1.2 How Markets Work

PIRATES

The larger the population, the higher the demand. Changing the structure of the population also affects demand, such as the distribution of different age groups.

If consumers have more disposable income, they are able to afford more goods, so demand increases.

Related goods are substitutes or complements. A substitute can replace another good, such as two different brands of TV. If the price of the substitute falls, the quantity demanded of the original good will fall because consumers will switch to the cheaper option. A complement goes with another good, such as strawberries and cream.

This will increase consumer loyalty to the good and increase demand. Subliminal messages from advertising cause non rational consumer decision making.

The demand curve will also shift if consumer tastes change. For example, the demand for physical books might fall, if consumers start preferring to read e-books

This is of future price changes. If speculators expect the price of shares in a company to increase in the future, demand is likely to increase in the present.

Demand changes according to the season. For example, in the summer, the demand for ice cream and sun lotions increases.

This is when the demand for one good is linked to the demand for a related good. For example, the demand for bricks is derived from the demand for the building of new houses. The demand for labour is derived from the goods the labour produces. For example, if the demand for cars increases, the demand for the labour to produce those cars will increase.

This is when the good demanded has more than one use. An example could be milk. Assuming there is a fixed supply of milk, an increase in the demand for cheese will mean that more cheese is supplied, and therefore less butter can be supplied.

This is when goods are bought together, such as a camera and a memory card.

The price elasticity of demand is the responsiveness of a change in demand to a change in price.

A price elastic good is very responsive to a change in price. In other words, the change in price leads to an even bigger change in demand. The numerical value for PED is >1.

A price inelastic good has a demand that is relatively unresponsive to a change in price. PED is <1.

A unitary elastic good has a change in demand which is equal to the change in price. PED = 1.

A perfectly elastic good has a demand which falls to zero when price changes. PED = Infinity.

A perfectly inelastic good has a demand which does not change when price changes. PED = 0

A necessary good, such as bread or electricity, will have a relatively inelastic demand. In other words, even if the price increases significantly, consumers will still demand bread and electricity, because they need it. Luxury goods, such as holidays, are more elastic. If the price of flights increases, the demand is likely to fall significantly.

If the good has several substitutes, such as Android phones instead of iPhones, then the demand is more price elastic. The elasticity can also change within markets. For example, the market for bread is less elastic than the market for white bread. This is because there are fewer substitutes for bread in general, but there are several substitutes for white bread. Hence, white bread is more price elastic. The closer and more available the substitutes are, the more price elastic the demand.

The demand for goods such as cigarettes is not sensitive to a change in price because consumers become addicted to them, and therefore continue demanding the cigarettes, even if the price increases.

If the good only takes up a small proportion of income, such as a magazine which increases in price from £1.50 to £2, demand is likely to be relatively price inelastic. If the good takes up a significant proportion of income, such as a car which increases in price from £15,000 to £20,000, the demand is likely to be more price elastic.

A good which lasts a long time, such a washing machine, has a more elastic demand because consumers wait to buy another one.

During peak times, such as 9am and 5pm for trains, the demand for tickets is more price inelastic.

If a firm sells a good with an inelastic demand, they are likely to put most of the tax burden on the consumer, because they know a price increase will not cause demand to fall significantly.

If a firm sells a good with an elastic demand, they are likely to take most of the tax burden upon themselves. This is because they know if the price of the good increases, demand is likely to fall, which will lower their overall revenue.

A subsidy is a payment from the government to firms to encourage the production of a good and to lower their average costs. It has the opposite effect of a tax because it increases supply.

Total revenue is equal to average price times quantity sold. TR= P x Q

If a good has an inelastic demand, the firm can raise its price, and quantity sold will not fall significantly. This will increase total revenue.

If a good has an elastic demand and the firm raises its price, quantity sold will fall. This will reduce total revenue.

Income elasticity of demand is the responsiveness of a change in demand to a change in income.

Inferior goods are those which see a fall in demand as income increases. For example, the ‘value’ options at supermarkets could be seen as inferior. As income increases, consumers switch to branded goods. YED < 0.

With normal goods, demand increases as income increases. YED >0.

With luxury goods, an increase in income causes an even bigger increase in demand. YED > 1. For example, a holiday is a luxury good. Luxury goods are also normal goods, and they have an elastic income.

Cross elasticity of demand is the responsiveness of a change in demand of one good, X, to a change in price of another good, Y.

Complementary goods have a negative XED. If one good becomes more expensive, the quantity demanded for both goods will fall.

Close complements: a small fall in the price of good X leads to a large increase in QD of Y.

