1.2 How Markets Work

1.2.1 Rational Decision Making

• Consumers: Aim to maximize utility, known as Homo Economicus.
• Firms: Aim to maximize profit for owners/shareholders.
• Governments: Aim to maximize social welfare.
• Behavioral Economics: Challenges the assumption that economic agents act rationally due to lack of information and calculated decision-making.

1.2.2 Demand

• Definition: Ability and willingness to buy a good at a given price and time.
• Movements vs Shifts:
  • Movements are due to price changes (contraction/extension).
  • Shifts are due to changes in demand factors (PIRATES mnemonic).
• Conditions of Demand:
  • Population, Income, Related Goods, Advertising, Taste/Fashion, Expectations, Seasons, Government Legislation can shift the demand curve.
• Diminishing Marginal Utility:
  • Explains downward slope of demand curve; satisfaction decreases with additional consumption.

1.2.3 Elasticities of Demand

Price Elasticity of Demand (PED)

• Measures responsiveness of quantity demanded to price changes.
• Types:
  • Unitary, Relatively Elastic, Relatively Inelastic, Perfectly Elastic/Inelastic.
• Influencing Factors: Substitutes, Time, Necessity, Percentage of Expenditure, Addictiveness.
• Significance: Affects tax burden, revenue, and subsidy impacts.

Income Elasticity of Demand (YED)

• Responsiveness of demand to income changes.
• Types of Goods: Inferior, Normal, Luxury.
• Significance: Impacts business sales strategies.

Cross Elasticity of Demand (XED)

• Responsiveness of demand for one product due to price change of another.
• Types: Substitutes, Complements, Unrelated.

1.2.4 Supply

• Definition: Willingness to provide a good/service at a price.
• Movements vs Shifts:
  • Movements due to price changes.
  • Shifts due to changes in supply factors.
• Conditions of Supply: Costs of Production, Price of Other Goods, Weather, Technology, Supplier Goals, Legislation, Taxes/Subsidies, Producer Cartels.

1.2.5 Elasticity of Supply

• Price Elasticity of Supply (PES): Measures responsiveness of supply to price changes.
• Types: Unitary, Relatively Elastic, Relatively Inelastic, Perfectly Elastic/Inelastic.
• Factors Affecting PES: Time, Stocks, Capacity, Availability of Factors, Market Entry, Substitutes.

1.2.6 Price Determination

• Equilibrium: Supply equals demand; market-clearing price.
• Excess Demand/Supply: Price imbalances lead to shortages/surpluses, correcting to equilibrium.
• Shifts in Curves: Affect price and output.

1.2.7 Price Mechanism

• Functions: Rationing, Signalling, Incentive.
• Market Contexts: Local, National, Global impacts on price mechanisms illustrated by examples like COVID-19 and oil embargo.

1.2.8 Consumer and Producer Surplus

• Consumer Surplus: Difference between willingness to pay and actual price.
• Producer Surplus: Difference between willingness to supply and actual price.
• Shifts in Curves: Affect surpluses.

1.2.9 Indirect Taxes and Subsidies

• Indirect Taxes:
  • Types: Ad Valorem, Specific.
  • Impacts: Affects prices, outputs, and tax burdens.
• Subsidies: Encourage production/consumption, affect supply.

1.2.10 Alternative Views of Consumer Behavior

• Influences: Social norms, Habitual behavior, Computational weaknesses lead to deviations from rational behavior.