1.2 How Markets Work

Question 1

What is PED?

Answer 1

PED is the responsiveness of demand to a change in price of good.

Question 2

Factors influencing PED

Answer 2

Substitutes
- High substitutes mean high elasticity; people can switch to more products
Percentage of income
- Low % = low elasticity
Luxury/Necessity
- Necessities are inelastic; people still need to buy them
Addiction
- Addictive items may have inelastic PED
Time period
- Longer time allows consumer to fidn substitutes

Question 3

What is income elasticity of demand (YED)?

Answer 3

Responsiveness of demand to a change in income

Question 4

What do the values of YED signify?

Answer 4

Inferior good / YED<0
- When a rise in income leads to a fall in demand for the good
Normal good / YED>0
- A rise in income will lead to a rise in demand for the good
Luxury good
- When YED>1

Inelastic YED usually means good is inelastic

Question 5

What is significance of YED?

Answer 5

It allows businesses to know how sales will be affected by changes in the income of the population.

Question 6

What is cross elasticity demand (XED)?

Answer 6

Responsiveness of demand for one product to a change in price of another product.

Question 7

What do the values of XED signify?

Answer 7

Substitutes / XED>0
- Increase in price of good causes increase in demand of other good
Complementary goods / XED<0
- Increase in price of good causes decrease in demand of other good

Question 8

What is the significance of XED?

Answer 8

Fimrs can be aware of their competition and those producing complementary goods.
They need to know how price changes by other firms will impact them.

Question 9

What is PES?

Answer 9

Responsiveness of quantity supplied to price change

Question 10

Factors affecting PES

Answer 10

Production Lag
- Longer it takes for production, less elastic
Stocks
- Higher stockpile of goods; more elastic
Spare capacity
- Firms able to increase capacity quicker; more elastic
Substitutability of FoPs
- More substitutable; more elastic
Time
- Long term; variable FoPs; more elastic

Question 11

How are consumers assumed to act rationally?

Answer 11

Consumers aim to maximise utility of products.

Question 12

How are firms assumed to act rationally?

Answer 12

Firms aim to maximise profit.

Question 13

How are workers assumed to act rationally?

Answer 13

Workers balance welfare at work with consideration of pay and benefits

Question 14

How are governments assumed to act rationally?

Answer 14

Place interest of people they serve first in order to maximise their welfare
Social welfare

Question 15

What is demand?

Answer 15

Demand is amount of product that a consumer is willing and able to purchase at a given price

Question 16

What causes movement along demand curve?

Answer 16

Price changes

Question 17

What causes shifts in demand curve?

Answer 17

Shifts are caused by changes in non-price factors

Question 18

Non-price factors of demand

Answer 18

Population
Advertising
Substitute’s price
Income
Fashion/taste
Interest rates
Complements price

Question 19

What is marginal utility?

Answer 19

Marginal utility is additional utility gained from consumption of an additional product

Question 20

What is diminishing marginal utility?

Answer 20

As additional products are consumed, utility from next unit is lower than the utility gained from the previous unit.

Question 21

How does law of diminishing marginal utility explain a downward sloping demand curve?

Answer 21

When first unit is purchased, utility is most, so more people willing to buy at higher price.
When subsequent units purchased, utility decreases and willingness of the consumers to pay initial price decreases

Question 22

What is supply?

Answer 22

Supply is amount a product that a producer is willing and able to supply at a given price

Question 23

Factors of supply

Answer 23

Productivity
Indirect tax
No of firms
Technology
Subsidy
Weather
Costs of production

Question 24

What is price mechanism?

Answer 24

Price mechanism is interaction of demand and supply in the free market.

Question 25

When does price mechanism kick in?

Answer 25

When there is disequilibrium in the market; excess demand/excess supply

Question 26

What are the 4 functions of price mechanism?

Answer 26

**Signal** - Signal excess demand/supply and need for resources **Incentive** - Incentive to change output **Ration** - Ration scarce resources to (dis)courage consumption **Allocate** - Allocate resources efficiently at equilibrium

Question 27

What is consumer surplus?

Answer 27

Consumer surplus is the difference between amount **Consumer is willing and able to pay** for a products and **price they actually pay**

Question 28

What is producer surplus?

Answer 28

Producer surplus is the difference between the amount the **producer is willing to sell** a product for and they price they **actually sell the product for**

Question 29

What is community surplus?

Answer 29

It is consumer surplus + producer surplus

Question 30

What is an indirect tax?

Answer 30

A tax paid on consumption of product

Question 31

What products are indirect taxes usually put on?

Answer 31

De-merit goods; decrease consumption

Question 32

What is a specific tax?

Answer 32

A fixed tax per unit of output

Question 33

What is a ad valorem tax?

Answer 33

A tax that is a percentage of purchase price

Question 34

What is a subsidy?

Answer 34

Amount of money per unit granted to firm by government

Question 35

What are reasons for subsidies?

Answer 35

Increase production Increase provision of merit good