED is where quantity demanded changes more than price
  • Relatively inelastic PED is where quantity demanded changes less than price
  • Perfectly elastic PED means quantity falls to 0 with a price change
  • Perfectly inelastic PED means price change has no effect on output
• Factors influencing PED:

  • Availability of substitutes affects elasticity
  • Time influences elasticity
  • Necessity of the good affects elasticity
  • Percentage of total expenditure spent on the good affects elasticity
  • Addictiveness of the good affects elasticity
• Significance of PED:

  • Determines effects of indirect taxes and subsidies
  • More elastic demand leads to lower tax burden on consumers
  • Inelastic demand leads to higher tax revenue for the government
  • Elastic demand with subsidies leads to small price falls and large producer gains
  • Inelastic demand with subsidies leads to large price falls and small output changes
• PED and revenue:

  • Elastic demand: price decrease increases revenue, price increase decreases revenue
  • Inelastic demand: price decrease decreases revenue, price increase increases revenue
  • Unitary elastic curve: revenue changes with price changes
• For an inelastic demand curve:

  • A decrease in price leads to a decrease in revenue
  • An increase in price leads to an increase in revenue
• For a unitary elastic curve, a change in price does not affect total revenue
• Original total revenue: 10,000 x £5 = £50,000
• % change in price: (-1/5) x 100 = -20%
• Change in output: -0.5 = Q / -20%

  • 0.5 x 20% = Q = 10%
• New output: 10% of 10,000 = 1000

  10,000 + 1000 = 11,000 (output increases by 10%)
• New total revenue: 11,000 x £4 = £44,000
• Difference in revenue: £44,000 - £50,000 = -£6,000

  Revenue will fall by £6,000
• Income elasticity of demand (YED):

  • This is the responsiveness of demand to a change in income
• An inferior good is when YED < 0: a rise in income will lead to a fall in demand for the good
• A normal good is when YED > 0: a rise in income will lead to a rise in demand for the good
• A luxury good is a type of normal good, when YED > 1
• Goods can also be 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 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
• Cross elasticity of demand (XED):

  • This is the responsiveness of demand for one product (A) to the change in price of another product (B)
• Substitutes are where XED > 0: an increase in the price of good B will increase demand for good A
• Complementary goods are where XED < 0: an increase in the price of good B will decrease demand for good A
• Unrelated goods are where XED = 0: a change in the price of good B has no impact on good A
• The size of the integer represents the strength of the relationship: the larger the number, the stronger the relationship between the two
• Significance of XED:

  • Firms need to be aware of their competition and those producing complementary goods
• Supply is the ability and willingness to provide a good or service at a particular price at a given moment in time
• Movements and shifts of the supply curve:

  • A movement along the supply curve is caused by a change in the price of the good
  • A shift of the supply curve is caused by a change in any of the factors which affect supply, the conditions of supply
• A movement from A to B is a contraction in supply, the quantity supplied falls because of a decrease in price

  • A movement from A to C is an extension in supply, the quantity supplied rises due to an increase in price
• A shift from S1 to S2 is a decrease in supply, because fewer goods are supplied at each and every price

  • A shift from S1 to S3 is an increase in supply, as more goods are supplied at each and every price
• Factors affecting PES:

  • Time: impacts the amount of a good that can be supplied at any price
  • Stocks: a stockpile of goods can make supply more elastic
  • Working below full capacity: can make supply more elastic
  • Availability of factors of production: can affect the elasticity of supply
  • Ease of entry into the market: affects the elasticity of supply
  • Availability of substitutes: affects the elasticity of supply
• Price determination:

  • Equilibrium point is where supply is equal to demand
  • Excess demand occurs when price is set below equilibrium
  • Excess supply occurs when price is set higher than equilibrium
• Shifts in demand and supply:

  • An increase in demand leads to an increase in price and output
  • A decrease in demand leads to a decrease in price and output
  • An increase in supply leads to an increase in output and a decrease in price
  • A decrease in supply leads to an increase in price and a decrease in output
• Price mechanism:

  • In a free market economy, the price mechanism allocates resources
  • Price is determined by the interactions of demand and supply
• The price mechanism has three main functions:

  • Rationing function: When prices increase, some people may no longer afford to buy the product, and resources are allocated to those who value them most
  • Signalling function: Prices rising indicate producers to move resources into manufacturing that product
  • Incentive function: Acts as an incentive for people to work hard and for suppliers to produce more goods
• The price mechanism operates in different markets:

  • Local markets: During the coronavirus pandemic, disruptions in supply chains led to higher food prices in British supermarkets, illustrating the rationing function
  • National markets: Discrepancies in house prices across the UK, with London having high prices due to high demand and offering an incentive for firms to produce more houses, showing the incentive function
  • Global markets: In 1973, OPEC's oil embargo led to record-breaking oil prices, demonstrating the rationing function