1.2 How markets work

Question 1

What does a consumer aim to maximimise?

Answer 1

Utility - the amount of satisfaction obtained from consuming a good or service

Question 2

What do producers aim to do?

Answer 2

A rational producer aims to maximise profits

Question 3

What is demand?

Answer 3

The quantity of a good/service purchased at a given price over a given time period

Question 4

What are the three reasons demand is downwards-sloping?

Answer 4

1. The income effect
2. The substitution effect
3. The law of diminishing marginal utility

Question 5

Explain the income effect

Answer 5

As the price of a good falls, more can be purchased with any given level of income - and more can be purchased by those on lower incomes

Question 6

Explain the substitution effect

Answer 6

As prices fall, the good becomes cheaper compared to substitute goods, and therefore demand increases for it.

Question 7

Explain the law of diminishing marginal utility

Answer 7

As successive units of a good are consumed, the utility gained from each extra good (i.e. the marginal utility) falls, and therefore reduces the quantity demanded.

Question 8

What is the difference between a movement along a demand curve and a shift of the curve?

Answer 8

A movement is caused by a change in the price of the good, whereas a shift is caused by anything but a price change.

Question 9

What are the two types of movements along the demand curve?

Answer 9

A fall in price causes an extension in demand and a rise causes a contraction.

Question 10

What shifts demand? [3]

Answer 10

Various factors, including:

• A fall in the price of complementary goods (derived demand)
• A rise in the price of substitue goods (derived demand)
• Changes in trends and fashion
• Increased advertising
• Increase in income or a decrease in tax
• Increase in population or age structure
• More credit facilities

Question 11

What is supply?

Answer 11

Supply is the quantity of a good/service that firms are willing to sell at a given price and over a quantity of time

Question 12

Why is Supply upwards-sloping? [3]

Answer 12

1. The profit incentive - firms supply more to increase profits
2. At higher prices, more firms are able to cover the costs of production
3. Finally, higher prices enourage more firms to enter the market

Question 13

What shifts supply? [3]

Answer 13

Essentially anything that reduces cost of production/unit of good

• Improvements in technology
• A reduction in labour/capital/transport costs
• Changes in taxes/subsidies
• Products in joint supply and competetive supply

Question 14

How is price determined?

Answer 14

Through the interaction of supply and demand - at an equilibrium price. This is where quantity demanded = quantity supplied for a good/service in a market.

Question 15

What is excess supply and excess demand?

Answer 15

When the level of goods either supplied or demanded is greater than the equilibrium quanitity

Question 16

How is excess supply and demand combatted? [high and low]

Answer 16

If the price is too low - i.e. in excess demand - consumers bid against each other in order to purchase the good, which pushes suppliers to raise the price and therefore reduces the extra demand.

If the price is too high - i.e. in excess supply - firms lower their prices and undercut each other in order to increase demand and sell more, reducing the extra supply.

Question 17

What are the three forms of the price mechanism?

Answer 17

1. Signalling device
2. Rationing device
3. Incentive device

Question 18

What is the price mechanism?

Answer 18

The use of market forces to allocate resources

Question 19

What is the rationing function/device?

Answer 19

Prices serve to ration scarce resources when demand in a market exceed supply.

Question 20

What is the incentive device?

Answer 20

Rising prices act as an incentive for firms to produce more of a good to earn a higher profit, and cover increased production costs.

Question 21

What is the signalling device?

Answer 21

Changes in price provide information to producers and consumers about market conditions

Question 22

What is consumer surplus?

Answer 22

The extra amount of money consumers are prepared to pay for a good or service above what they actually pay

Question 23

What is producer surplus?

Answer 23

The extra amount of money paid to producers above what they are willing to accept to supply a good or service

Question 24

Where is consumer and producer surplus (total welfare) maximised?

Answer 24

At equilibirum

Question 25

How does shifts in demand/supply affect consumer and producer surplus?

Answer 25

An **increase** in **demand increases total welfare** A **decrease** in **supply reduces total welfare**

Question 26

What is price elasticity of demand? (PED)

Answer 26

The **responsiveness** of **demand** for a good or service to a **change in its price**.

Question 27

What is the formula for PED?

Answer 27

% Change in Qd \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ % Change in price

Question 28

Explain the possible values of PED

Answer 28

If PED \> |1| : The good is relatively price elastic If PED \< |1| : The good is relatively price inelastic If PED = |1| : The good has unit elasticity If PED = 0: The good is perfecftly inelastic and price has no effect on demand If PED = infinity : The good is perfectly elastic, and any change in price causes demand to fall to zero

Question 30

What determines PED? [4]

Answer 30

* Availibilty of substitutes * Luxury and necessary goods * Proportion of income spent on good * Addictive and habit forming goods * The time period * Brand image

Question 31

What is total revenue?

Answer 31

The **price** per unit of a good **multiplied** **by** the **quantity sold**

Question 32

Why is PED useful for firms to know?

Answer 32

When **PED = |1|, revenue is maximised**. A price decrease on an elastic good and a price increase on an inalastic good will raise consumer spending and revenue to the firm.

Question 33

What is marginal revenue? What do its values signfify?

Answer 33

**Revenue** gained by a firm by selling **one extra unit** of output. When **MR = 0, revenue is maximised.** When it is positive, demand is elastic.

Question 34

What is price elasticity of supply? (PES)

Answer 34

The **responsiveness** of the **supply** of a good or service to a **change in its price**

Question 35

Explain the possible values of PES

Answer 35

If PES \> 1, supply for the good is relatively price elastic If PES = 1, supply for the good is unitary elastic If PES \< 1, supply for the good is relatively price inelastic If PES = 0, supply for the good is perfectly inelastic If PES = infinity, supply for the good is perfectly elastic

Question 36

What is the formula for PES?

Answer 36

% change in supply of good \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ % change in price of good

Question 38

What determines PES? [4]

Answer 38

* **Time period** - in the short run, supply is likely to be inelastic as it is hard to quickly increase production * Level of spare capaciy - can production be increased easily * State of the economy * Level of stocks of finished goods: i.e designer wedding dresses vs ready made cars * Perishability of the good - can it be stockpiled etc * Easy of entry into the industry - High entry barriers means it is hard for new firms to enter, even if they attracted by prices

Question 39

What is income elasticity of demand (YED)?

Answer 39

The **responsiveness of demand** for a good or service to a **change in real income**

Question 40

What is the formula for YED?

Answer 40

% Change in demand \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ % Change in real income

Question 41

What is the difference between a postive and negative YED?

Answer 41

If YED is positive, it is a **normal good** - i.e demand rises with real income If YED is negative, it is an **inferior good** - as income rises demand decreases, e.g. value brand meals or domestic holidays

Question 42

Explain the values of positive YED

Answer 42

If YED \> 1, demand is relatively income elastic (also called a **luxury good**) ## Footnote If YED = 1, demand is unitary income elastic If YED \< 1, demand is relatively income inelastic

Question 43

What is cross price elasticity of demand? (XED)

Answer 43

The **responsiveness of demand for _good B_** to a **change in the price of _good A_**

Question 44

What is the formula for XED?

Answer 44

% change in demand for **good B** \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ % change in price of **good A**

Question 45

Explain the possible values of XED

Answer 45

If XED is **positive**, the goods are **substitutes** for each other, as an increase in price (and therefore a decrease in demand) for good A leads to an increase in demand for good B. This is called **competitive demand.** If XED is 0, the goods are unrelated. If XED is negative, the goods are complements to eah other and tend to be consumed together. A decrease in demand for good A decreases demand for good B - this is called **joint demand**.