Economics CT First Set 1 Market Economy Resource allocation in a competitive market 1 1 Free Market System free from government intervention resources allocated according to forces of demand and supply Necessary characteristics for market based economy to allocate resources efficiently a Competition Primarily refers to perfect completion large numbers of buyers and sellers individuals have insignificant share in the market and no influence on the market demand or market supply b Rational behaviour Pursuit of self interest Each unit behaves rationally every single person is an optimizing individual Consumers maximize satisfaction utility producers maximize profits and workers maximize wages by getting a job that yields as a return as possible c Freedom of choice Enterprise d Private ownership of property Consumer sovereignty where consumers decide what to do with their incomes whilst firms choose what to sell and what production methods to use and workers choose where and how much to work Individuals have the right to own control and dispose whilst owners have the right to the income of factors of production 1 2 Price Mechanism invisible hand that allocates resources in society Operates in market economies where changes in price resulting from changes in demand and supply cause resources to move in and out of industries conveying information to buyers and sellers 2 Demand Theory 2 1 Demand desired purchases amount that consumers are able and willing to pay at any given price and given period of time Flow concept amount per period of time v Stock concept amount at specific point in time 2 2 The Law of Demand the quantity demanded of a good service is inversely related to its price ceteris paribus The demand curve Diagra mmatic representation of the maximum price that consumers are willing and able to pay for each quantity of the good or service Price of good represents consumers marginal willingness to pay The change in price of good has two effects on consumers a Income effect b Substitution effect The effect of a change in real income resulting from change in the price cet par Purchasing power of income hence real income falls or rises when the price of the good rises or falls respectively The effect of a change in price on quantity demanded arising from tendency of consumers to switch to or from alternative products relatively cheaper goods maximise satisfaction with given income 2 3 Conditions of Demand Non price determinants influencing market demand determine position of the demand curve a Taste and preferences Seasonal changes climatic conditions or festivals b Income Positive relationship between income and demand for Normal goods Negative relationship between income and demand for Inferior goods c Expectations of future prices Assuming no change in people s income d Prices of interrelated goods Substitutes can be used in place of one another a good appears relatively cheaper if its substitutes price rises hence demand for former increases Complements are jointly demanded and the fall or rise in demand for one is directly proportional to the other e Government Policies Direct tax policy affects disposable income of consumers affecting purchasing power Direct subsidy policy increases purchasing power of consumers increasing demand f Population g Interest rates h Exchange rates Affects size of markets due to absolute increase or decrease in total population or change in demographic composition of population Changes in rate of interest inversely proportionate to changes in demand Changes in currency exchange rates affect foreign demand for a country s good and services Strengthening of a country s currency against another causes a fall in demand in the goods sold to the latter 2 4 Change in Quantity Demanded v Change in Demand QD quantity that consumers are willing and able to buy at given price refers to response of consumers to changes in price cet par reflected in upward or downward movement of a point along demand curve 2 5 Consumers Surplus the difference between the maximum amount where marginal benefit equals marginal cost that consumers are willing to pay and what they actually pay The bigger the surplus the higher the level of consumer welfare satisfaction 3 Supply Theory 3 1 Supply quantity of goods and services producers are willing and able to offer for sale at each given price over a given period of time 3 2 The Law of Supply the quantity supplied of a good service is directly related to its price cet par The supply curve Diagrammatic representation of the minimum price that producers are willing and able to supply each quantity of the good or service As producers produce more of a commodity marginal cost increases hence inducing firms to increase supply so that marginal benefits can cover marginal costs 2 3 Conditions of Supply Non price determinants influencing market supply determine position of the supply curve a Costs of production b Innovation State of technology Price of factor inputs like raw materials cost of labour and cost of capital affects supply of commodity Technological advances within industry increase productivity of factors of production lowering cost per output increasing supply Favourable climatic conditions and natural phenomena disasters increase and decreases supply respectively Entry of new firms or exit of existing firms increases and decreases supply respectively c Natural factors d Number of firms e Government policies Indirect taxes increases minimum price firms are willing and able to produce at leading to fall in supply and leftward shift of supply curve Indirect subsidy decreases minimum price firms are willing and able to produce at leading to rise in supply and rightward shift of supply curve f Prices of interrelated goods Supply of goods in Joint supply is increased or decreased at the same time Goods in Competitive supply are alternative goods firms can make with its factor resources opportunity costs are incurred in the production of one or the other g Expectations of future price changes Build up stock when prices are expected to rise and release when prices are expected to fall 3 4 Change in Quantity Supplied v Change in Supply QS quantity that producers are willing and able to offer for sale as a result of a change in price cet par reflected in upward or downward movement of a point along supply curve 3 5 Producer Surplus the difference between the amount received by producers for selling their good and the minimum amount