Assumptions: consumers aim to maximise utility, firms aim to maximise profits
1.2.2, 1.2.3, 1.2.4, 1.2.5
Demand, Price, income and cross elasticities of demand, Supply & Elasticity of supply - Combined
What is a market?
a market is a place where buyers and sellers meet to exchange goods and services
What is demand?
demand is the number of goods and services that consumers are willing and able to buy at each price point
What is the relationship between price and demand?
downward sloping (inverse relationship)
at higher prices, quantity demanded is lower because goods and services are less affordable so less people are willing and able to buy
What is diminishing marginal utility?
as quantity increases, there is a decrease in the extra satisfaction the consumer gains
How do you describe a right shift in demand?
people are willing and able to consume a higher quantity of the good or service at each price point
Non-price factors that shift the demand curve
PIRATES
Population
Incomes
Related goods
complementary goods
substitute goods
Advertising
Trends (new fashion etc.)
Expectations (toilet roll during covid)
Seasons (ice cream/ holiday packages)
What is supply?
supply is the number of goods and services that firms are willing and able to produce at each price point
What is the relationship between price and supply?
upward sloping (positive relationship)
at higher prices, quantity supplied is higher because there is a greater incentive for firms to sell due to the potential to make higher profits
How do you describe a right shift in supply?
firms are more willing and able to produce a good or service at each price point
Non-price factors that shift the supply curve
PCTWINS
Productivity
Costs of production
Technology
Weather
Indirect tax
Number of firms
Subsidies
What is elasticity?
responsiveness
0 - perfectly inelastic
1 or -1 - unit elastic
infinity - perfectly elastic
somewhat inelastic - between 0 and 1 or between 0 and -1
Elasticity Equations
% change in the third letter/ % change in the first letter
What is PED?
price elasticity of demand
the responsiveness of demand to a change in price
PED = % change in D/ % change in P
What is PES?
price elasticity of supply
the responsiveness of supply to a change in price
PES = % change in S/ % change in P
What is YED?
income elasticity of demand
the responsiveness of income to a change in price
PED = % change in D/ % change in Y
What is XED?
cross elasticity of demand
the responsiveness of demand of one good, to a change in price of a different good
PED = % change in D of good A/ % change in P of good B
Factors that affect PED
SANDPIT
S - number of substitutes
A - addictiveness (cigarettes)
N- necessity (electricity/ energy bills)
D - durability (sofa)
P - proportion of income (inelastic if it is something that is £1 increases by 50% to £1.50, elastic if it is something that increases by 50% from £1000 to £1500)
I
T - time (over time, the other factors change e.g. people get used to substitutes over time)
Factors that affect PES
SECTS
S - substitutability of factors
E - barriers to entry
C - spare capacity
T - time
S - stock level
Factors that affect YED
inferior goods - YED < 0
normal goods - 0 < YED < 1
luxury goods - YED > 1
Factors that affect XED
strong complements - XED < -1
weak complements - -1 < XED < 0
unrelated goods - XED = 0
weak substitutes - 0 < XED < 1
strong substitutes - XED > 1
1.2.6 Price determination
Equilibrium price and quantity is where demand meets supply. At this quantity, price has no tendency to change. It is the market-clearing price.
Disequilibrium: when demand is not equal to supply.
Excess demand: when demand is more than supply. There is a shortage of supply causing prices to push up to ration supply. This causes demand to contract, to create a new, higher equilibrium price.
Excess supply: when supply is higher than demand. This causes firms to lower prices to sell their goods. When supply clears, the market returns to equilibrium.
The model of demand and supply assumes that prices change instantly when there is a shift in demand or supply, but in reality there is disequilibrium before firms react to quantity changes.
1.2.7 Price mechanism
The price mechanism determines the market price (Adam Smith’s invisible hand).
Rationing: higher prices ration demand.
Incentive: prices create incentives for people to alter their economic behaviour (e.g. high prices incentivise higher supply due to the profit motive).
Economic incentives influence what, how and for whom goods and services are produced.
Signal: prices provide information to buyers and sellers.
The price mechanism is arguably an impersonal method of allocating resources. Relying on free markets also maximises consumer and producer surplus, and there is no risk of government failure.
However, introducing the price mechanism and markets into some fields may be undesirable and is likely to affect the nature of the activity, e.g. introducing a market for blood changes the nature of the transaction and the incentives involved. The forces of supply and demand can also widen inequality of living standards, and free markets do not account for inequalities.
1.2.8 Consumer and producer surplus
Consumer surplus: the difference between the maximum price consumers are willing to pay, and actual price paid.
Producer surplus: the difference between the minimum price producers are willing to sell for, and the actual price paid.
1.2.9 Indirect taxes and subsidies
Indirect tax: a cost of production, shifting supply to the left.
Evaluations: inelastic, tax revenue, burden.
Subsidy: a payment made by the government, shifting supply to the right.
Evaluations: opportunity cost, space e.g. for housing.
1.2.10 Alternative views of consumer behaviour
Three reasons why may consumers may not behave rationally?
They may be influenced by other people (herd behaviour or social norms)
They may form habitual behaviour
Computaional weakness (consumers may struggle to make accurate and fast choices based on the information that is available to them).