Microeconomics AS Part 2

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Markets & Forces

A market is anywhere where buyers and sellers come together for exchange.

Money developed as a means of allowing people to specialise as they can sell their goods for money, rather than having to barter for products in exchange. As it is generally accepted, you can buy products using money, so aloows everyone to access specialist-produced products

Market Forces are the conditions of supply and demand for a product.

An increase in demand will result in a rise in price and quantity exchanged. 

An increase in supply will result in a fall in price and increase in quantity exchanged.

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Demand

Demand refers to the amount of a product that consumers are willing and able to buy at various prices, per period of time, with other things being equal (ceteris paribus).

There is a distinct difference between notional and effective demand:

  • Notional demand is when you are willing to buy a product, but lak the ability to do so (not enough money)
  • Effective demand is notional demand, backed by purchasing power

The price you are willing to pay for a product is going to be greater than or equal to the value of the benefit that you perceive getting from it - the utility we gain. When making a choice, we evaluate the opportunity costs and benefits, based on the information available to us.

Derived demand is when demand for a product is connected to demand for another, such as steel and manufactured products.

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Explaining the law of Demand

There is an inverse relationship between the price of a good and its demand:

  • If prices fall, we see an expanson of demand
  • If pices rise, there is a contraction of demand

This effect happens for two resons:

  1. The Income Effect: When the price of a product falls, consumers can maintain the same consumption for less expenditure. Provided the product is normal, some of the resulting increase in real income is used to purchase more of the product. When price rises, they must spend more to consume the same amount, so they buy less. 
  2. The Substitution Effect: When the price of a product falls, it is now relatively cheaper than its substitutes, and so some consumers will switch their spending to this product. Conversely when price rises, it becomes relatively more expensive, and so consumers will switch their spending away from it.

The income effect deals with the consumer's willingness and ability to buy the product, the substitution effect with the opportunity cost of purchasing it over its alternatives.

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Shifts in Demand

A shift in demand is caused by a change in any factor other than the price of the product, such as:

  • Population: As the population structure changes, so will the demand for products. E.g. More elderly people would create an increase in demand for healthcare
  • Advertising and Marketing: Spending on advertising and marketing can help to bring about changes in consumer tastes and fashions.  
  • Substitutes (price of): Substitutes are goods in competitive demand and act as replacements for another product, i.e. they fulfill the same want and provide the same utility for consumers
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Consumer Surplus

Consumer surplus is a measure of the welfare that people gain from consuming goods and services

Consumer surplus is the difference between the total amount that consumers are willing and able to pay for a good or service (indicated by the demand curve) and the total amount that they actually do pay (i.e. the market price).

Consumer surplus is shown by the area under the demand curve and above the equilibrium price.

The majority of demand curves are downward sloping. When demand is inelastic, there is a greater potential consumer surplus because there are some buyers willing to pay a high price to continue consuming the product, and vice-cersa with elastic curves.

Consumer surplus can be used frequently when analysing the impact of government intervention in any market

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Supply

Supply refers to the amount of a product that companies are willing and able to sell at various prices per period of time, other things being equal (ceteris paribus). 

The basic law of supply is that as the price of a product rises, producers expand their supply onto the market.

If the price of the good varies, there is a movement along the supply curve.

An increase in price will result in an increase (or expansion) of supply.

If the market price falls there would be a decrease (or contraction) of supply in the market.

Businesses are responding to price signals when making their output decisions.

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Explaining the Law of Supply

There are three main reasons why supply curves for most products are drawn as sloping upwards from left to right giving a positive relationship between the market price and quantity supplied:

  • The profit motive: When the market price rises (for example after an increase in consumer demand), it becomes more profitable for businesses to increase their output. Higher prices send signals to firms that they can increase their profits by satisfying demand in the market, and vice-versa.
  • Production and costs:When output expands, a firm’s production costs rise, therefore a higher price is needed to justify the extra output and cover these extra costs of production.
  • New entrants coming into the market:Higher prices may create an incentive for other businesses to enter the market, leading to an overall increase in supply.
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Shifts in Supply

A shift in supply is caused by a change in any factor other than the price of the product, such as:

  • Costs of production: Lower costs of production mean that a business can supply more at each price. Conversely, if the costs of production increase then businesses cannot supply as much at the same price and this will cause an inward shift of the supply curve.
  • A fall in the exchange rate causes an increase in the prices of imported components and raw materials, which will lead to a decrease in supply as costs increase.
  • Changes in production technology: Production technologies can change quickly, and in industries where technological change is rapid we see increases in supply due to lower costs.
  • Subsidies: By subsidising supply, this will lower costs, encouraging firms to supply more.
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Shifts in Supply 2

And,

  • Indirect Taxes: A tax on supply increases costs, lowering supply.
  • Weather: For agricultural goods the weather has a great influence on supply. Favourable weather will produce a good harvest and will increase supply.
  • The number of producers in the market and their objectives: The number of sellers (businesses) in an industry affects market supply. When new businesses enter a market, supply will increase 
  • Change in the prices of a substitute in production: A substitute in production is a product that could have been produced using the same resources.  A higher market price for a substitute will men supply switches to this substitute.
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Shifts in Demand 2

And,

  • Income (level of): Most proucts are normal goods, i.e. when income goes up, our ability to purchase them increases, and this causes an outward shift in the demand curve and vice versa.
  • Interest Rates: Many products are bought on credit using borrowed money, thus the demand for them is sensitive to the rate of interest charged by the lender. Therefore if the Bank of England decides to alter interest rates, the demand for many goods and services may change.
  • Complements (price of): Two complements are injoint demand, e.g. DVDs and DVD players. A decrease in the price of a product's complement will increase the demand for that product
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Producer Surplus

Producer surplus is a measure of producer welfare

It is measured as the difference between the price producers are willing and able to supply a good for (shown by the supply curve) and the price they actually receive (the market price).

The level of producer surplus is shown by the area above the supply curve and below the market price

As the price rises, there is a great incentive to supply – production will expand as a business moves up their supply curve.

An inelastic supply curve will lead to a large producer surplus, and elastic supply will have a smaller producer surplus.

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