1.2 - How Markets Work

Question 1

What is the income effect

Answer 1

when prices fall, consumers can afford a greater quantity of goods and services (assuming income is fixed), so demand for these goods and services increases

Question 2

What is the substitution effect

Answer 2

when the price of one good falls, consumers will buy more of the cheaper good or service and less of the more costly good or service, so demand for the cheaper good will increase and demand for the costlier good decreases

Question 3

What happens to demand for normal and inferior goods when income increase

Answer 3

Normal - demand increases
Inferior- demand decreases

Question 4

What is marginal utility

Answer 4

marginal utility is the extra benefit to an individual of consuming a good or service

Question 5

What does elasticity measure

Answer 5

the responsiveness of one variable to the change in another variable

Question 6

Formula for PED

Answer 6

% change in quantity demanded / % change in price

Question 7

Formula for Income elasticity of demand (YED)

Answer 7

% change in quantity demanded / % change in income

Question 8

Formula for cross price elasticity of demand (XED)

Answer 8

% change in quantity demanded of good A / % change in price of good B

Question 9

What does it mean when PED is greater than 1, less than 1, equals infinity, equals 0, equals 1

Answer 9

PED > 1- elastic demand
PED < 1- inelastic demand
PED = infinity- perfectly elastic
PED = 0-perfectly inelastic
PED = 1- unitary elastic

Question 10

What type of good has YED: greater than 0, greater than 1, less than 1

Answer 10

YED > 0 = normal goods
YED > 1 = luxury goods
YED < 0 = inferior goods

Question 11

When is XED positive, negative, and close to 0

Answer 11

XED > 0 = substitute goods
XED < 0 = complement goods
XED = 0 = unrelated goods

Question 12

What affects elasticity of demand (5)

Answer 12

Availability of substitute goods /services
Types of good
Impact of indirect taxes
Impact of subsidies
Percentage of income and time

Question 13

What does it mean for elasticity of decreasing price increases total revenue

Answer 13

Elastic demand

Question 14

What does it mean for elasticity if increasing price increases total revenue

Answer 14

Inelastic demand

Question 15

Why do firms aim for high elasticity of supply

Answer 15

So they can react rapidly to changes in price and demand

Question 16

How do firms increase supply elasticity

Answer 16

Improve tech
Introduce flexible working patterns
Have excess production capacity

Question 17

What is the formula for price elasticity of supply (PED)

Answer 17

% change in quantity supplied / % change in price

Question 18

When is supply elastic

Answer 18

PES > 1

Question 19

When is supply inelastic

Answer 19

1 > PES > 0

Question 20

When is supply unitary elastic

Answer 20

PES = 1

Question 21

What factors effect PES (3)

Answer 21

Perishable goods
Recessionary period (increases)
Agility

Question 22

What is the difference between the quantity demanded and quantity supplied

Answer 22

Excess supply

Question 23

What happens when quantity demanded excess quantity supplied

Answer 23

There is excess demand

Question 24

What does the price mechanism use to achieve an efficient allocation of resources

Answer 24

The invisible hand

Question 25

Why is the price mechanism free from bias

Answer 25

Is it governed by lots of agents interacting rather than an individual

Question 26

What are the 3 functions of the price mechanism

Answer 26

Incentive function
Signalling function
Rationing function

Question 27

What is the consumer and producer surplus

Answer 27

the benefit that goes to different economic agents as a result of buying and selling goods in the market

Question 28

What is the total surplus

Answer 28

total benefit to society of economic agents buying and selling a particular good or service (producer + consumer surplus)

Question 29

What are indirect taxes

Answer 29

Taxes on consumption

Question 30

What does it mean if a tax is imposed with inelastic demand

Answer 30

Lots of the tax is passed onto the consumer and little absorbed

Question 31

What happens if a tax is imposed on perfectly elastic demand

Answer 31

Producers bear the whole burden of the tax

Question 32

What do traditional economists assume

Answer 32

Economic agents act perfectly rationally to maximise utility

Question 33

What are theories of irrationality (3)

Answer 33

Asymmetric information
Limits on time
Computational weakness

Question 34

What is availability bias

Answer 34

We assume things that happen in the past are more likely to occur again