1.2 How Markets Work (Edexcel A Level Economics A)

Utility is the satisfaction or benefit a consumer derives from consuming a good or service.

The main goal of rational decision making in economics is to select the choice that presents the highest benefits or utility.

Demand is the amount of a good/service that a consumer is willing and able to purchase at a given price in a given time period.

Effective demand is when a consumer is both willing and able to purchase a good or service.

A demand curve is a graphical representation of the price and quantity demanded by consumers.

False.

Economists simplify demand curves into straight lines to make analysis easier.

A movement along the demand curve is caused by a change in price, assuming all other factors remain constant (ceteris paribus).

A contraction in quantity demanded is an upward movement (left) along the demand curve due to a price rise causing a reduction in demand.

An extension in quantity demanded is a downward movement along the demand curve (right) due to a price fall causing an expansion in demand.

The law of demand states that there is an inverse relationship between price and quantity demanded.

False.

When price rises, quantity demanded contracts.

The conditions of demand are the non-price factors that will change the demand for a good/service, irrespective of the price of the good/service.

A change in the conditions of demand shifts the entire demand curve left or right.

A change in demand shifts the entire demand curve, while a change in quantity demanded is a movement along the existing demand curve.

Price elasticity of demand reveals how responsive the change in quantity demanded is to a change in price.

Formula.

A PED value of 0 indicates perfectly price inelastic demand, where quantity demanded is completely unresponsive to a change in price.

Relatively price inelastic demand is when the percentage change in quantity demanded is less than the percentage change in price. E.g. PED = -0.4.

Unitary price elasticity is when the percentage change in quantity demanded is exactly equal to the percentage change in price (PED = -1).

Relatively price elastic demand is when the percentage change in quantity demanded is greater than the percentage change in price. For example PED = -2.5.

A PED value of infinity indicates perfectly price elastic demand, where any change in price will cause quantity demanded to fall to zero.

Income elasticity of demand reveals how responsive the change in quantity demanded is to a change in income.

Formula.

A normal income inelastic necessity good has a YED value between 0 and 1.

A normal luxury good has a YED value greater than +1, meaning the percentage change in demand is greater than the percentage change in income.

An inferior good has a negative YED value, meaning demand decreases when income increases.

Cross price elasticity of demand reveals how responsive the change in quantity demanded for good A is to a change in price of good B.

Formula.

A negative XED value indicates that the two goods are complements.

Goods with a positive XED value are substitutes.

An XED value of zero suggests that the two goods are unrelated.

Supply is the amount of a good/service that a producer is willing and able to supply at a given price in a given time period.

A supply curve is a graphical representation of the price and quantity supplied by producers.

False.

The supply curve slopes upward as there is a positive relationship between price and quantity supplied.

A movement along the supply curve is caused by a change in price, assuming all other factors remain constant (ceteris paribus).

An extension in quantity supplied is an expansion in the quantity supplied due to an increase in price, shown as an upward movement along the supply curve.

A contraction in quantity supplied is a reduction in the quantity supplied due to a decrease in price, shown as a downward movement along the supply curve.

The conditions of supply are the non-price factors that will change the supply of a good/service, irrespective of the price level of the good/service.

A change in the conditions of supply shifts the entire supply curve left or right.

A change in supply shifts the entire supply curve, while a change in quantity supplied is a movement along the existing supply curve.

False.

An increase in costs of production shifts the supply curve to the left.

An increase in indirect taxes shifts the supply curve to the left.

An increase in subsidies shifts the supply curve to the right.

Price elasticity of supply reveals how responsive the change in quantity supplied is to a change in price.

Formula.

A PES value of 0 indicates perfectly price inelastic supply, where quantity supplied is completely unresponsive to a change in price.

Relatively price inelastic supply is when the percentage change in quantity supplied is less than the percentage change in price. For example +0.6.

Relatively price elastic supply is when the percentage change in quantity supplied is more than the percentage change in price. For example +1.5.

A PES value of infinity indicates perfectly price elastic supply, where supply is unlimited at a particular price.

Any of the following factors:

• The mobility of land, labour and capital

• The availability of raw materials

• The ability to store goods

• Spare production capacity

• The time period involved

If raw materials are scarce, PES will be less than +1 but greater than zero (price inelastic). If they are abundant, PES will be greater than +1 (price elastic).

If products can be easily stored, PES will be greater than +1 (price elastic). An inability to store products results in a PES lower than +1 but greater than zero (price inelastic).

If there is spare capacity to increase production, supply will be price elastic. If there is no spare capacity, supply will be price inelastic.

