AS micro topic 1.2

• 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

  1. A movement along the demand curve is caused by a change in the price of the good

  2. A shift of the demand curve is caused by a change in any of the factors which affect demand, the conditions of demand
• Contraction in demand


  The quantity demanded falls because of an increase in price
• Extension in demand


  The quantity demanded rises due to a decrease in price
• Decrease in demand


  Fewer goods are demanded at each and every price
• Increase in demand


  More goods are demanded at each and every price
• 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
• 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
• 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
• Unitary elastic PED


  Quantity demanded changes by exactly the same percentage as price. PED = 1
• Relatively elastic PED


  Quantity demanded changes by a larger percentage than price, so demand is relatively responsive to price. PED > 1
• Relatively inelastic PED


  Quantity demanded changes by a smaller percentage than price, so demand is relatively unresponsive to price. PED < 1
• Perfectly elastic PED


  A change in price means that quantity falls to 0 and demand is very responsive to price. PED = infinity
• Perfectly inelastic PED


  A change in price has no effect on output. PED = 0
• 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
• 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
  • The more elastic the demand curve, the lower the incidence of tax on the consumer
  • When demand is inelastic, the tax will be mainly passed onto the consumer
  • The more inelastic the demand curve, the higher the tax revenue for the government
• Elastic demand


  A subsidy leads to a small fall in price whilst the producer gains a lot in extra revenue
• Inelastic demand


  A subsidy leads to a large fall in price but little change in output
• 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
• 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
• PED= -0.5. The firm currently sells 10,000 at a price of £5. What will happen to total revenue if the price falls to £4?
• 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
  • Normal good: YED>0, a rise in income will lead to a rise in demand
  • Luxury good: YED>1, a type of normal good
• 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
  • Complementary goods: XED<0, an increase in the price of good B will decrease demand for good A
  • Unrelated goods: XED=0, a change in the price of good B has no impact on good A
• Firms need to be aware of their competition and those producing complementary goods. They need to know how price changes by other firms will impact them so they can take appropriate action