HOW MARKETS WORK

• Rational decision making


  The underlying assumptions of rational economic decision making
• Consumers aim to maximise utility

  Utility is the satisfaction gained from consuming a product. The rational consumer is called Homo Economicus, who makes decisions by calculating the utility gained from each decision and chooses the one which will give them the most satisfaction
• Firms aim to maximise profit


  Economic theory assumes that firms are run for their owners and shareholders and so aim to maximise profit in order to keep the shareholders happy
• Governments aim to maximise social welfare


  Governments are voted in by the public and work for the public, so should aim to maximise their satisfaction by taking decisions which increase social welfare
• This is the basis for economic thinking, but it is currently being questioned by behavioral economists. Economic agents do not always have the information necessary to act rationally and consumers do not always make calculated decisions
• Demand


  The ability and willingness to buy a particular good at a given price and at a given 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 any of the factors which affect demand, the conditions of demand
• Conditions of demand


  • Population
  • Income
  • Related goods
  • Advertising
  • Taste/fashion
  • Expectations
  • Seasons
  • Government legislation
• Population


  If population rises, we would expect demand for all products to increase and so the demand curve will shift to the right
• Income


  For most goods, if income increases, demand increases because a person can afford to buy more of the product. If there is a fall in income then the demand would decrease and shift to the left. However, for some goods an increase in income can lead to a fall in demand and vice versa, this is a concept called income elasticity of demand
• Related goods


  If goods are complements or substitutes of each other then a change in the price of another good can cause a shift in the demand curve
• Advertising


  If a firm carries out a successful advertising campaign, demand is likely to increase. If a competitor firm carries out a successful advertising campaign, demand for the first firm will fall
• Taste/fashion


  If something becomes more fashionable, we expect demand to increase and if it becomes less fashionable, then demand will fall
• Expectations


  Expectations of what might happen in the future can have a big impact on the level of demand for some goods
• Seasons


  Some products will find their demand affected by the weather
• Government legislation


  Can also have an effect on the demand for goods
• Diminishing marginal utility


  The demand curve slopes downward, showing the inverse relationship between price and quantity. This can be explained by the law of diminishing marginal utility
• Total utility


  The satisfaction gained by a customer as a result of their overall consumption of a good
• Marginal utility


  The change in satisfaction resulting from the consumption of the next unit of a good
• Law of Diminishing Marginal Utility


  The satisfaction derived from the consumption of an additional unit of a good will decrease as more of a good is consumed, assuming the consumption of all other goods remains constant
• Price elasticity of demand (PED)


  The responsiveness of demand to a change in the price of the good
• Numerical values of PED

  • Unitary elastic PED is where PED=1
  • Relatively elastic PED is where PED>1
  • Relatively inelastic PED is where PED<1
  • Perfectly elastic PED is where PED=infinity
  • Perfectly inelastic PED is where PED=0
• Factors influencing PED


  • Availability of substitutes
  • Time
  • Necessity
  • How large of a % of total expenditure
  • Addictive
• Significance of PED


  The price elasticity of demand, along with the price elasticity of supply, determine the effects of the imposition of indirect taxes and subsidies
• Elastic demand


  The lower the incidence of tax on the consumer. The more the producer has to cover the cost of the tax
• Inelastic demand


  The tax will be mainly passed onto the consumer. The tax will be ineffective at reducing output but will generate higher tax revenue for the government
• Elastic demand and subsidies


  The consumer sees a small fall in price whilst the producer gains a lot in extra revenue. There is a large change in output
• Inelastic demand and subsidies

  There is a small rise in output but a large fall in price, with little producer gain. Subsidies are cheaper for the government to impose
• PED and revenue


  • For an elastic demand curve, a decrease in price leads to an increase in revenue and an increase in price leads to a decrease in revenue
  • For an inelastic demand curve, a decrease in price leads to a decrease in revenue and an increase in price leads to an increase in revenue
  • For a unitary elastic curve, a change in price does not affect total revenue
• Income elasticity of demand (YED)

  The responsiveness of demand to a change in income
• Inferior good


  YED<0: a rise in income will lead to a fall in demand for the good
• Normal good


  YED>0: a rise in income will lead to a rise in demand for the good
• Luxury good


  A type of normal good where YED>1
• An increase in revenue and an increase in price


  Leads to an increase in revenue
• Unitary elastic curve


  A change in price does not affect total revenue
• Luxury good


  A type of normal good, when YED>1
• 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 this 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
  • It may have an impact on the type of goods that a firm produces. During times of prosperity, firms might produce more luxury goods and less inferior goods
• Cross elasticity of demand (XED)

  The responsiveness of demand for one product (A) to the change in price of another product (B)
• Substitutes


  XED>0: an increase in the price of good B will increase demand for good A