1.2 How Markets Work

Question 1

What are the assumptions of rational economic decision making?

Answer 1

Consumers aim to maximise utility and firms aim to maximise profits

Question 2

Factors causing a shift in demand

Answer 2

P - Population
I - Income
R - Related goods
A - Advertising
T - Tastes and Fashions
E - Expectations
S - Seasons

Question 3

What is the concept of diminishing marginal utility

Answer 3

The law of diminishing marginal utility states that as an extra unit of the good is
consumed, the marginal utility, i.e. the benefit derived from consuming the good,
falls. Therefore, consumers are willing to pay less for the good.

Question 4

Why is demand curve downward sloping?

Answer 4

Shows inverse relationship between price and quantity

Question 5

Formula for PED

Answer 5

% change in Price / % change in QD

Question 6

PED for an elastic good

Answer 6

PED>1

Question 7

PED for an inelastic good

Answer 7

PED<1

Question 8

Value of unitary elastic good

Answer 8

1

Question 9

Value of perfectly inelastic good

Answer 9

0

Question 10

Factors influencing elasticity of demand

Answer 10

P - Proportion of Income
L - Loyalty (Brand)
A - Addictiveness
N - Necessity
T - Time
S - Substitutes

Question 12

Why is the demand curve downward sloping?

Answer 12

Shows the inverse relationship between price and quantity

Question 13

Formula for price elasticity of demand

Answer 13

% change in Price/ % change in QD

Question 14

Factors influencing PED

Answer 14

P - Proportion of income
L - Loyalty
A - Addictiveness
N - Necessity
T - Time (durability)
S - Substitutes

Question 15

PED of elastic good

Answer 15

PED>1

Question 16

PED of inelastic good

Answer 16

PED<1

Question 17

PED of unitary elastic good

Answer 17

1

Question 18

PED of perfectly inelastic good

Answer 18

0

Question 19

Tax on an inelastic good

Answer 19

If the good is inelastic, burden will fall mostly on consumer. Tax most effective on goods with inelastic demand

Question 20

Tax on an elastic good

Answer 20

Burden will fall mostly on producers. Tax won’t raise as much revenue however it will be effective in lowering demand on a product.

Question 21

PED and Revenue: If firm increases price of good

Answer 21

Inelastic good - revenue will increase
Elastic good - revenue will fall

Question 22

Formula for YED

Answer 22

% change in income / % change in quantity demanded

Question 23

YED of inferior goods

Answer 23

YED<0

Question 24

YED of normal goods

Answer 24

YED>0

Question 25

Luxury goods

Answer 25

YED>!

Question 26

Cross Elasticity of Demand Formula

Answer 26

% Change in QD good A / % Change in QD good B

Question 27

XED of Complementary goods

Answer 27

Negative

Question 28

XED of Substitute goods

Answer 28

Positive

Question 29

What type of goods will firms increase more of when the economy is prospering?

Answer 29

Luxury

Question 30

Factors that shift supply curve

Answer 30

P - Productivity I - Indirect Taxes N - Number of firms T - Technology S - Subsidies W - Weather C - Cost of production

Question 31

Formula for PES

Answer 31

% change in price / % change in QS

Question 32

PES of elastic supply

Answer 32

PES>1

Question 33

PES of inelastic supply

Answer 33

PES<1

Question 34

PES of perfectly inelastic supply

Answer 34

0

Question 35

PES of perfectly elastic supply

Answer 35

Infinity

Question 36

Factors influencing elasticity of supply

Answer 36

B - Barriers to entry R - Raw Material availability I - Inventories (stock levels) T - Time S - Spare capacity

Question 37

How does time affect elasticity of supply?

Answer 37

In short run, supply may be less elastic as it takes firms time to adjust to production capacity. In long run, supply may be more elastic as firms can make capital investments to expand capacity.

Question 38

What is the market clearing price?

Answer 38

The price at which supply meets demand

Question 39

What is a surplus?

Answer 39

Where there is more supply than demand

Question 40

What is a shortage?

Answer 40

Where there is more demand than supply.

Question 41

What are the functions of the price mechanism?

Answer 41

Rationing - Allocating correct amount of resources due to scarcity Signalling - Shows where resources are needed in a market. High price signals to firms to enter market and for consumers to lead the market. Incentive - Encourages firms to join market if price is high.

Question 42

What is consumer surplus?

Answer 42

Difference between the price and the price consumers are willing to pay, (Above market price and below demand curve

Question 43

Producer surplus

Answer 43

Difference between price producer is willing to charge and the price they actually charge

Question 44

How does an increase in demand affect consumer surplus?

Answer 44

It would increase consumer surplus

Question 45

How does an increase in supply affect consumer surplus?

Answer 45

Reduces consumer surplus

Question 46

How does an increase in supply affect producer surplus?

Answer 46

Increase producer surplus

Question 47

How does an increase in demand affect Producer surplus?

Answer 47

Reduces consumer surplus

Question 48

What are the two types of indirect taxes?

Answer 48

Ad valorem (%) or Specific taxes (fixed amount)

Question 49

If demand is elastic, who will the burden of an indirect tax fall on?

Answer 49

Incidence will fall on supplier

Question 50

If demand is inelastic, who will the burden of an indirect tax fall on?

Answer 50

Incidence will fall on consumer

Question 51

Negatives of ad valorem taxes

Answer 51

Tax could be inflationary Tax could be regressive

Question 52

Benefits of ad valorem tax

Answer 52

Inelastic demand can lead to large government revenue (e.g petrol,tobacco)

Question 53

What is a subsidy?

Answer 53

A subsidy is a payment from the government to a producer to lower their costs of production and encourage them to produce more.

Question 54

Effects of subsidies on consumers

Answer 54

Lower prices, reduce inequality, encourage consumption of merit goods. Taxpayer pays for subsidy but may not benefit

Question 55

Effects of subsidy on firms

Answer 55

Lower costs of production, more skilled workers (if subsidy encourages),increase in LRAS

Question 56

Effects of subsidy on government

Answer 56

Boost demand in economic decline, gov failure if subsidy inefficient, opportunity cost

Question 57

Subsidy on elastic demand curve

Answer 57

Benefits consumers more

Question 58

Subsidy on inelastic demand curve

Answer 58

Benefits producers more

Question 59

Reasons people may not act rationally

Answer 59

Other peoples actions (Herd Mentality) Habitual behaviour Computational weakness