(1.2) 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 (Homo Economicus) 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
• Movement from A to B

  Contraction in demand, the quantity demanded falls because of an increase in price
• Movement from A to C

  Extension in demand, the quantity demanded rises due to a decrease in price
• Shift from D1 to D3


  Increase in demand, more goods are demanded at each and every price
• The conditions of demand (PIRATES)

  • Population
  • Income
  • Related goods
  • Advertising
  • Taste/fashion
  • Expectations
  • Seasons
  • Government legislation
• 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
• This explains why the demand curve slopes downwards: if more of a good is consumed, there is less satisfaction derived from the good. This means that consumers are less willing to pay high prices at high quantities since they are gaining less satisfaction
• 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 = 1: quantity demanded changes by exactly the same percentage as price
  • Relatively elastic PED > 1: quantity demanded changes by a larger percentage than price
  • Relatively inelastic PED < 1: quantity demanded changes by a smaller percentage than price
  • Perfectly elastic PED = infinity: a change in price means quantity falls to 0
  • Perfectly inelastic PED = 0: a change in price has no effect on output
• Perfectly elastic PED


  A change in price means that quantity falls to 0 and demand is very responsive to price. This would be shown by a horizontal line
• Perfectly inelastic PED


  A change in price has no effect on output so demand is completely unresponsive to price. This would be shown by a vertical line
• Factors influencing PED


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


  If a product has lots of substitutes, people will switch to other products when prices go up, so PED will be elastic. If there are no substitutes, the demand curve will be inelastic
• Time


  The longer the time, the easier it will be for a person to find an alternative product/supplier of the product so the more elastic the good is. In the short term, many goods are inelastic as people may not even notice the price difference
• Necessity


  If you need something, the demand curve will be inelastic because even if the price goes up, you still need to buy it
• How large of a % of total expenditure

  If a good/service represents a very small percentage of a person's expenditure, a significant increase in price will have a relatively small impact on how much they buy of that product so it will be inelastic e.g. matches
• Addictive


  If a product is addictive, then the demand curve will be inelastic. No matter how high prices are, people will still buy the good to fulfill their addiction
• 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. A tax will only lead to a small increase in price and the supplier will have to cover the majority of the cost of the tax
• Inelastic demand


  The tax will be mainly passed onto the consumer. Quantity demanded will not fall by a large amount, so the tax will be ineffective at reducing output. However, it also means that there is higher tax revenue for the government
• Elastic demand

  A small fall in price with a subsidy, but the producer gains a lot in extra revenue
• Inelastic demand


  The price falls a lot with a subsidy, but there is little change in output. Subsidies on goods with inelastic demand are ineffective at increasing output and are cheaper for the government to impose
• The shift from S1 to S2 on tax diagrams is a result of the imposition of an indirect tax: this raises the cost of production and shifts supply to the left. The opposite occurs with a subsidy
• Elastic demand curve


  A decrease in price leads to an increase in revenue and an increase in price leads to a decrease in revenue
• Inelastic demand curve


  A decrease in price leads to a decrease 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
• For PED=-0.5, a 20% decrease in price leads to a 10% increase in quantity demanded, resulting in a decrease in total revenue of £6,000
• Income elasticity of demand (YED)


  The responsiveness of demand to a change in income
• Numerical values of YED

  • Inferior good (YED<0)
  • Normal good (YED>0)
  • Luxury good (YED>1)
  • Elastic in income (integer>1)
  • Inelastic in income (integer<1)
• Businesses need to know how their sales will be affected by changes in the income of the population. This may impact the type of goods they produce
• Cross elasticity of demand (XED)

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


  • Substitutes (XED>0)
  • Complementary goods (XED<0)
  • Unrelated goods (XED=0)
• Firms need to be aware of their competition and those producing complementary goods, and how price changes by other firms will impact them
• Supply


  The ability and the willingness to provide a good or service at a particular price at a given moment in time