The rational agent assumption

Almost all of Theme 1 rests on two assumptions:

• Consumers aim to maximise utility — the satisfaction gained from consuming a good. They weigh up costs and benefits at the margin and choose the option with the highest net benefit.
• Firms aim to maximise profits — the difference between total revenue and total cost.

Hold this lightly. These are assumptions, not facts (1.1.1). They make demand and supply curves tractable. Screen 1.2.10 at the end of this lesson shows what happens when consumers are not rational — and it is worth top-band evaluation marks in almost any Theme 1 essay.

Demand and diminishing marginal utility

The demand curve slopes downwards. Why? Diminishing marginal utility: each extra unit consumed gives less additional satisfaction than the last. Your first coffee of the day is worth a lot; the fourth is worth little. So a consumer will only buy an extra unit if the price falls to match the lower marginal utility — which is exactly a downward-sloping demand curve.

Conditions of demand (the shifters) — remember PASIFIC: Population · Advertising/tastes · Substitutes' prices · Income · Fashion · Interest rates · Complements' prices. Plus expectations of future prices.

Shift or movement?

Tap a card, then tap the correct bin. Remember: only the good's own price causes a movement along.

PED — how responsive is demand to price?

• |PED| > 1 — relatively elastic: quantity is very responsive.
• |PED| < 1 — relatively inelastic: quantity barely moves.
• |PED| = 1 — unitary elastic. PED = 0 — perfectly inelastic (vertical D). PED = ∞ — perfectly elastic (horizontal D).

Determinants of PED — the more of these, the more elastic demand is: many close substitutes; the good is a large proportion of income; it is a luxury not a necessity; it is not addictive/habit-forming; and there is a long time period to adjust (demand is always more elastic in the long run).

Your turn — calculate PED

PED and total revenue

• Demand inelastic (|PED| < 1) → raise price to raise total revenue. Quantity falls by proportionately less than price rises.
• Demand elastic (|PED| > 1) → cut price to raise total revenue. Quantity rises by proportionately more than price falls.
• Demand unitary elastic → total revenue is unchanged; it is at its maximum.

Significance to firms and government: a firm with inelastic demand (a train operator on a commuter line) can raise price and revenue. A government wanting tax revenue taxes inelastic goods (fuel, tobacco, alcohol) — quantity barely falls, so revenue is large. But a government wanting to change behaviour is frustrated by exactly the same inelasticity: a sugar tax on an addictive product cuts consumption very little in the short run.

Your turn — PED and total revenue

Income and cross elasticities

Income elasticity (YED) — the sign tells you the type of good:

• YED > +1 → luxury (superior) good, income-elastic: restaurant meals, foreign holidays.
• 0 < YED < +1 → normal necessity, income-inelastic: bread, electricity.
• YED < 0 → inferior good: demand falls as income rises — supermarket value ranges, bus travel.

Cross elasticity (XED) — the sign tells you the relationship:

• XED > 0 → substitutes (Pepsi and Coke). The bigger the value, the closer the substitutes.
• XED < 0 → complements (printers and ink).
• XED ≈ 0 → unrelated goods.

Why firms care: a supermarket with income-elastic premium lines knows a recession (falling real income) will hit those lines hardest while its value range grows. A firm with a close substitute (high positive XED) cannot raise price without haemorrhaging customers.

Your turn — calculate YED

Your turn — calculate XED

Match the elasticity value to its meaning

Tap a value on the left, then its interpretation on the right.

Supply and price elasticity of supply

Supply slopes upwards: a higher price makes production more profitable and covers the rising marginal cost of extra output. Conditions of supply (the shifters) — PINTSWC: Productivity · Indirect taxes · Number of firms · Technology · Subsidies · Weather/shocks · Costs of production.

Determinants of PES — supply is more elastic when: there is spare capacity; stocks of finished goods can be released; the production process is short; factors of production are mobile; and there is a long time period.

Short run vs long run: in the short run at least one factor (usually capital) is fixed, so firms can only expand output by working existing capital harder — PES is inelastic. In the long run all factors are variable: firms can build new plants and new firms can enter, so PES is far more elastic. This is why a demand shock spikes prices sharply at first, then prices ease as supply catches up.

Your turn — calculate PES

Equilibrium, excess demand and excess supply

The three functions of the price mechanism

• Rationing — when a good becomes scarce, its price rises, choking off demand and distributing the limited supply to those who value it most (i.e. are willing and able to pay).
• Signalling — the price conveys information. A rising price tells producers "there is a shortage here" and tells consumers "economise". This is Hayek's point from 1.1.6 in action.
• Incentive — a high price creates a profit motive to switch resources into that market; a low price drives resources out. This is how resources are reallocated without anyone giving an order.

Worked example — a poor coffee harvest in Brazil. Supply shifts left → price rises (rationing the smaller crop). The high price signals scarcity worldwide and incentivises growers in Vietnam and Colombia to plant more and release stocks. Supply rises, price eases. No planner did any of this. Prices work at local (a car boot sale), national (UK housing) and global (crude oil) level alike.

Functions of price

Consumer and producer surplus

• Consumer surplus = the difference between what consumers are willing to pay and what they actually pay.
• Producer surplus = the difference between the price producers actually receive and the minimum they would have accepted.
• An increase in supply lowers price: consumer surplus rises. An increase in demand raises price: producer surplus rises, and consumer surplus can go either way (more units bought, but each costs more).
• The more inelastic demand is, the larger consumer surplus tends to be — consumers were willing to pay far above the market price.

Indirect taxes and who really pays

An indirect tax is levied on expenditure and paid to the government by the producer, who then tries to pass it on. It raises costs, so it shifts supply left/upwards by the amount of the tax.

• Specific (unit) tax — a fixed amount per unit (e.g. 58p per litre of fuel duty). Shifts S up in parallel.
• Ad valorem tax — a percentage of price (e.g. 20% VAT). Shifts S up as a pivot, widening as price rises.

Subsidies work in reverse: a grant per unit shifts S right/down, cutting price and raising quantity. The consumer subsidy is the part that lowers the price paid; the producer subsidy is the part that raises the price received. Cost to government = subsidy per unit × new quantity. Again, elasticity decides the split: if demand is inelastic, most of a subsidy is captured by producers as a higher price received — a classic evaluation point against subsidising, say, rented housing.

Your turn — tax incidence

Elasticity and tax revenue

When consumers are not rational

Behavioural economics (Kahneman, Tversky, Thaler) shows that real consumers systematically break the rational-utility-maximiser assumption. Edexcel names three reasons:

• The influence of other people's behaviour — herding and social norms. People buy what others buy (bank runs, housing bubbles, fashion) rather than computing their own utility.
• The importance of habitual behaviour — consumers stick with the same energy supplier, bank or brand for years, even when a cheaper option is one click away. Habit and inertia beat optimisation.
• Consumer weakness at computation — people cannot process complex information. Faced with 30 tariffs, they use crude rules of thumb. They also show anchoring (fixating on the first price seen — hence "was £80, now £40"), loss aversion, and present bias (over-weighting today's pleasure over tomorrow's cost — which is why people under-save and over-eat).

Nudge theory: if consumers are predictably irrational, government can change the choice architecture rather than change prices. Default options are the most powerful nudge — auto-enrolment into UK workplace pensions raised participation dramatically because people simply do not opt out. Evaluation: nudges are cheap and preserve freedom of choice, but they are paternalistic, effects can fade, and they may be too weak against a strong financial incentive.

Behavioural economics

Evaluating an elasticity estimate

The big ideas to know

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