1.2 How markets work

• Rational decision making

  Individuals make choices that maximise their utility or well-being, given the available resources and information
• Assumptions of Rational Decision Making

  • Consistency: Individuals have stable preferences and will make the same choice when faced with the same set of options
  • Completeness: People can compare and rank all possible alternatives to make a decision
  • Transitivity: If option A is preferred to option B, and option B is preferred to option C, then option A is preferred to option C
  • Rationality: Individuals will always choose the option that maximises their utility or well-being
• Utility

  Satisfaction or happiness that an individual derives from consuming a good or service
• Total Utility

  Overall satisfaction obtained from consuming a certain quantity of a good
• Marginal Utility

  Additional satisfaction gained from consuming one more unit of the good
• Law of Diminishing Marginal Utility: As a person consumes more units of a good, the additional satisfaction (marginal utility) derived from each additional unit diminishes
• Imperfect Information

  Individuals often face imperfect information, which may lead to less than optimal decisions
• Bounded Rationality

  Due to limited cognitive abilities and time, individuals may make decisions that are "good enough" rather than completely optimal
• Rational decision making (from a firm's point of view)

  The process by which a company makes choices and allocates its resources to maximise profits and achieve its business objectives
• Firm's primary goal

  Maximise shareholder wealth or long-term value
• Principles and considerations in rational decision making for a firm

  • Profit Maximisation
  • Cost-Benefit Analysis
  • Market Demand and Pricing
  • Production and Resource Allocation
  • Investment Decisions
  • Risk Management
  • Competitive Analysis
  • Long-Term Perspective
  • Information and Data Analysis
  • Legal and Ethical Considerations
• Real-world business decisions are often influenced by external factors, uncertainties, and behavioural aspects of decision-makers, so firms may make "satisficing" decisions that are considered good enough, even if they are not strictly optimal
• what does it mean when we say that consumers aim to maximise utility

  when making decisions, people aim to maximise their own welfare

  they have limited income and they allocate money in a way that gives them the highest total satisfaction
• assumptions about rational consumers

  consumers choose independently (my preferences don't affect your choices)

  a consumer has fixed and consistent tastes and preferences

  consumers gather complete information on the alternatives available in the market

  consumers always make an optimal choice given their preferences
• do consumers always behave rationally

  consumers rarely behave in a well-informed and rational way:

  • herd behaviour
  • habitual behaviour
  • poor computational ability
  • heuristics/shortcuts
  • framing effects
• demand

  the quantity that purchasers are willing and able to buy at a given price in a given period of time
• effective demand

  only if demand for a product is backed up by a willingness and ability to pay the market price
• basic law of demand

  demand varies inversely with price - lower prices make products more affordable for consumers
• why does the demand curve slope downwards - law of diminishing marginal utility

  as quantity consumed increases, the value to the consumer of each additional unit decreases and therefore as consumers are rational, the price they are willing to pay decreases
• why does the demand curve slope downwards - income effect

  as the price of the good falls, the consumers can buy more of that good with their income; their money goes further, so they can afford to buy more
• why does the demand curve slope downwards - substitution effect

  when the price of a good falls, its substitutes become relatively more expensive, consumers switch away from other goods towards the relatively cheaper good
• demand curve

  shows how much of a good/service consumers want at each price - only changes in market price of the product causes a movement along the demand curve

  higher price - contraction of quantity demanded, ceteris paribus

  lower price - expansion of quantity demanded, ceteris paribus

  
• what causes a shift in demand curve

  expectations of sales in the future

  consumer tastes

  price of substitute goods

  price of complimentary goods

  income

  seasonality
• how do changing seasons affect the demand for goods

  seasonality refers to fluctuations in output and sales related to the season
• changing prices of a substitute goods/services in competitive demand

  fall in the price of a good makes it relatively cheaper compared to substitutes

  some consumers will switch to that good leading to higher demand - depends on whether products are close substitutes
• changing price of a complement - products in joint demand

  fall in the price of a good leads to an expansion of quantity demanded - may lead to higher demand for the complement good
• changes in real income of consumers

  real income increases, ability to purchase goods and services increases causing outward shift in demand curve - unless it is an inferior good

  changes in the distribution of income - more equal distribution of income can increase total demand as relatively poorer consumers spend a higher proportion of their income

  interest rates can affect deman
• changes in consumer preferences, such as:

  • effects of advertising and marketing
  • changes in the size and age structure of a population
  • seasonal factors for some goods and services
  • social and emotional factors
• what affects demand - PIRATES

  Population

  Income

  Related goods

  Advertising

  Tastes and fashion

  Expectations

  Seasons
• derived demand

  demand for a factor of production used to produce another good or service
• composite demand

  exists where goods have more than one use - an increase in the demand for one product leads to a fall in supply of the other
• elasticity

  sensitivity or responsiveness
• Price Elasticity of Demand (PED)

  the responsiveness of quantity demanded to a change in price
• what determines Price Elasticity of Demand

  number of close substitutes available for consumers

  price of the product in relation to total income

  cost of substituting between different products

  brand loyalty and habitual consumption

  degree of necessity/luxury
• $PED =$$\frac{\%\Delta\mathit{QD}_{}}{\%\Delta\mathit{P}_{}}$

  the value is called the coefficient of PED, we know it is always negative so we just talk about the positive value
• PED

  if the % change in price leads to a bigger change in quantity demanded, i.e. the % change in quantity demanded is highly responsive, this means the relationship is elastic (more than 1)
• PED

  the % change in price leads to a smaller change in quantity demanded, i.e. the % change in quantity demanded is not responsive, this means relationship is inelastic (less than 1)
• why is PED always a negative number

  the demand curves show an inverse relationship, i.e. as prices rise, quantity falls and as price falls, quantity rises
• PED is -∞

  described as perfectly elastic, only 1 price consumers are willing to pay

  
• elastic PED

  % change in price is less than the % change in quantity demanded