Assumptions: consumers aim to maximise utility, firms aim to maximise profits
1.2.2 Demand
Demand: the quantity of a good or service that consumers are willing and able to buy at a given price in a given period of time.
A movement along the demand curve is different to a shift. A movement along is caused by a change in price, a shift is caused by PIRATES.
Factors of demand (PIRATES): population, income, related goods, advertising, trends, expectations, seasons.
Diminishing marginal utility: as a consumer consumes more units of a good or service, the additional utility derived from each additional unit decreases.
As price decreases, consumers are willing to buy more because the marginal utility of each additional unit exceeds the price.
1.2.3 Price, Income and Cross Elasticities of Demand
PED: responsiveness of quantity demand following an initial change in price.
Factors of PED (SANDPIT): substitute goods, addictiveness, necessity, durability, proportion of income spent on good, time.
The relationship between PED and total revenue: when a good is demand inelastic, firms can raise the price and demand will not fall much. So, total revenue increases after a price increase because total revenue = price x quantity
YED: the degree of responsiveness of quantity demanded following an initial change in income.
Factors of YED: Inferior goods: negative, normal goods: between 0 and 1, luxury goods: >1.
Supply: the quantity of goods and services that producers are willing and able to sell at any given price.
Movements along the supply curve show expansion/ contraction and they are caused by price changes.
Shifts can be caused by (PCTWINS): productivity, costs of production, technology, weather, indirect taxation, number of firms, subsidies.
PES: the degree of responsiveness of quantity supplied following an initial change in price.
Factors of PES (SECTS): substitutability of factors, entry barriers, spare capacity, time, level of stocks.
XED: the degree of responsiveness of the demand of a good X, following a change in the price of a different good Y.
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.
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.
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.
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.
Consumers may not behave rationally: influenced by other people, habitual, use of mental shortcuts.