The short run is any period of time in which at least one factor of production is fixed.

The long run is any period of time in which all factors of production are variable.

Price determination is the process by which prices are set through the interaction of demand and supply in a market.

A market is any place that brings buyers and sellers together to trade at an agreed price.

Consumer sovereignty is the power of consumers to influence the production of goods and services through their purchasing decisions.

Equilibrium in a market occurs when demand equals supply.

The market clearing price is the price at which sellers are clearing their stock at an acceptable rate and demand equals supply.

Disequilibrium occurs whenever there is excess demand or excess supply in a market.

Excess demand occurs when the demand is greater than the supply at a given price.

In response to excess demand, sellers gradually raise prices, causing a contraction in quantity demanded and an extension in quantity supplied.

Excess supply occurs when the supply is greater than the demand at a given price.

In response to excess supply, sellers gradually lower prices, causing an extension in quantity demanded and a contraction in quantity supplied.

True.

Dynamic markets are constantly changing.

Disequilibrium is caused by any change to a condition of demand or supply.

The price mechanism is the interaction of demand and supply in a free market that determines prices and allocates scarce resources.

The three functions of the price mechanism are to ration, signal and incentivise.

The rationing function of the price mechanism allocates scarce resources by setting prices that only those who can afford will pay.

The signalling function of the price mechanism provides information to producers and consumers about where resources are required or not.

The incentive function of the price mechanism motivates producers to reallocate resources to more profitable markets when prices rise.

Adam Smith referred to the functions of the price mechanism as the 'mystery of the invisible hand'.

False.

The price mechanism operates in all markets including local, national and global.

A higher price serves to ration a valuable product by ensuring only those who can afford it receive it.

A shift in demand signals to producers that demand for a product is strong and they should consider entering the market.

A lower price incentivises consumers to purchase more of a product.

The price mechanism is built on the principle of self-interest.

Producers use world prices to guide their production decisions in global markets.

Consumer surplus is the difference between the amount the consumer is willing to pay for a product and the price they actually pay.

Producer surplus is the difference between the amount that the producer is willing to sell a product for and the price they actually receive.

Consumer surplus is represented by the area above the horizontal line formed by the equilibrium price and the area below the demand curve.

Producer surplus is represented by the area below the horizontal line formed by the equilibrium price and the area above the supply curve.

Social surplus is the sum of consumer surplus and producer surplus.

True.

Consumer and producer surplus are maximised at market equilibrium.

An increase in supply increases consumer surplus.

An increase in supply increases producer surplus.

Social surplus increases when supply increases.

An increase in demand increases consumer surplus.

An increase in demand increases producer surplus.

Social surplus increases when demand increases.

The incidence of a tax is the share of the tax paid by producers and consumers.

A specific tax shifts the supply curve to the left by the amount of the tax.

The price elasticity of demand (PED) of the product determines how much of an indirect tax is passed on to consumers.

False.

For products with price inelastic demand, producers pass on a larger proportion of the tax to consumers.

A producer subsidy is a per unit amount of money given to a firm by the government to increase production or provision of a merit good.

A subsidy shifts the supply curve to the right.

The price elasticity of demand (PED) of the product determines the incidence of a subsidy.

A subsidy decreases the market price.

The total cost to the government of a subsidy is the subsidy per unit multiplied by the new equilibrium quantity.

False.

The distribution benefit of subsidies between consumers and producers depends on the price elasticity of demand.

The main factors that influence irrational consumer decision making are the influence of other people's behaviour, habitual behaviour and consumer weakness in computation.

Peer pressure often prompts consumers to make purchasing decisions that may go against a computation of net benefits.

Neuro branding refers to advanced behavioural psychology techniques used by producers to influence consumer choices.

Rule of thumb refers to a shortcut that makes a quick estimation of benefits without gathering too much information.

Consumer inertia is when consumers prioritise convenience and habitually purchase the same products.

Sellers exploit habitual patterns by placing products strategically, such as at checkout tills to benefit from impulse purchasing.

False.

A wider range of choice makes it harder for consumers to gather information and compute which option offers the highest net benefits.

Sellers influence consumer computation by placing products they want to sell at eye level where computation is easy and less beneficial products where computation is harder.

Advertising influences consumers to make emotional rather than rational decisions using various forms, including lifestyle, celebrity endorsement, and influencer culture.

Addiction can lead consumers making purchasing decisions that directly harm them, going against rational decision-making.

Consumers often use information from the past, which may be outdated, as they habitually purchase the same products.

False.

Many consumer decisions are influenced by factors other than rational computation, such as emotions, habits, and social influences.