Weak complements: a large fall in the price of good X leads to only a small increase in QD of Y.

Substitutes can replace another good, so the XED is positive and the demand curve is upward sloping.

Close substitutes: a small increase in the price of good X leads to a large increase in QD of Y.

Weak substitutes: a large increase in the price of good X leads to a smaller increase in QD of Y.

Unrelated goods have a XED equal to zero. For example, the price of a bus journey has no effect on the demand for tables.

Supply is the quantity of a good or service that a producer is able and willing to supply at a given price during a given period of time.

Only changes in price will cause these movements along the supply curve. This is based on the theory of the profit motive. Firms are driven by the desire to make large profits.

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Higher productivity causes an outward shift in supply, because average costs for the firm fall.

Inward shift in supply.

The more firms there are, the larger the supply

More advanced the technology causes an outward shift in supply

Subsidies cause an outward shift in supply.

This is particularly for agricultural produce. Favourable conditions will increase supply

If costs of production fall, the firm can afford to supply more. If costs rise, such as with higher wages, there will be an inward shift in supply.

This is when increasing or decreasing the supply of one good causes an increase or decrease in the supply of another good. For example, producing more lamb will increase the supply of wool.

The price elasticity of supply is the responsiveness of a change in supply to a change in price.

If supply is elastic, firms can increase supply quickly at little cost. The numerical value for PES is >1.

If supply is inelastic, an increase in supply will be expensive for firms and take a long time. PES is <1.

A perfectly inelastic supply has PES = 0. Supply is fixed, so if there is a change in demand, it cannot be met easily.

Supply is perfectly elastic when PES = infinity. Any quantity demanded can be met without changing price.

In the short run, supply is more price inelastic, because producers cannot quickly increase supply. In the long run, supply becomes more price elastic. The short run is the period of time in which at least one factor of production is fixed. The long run is the period of time in which all factors of production are variable.

If the firm is operating at full capacity, there is no space left to increase supply. If there are spare resources, for example in a recession there are lots of spare and unemployed resources, supply can be increased quickly.

If goods can be stored, such as CDs, firms can stock them and increase market supply easily. If the goods are perishable, such as apples, firms cannot stock them for long so supply is more inelastic.

If labour and capital are mobile, supply is more price elastic because resources can be allocated to where extra supply is needed. For example, if workers have transferable skills, they can be reallocated to produce a different good and increase the supply of it.

Higher barriers to entry means supply is more price inelastic, because it is difficult for new firms to enter and supply the market.

If there is a shortage in the market, prices are pushed up and causing firms to supply more. Since prices increase, demand will contract, creating a new equillibrium point.

If there is a surplus, price falls to try sell the excess goods. The market will clear and return to equilibrium.

When there are scarce resources, price increases due to the excess of demand. The increase in price discourages demand and consequently rations resources. For example, plane tickets might rise as seats are sold, because spaces are running out. This is a disincentive to some consumers to purchase the tickets, which rations the tickets.

This encourages a change in behaviour of a consumer or producer. For example, a high price would encourage firms to supply more to the market, because it is more profitable to do so.

The price acts as a signal to consumers and new firms entering the market. The price changes show where resources are needed in the market. A high price signals firms to enter the market because it is profitable. However, this encourages consumers to reduce demand and therefore leave the market. This shifts the demand and supply curves.

This is the difference between the price the consumer is willing and able to pay and the price they actually pay. This is based on what the consumer perceives their private benefit will be from consuming the good.

This is the difference between the price the producer is willing to charge and the price they actually charge. In other words, it is the private benefit gained by the producer that covers their costs, and is measured by profit.

A tax on expenditure where the person is charged the tax is not responsible for paying it. Business is required to pay but charges it to customer instead.

Can be regressive

Tax payed increases in proportion to the value of the good. Is a percentage e.g. VAT

Specific amount gets taxed e.g. 10p a litre on alcohol

Tax burden on the taxpayer. If PED is perfectly elastic or PES is perfectly inelastic, supplier will pay all the tax (and vice versa)

Grant given by government and is the opposite of tax.

Rationality assumes people to act individually to their own benefit but sometimes individuals are influenced by social norms. Consumers become unwilling to change and begin to copy a large group.

Habits create a barrier to decision making since they limit / prevent consumers considering alternatives. Includes addictions.

Consumers aren’t willing or able to make comparisons between prices and will hence pay more than they have to e.g. buying multipacks.

Sometimes poor at self control and buy things they know they shouldn’t. Don’t consider long term effects.