1.2 How markets work

Cards (169)

  • 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= PED =%ΔQD%ΔP \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