Chapter 2 Price Mechanism

Question 1

Define demand

Answer 1

Demand is defined as the quantity of a good (or service) that a consumer is both willing and able to buy at each possible price during a given period of time, ceteris paribus

Question 2

Define Quantity Demanded

Answer 2

Quantity demanded is defined as amount of good that a consumer is willing and able to buy at a given price over a period of time

Question 3

What are the Determinants of demand?

Answer 3

E- expectation of future prices
G- government policies
Y- level and distribution of income
P- price and availability of related goods
T- taste and preference

Question 4

Law of Demand?

Answer 4

Law of demand states that in a given period of time, quantity of a good demanded is inversely related to its price, ceteris paribus

Question 5

How does increase in Y affect demand?

Answer 5

income increases, leads to increased purchasing power and ability to buy good and services. As utility maximising consumers they are more willing and able to increase their demand
assuming it is normal good

Question 6

What are substitutes

Answer 6

substitutes are defined as pair of goods considered by consumers to be alternatives to each other with level of utility derived from consuming either good relatively similar

Question 7

How does substitutes affect demand?

Answer 7

when price of a fall, qdd will rise as rational and utility maximising consumers will switch away from b and buy a instead thus goods in competitive demand

Question 8

What are complementary goods

Answer 8

Complementary goods are defined as pair of goods consumed together to satisfy same want

Question 9

How does complementary goods affect demand?

Answer 9

when price of a increases, rational max utility consumers with their give income reconsider their purchase with some not buying a at all. Thus qdd a decreases and qdd for b decreases (state relationship)

Question 10

What is composite demand?

Answer 10

Demand for good with multiple uses

Question 11

What is Taste and preference?

Answer 11

The more desirable a consumer find a good, the more the demand. Change in taste and preference can be due to influences like advertisements

Question 12

How does expectation of high future prices affect demand?

Answer 12

current demand increase as rational max utility consumers in given budget want to prevent paying higher price in future

only if non-perishable

Question 13

How does population size affect demand?

Answer 13

Since market demand is summation of individual demand, rise in population size will increase demand

Question 14

What is supply?

Answer 14

Supply is defined as quantity of good of service that producer is both willing and able to sell at each possible price during a given period of time, ceteris paribus

Question 15

Define quantity supplied

Answer 15

Quantity supplied is amount of good that a producer is both willing and able to sell at a given price.

Question 16

Determinants of supply

Answer 16

G- government policies
E- expectations of future prices
R- price of related goods
M- marginal cost of production
O - Nature, Technology

Question 17

How does Marginal Cost of Production affect supply?

Answer 17

cost of producing an additional unit increases, higher mc relative to mr, profit driven producers cut production to reduce ml
minimum price producers are willing and able to accept increases

when Mc decreases, producers more willing and able to accept lower price to supply each additional unit

Question 18

How does Technology affect supply?

Answer 18

Tech bring about productivity increase, reducing input required for each additional unit of output, lowering mc

Question 19

What are types of government policies

Answer 19

Indirect tax (specific and ad valorem), direct tax, subsidy (specific or ad valorem)

tax increases mc of producers

Question 20

What are the related goods?

Answer 20

Goods in joint supply, goods in competitive supply

Question 21

What are goods in competitive supply?

Answer 21

increased production of one means diverting resources away from producing the other.

Question 22

How does expectation of future prices affect supply?

Answer 22

if expected to rise, producers may temporarily hold back amount of goods released into market likely to build up their stock to sell at higher prices in future current supply

Question 23

Assumptions of Market equilibrium

Answer 23

many buyers many sellers, perfect competitive market

Question 24

MAP for demand increase

Answer 24

Shortage at original price where utility-max consumers constrained by budget bid up prices causing some to drop out market
the units of output that can only be produced at higher mc become profitable at higher prices increases qss to capture additional profits

Question 25

MAP for increase in supply

Answer 25

surplus at original point, to remove surplus firms cut prices, qdd rises as utility max consumers are now willing and able to buy larger quantities. Units of output that can only be produced at higher MC become unprofitable, profit driven producers cut back output to avoid marginal loss decreasing qss

Question 26

Quantity transacted when demand increase more than supply decrease?

Answer 26

overall increase

Question 27

Quantity transacted when supply decrease more than demand increases?

Answer 27

Quantity transacted decreases

Question 28

Three functions of price mechanism

Answer 28

Signalling. incentive and rationing function

Question 29

What is signalling function of price mechanism?

Answer 29

Market prices will adjust to demonstrate where resources are required, prices rise to reflect shortages, and fall to reflect surplus

Question 30

What is incentive function?

Answer 30

When demand is high and strong, higher prices act as incentive for producers to raise output to make higher profit. Increased competition for equipment, raw materials bid up input prices to draw fop from slower growth industries into more profitable ones

Question 31

What is rationing function?

Answer 31

Price rations out goods according to willingness and ability to pay.

Question 32

Define economic efficiency

Answer 32

1) Allocative efficiency is achieved when mix of goods and services produced meets wants of all it consumers as effectively as possible 2) allocative efficiency production of commodity as that level for which total net social benefit

Question 33

Define consumer surplus

Answer 33

Difference between what consumer are willing to pay and able to pay for each unit of goods and the actual price they pay

Question 34

Define producer surplus

Answer 34

Difference between actual prices received by firms and minimum price they are willing and able to accept for successive unit of goods supplied

Question 35

Define price elasticity of demand

Answer 35

Measure of degree of responsiveness of qdd of a good to change in price of good itself ceteris paribus

Question 36

Determinants of PED

Answer 36

A- Availability and closeness of substitutes, P- Proportion of income spent on good, A - addiction T - Time period

Question 37

How does Availability and Closeness of substitutes affect PED?

Answer 37

Greater and closer, the more price elastic ceteris paribus. A good with many close substitution will face MTP fall in qdd when price increase as consumer can readily switch to cheaper alternative to satisfy same want

Question 38

How does Proportion of Income spent on good affect PED

Answer 38

Greater, more price elastic of demand ceteris paribus. When price increases, consumers will experience more significant reduction in their real income and purchasing power, forcing a greater cutback in qdd.

Question 39

How does degree of necessity of a good affect its PED

Answer 39

Demand for necessities is more price inelastic. Increase in price of non necessities, consumers may switch to alternative goods or forgo as they reduce their pp to consume

Question 40

How does Time period affect PED

Answer 40

longer the time period in which a consumer makes a purchasing decision, more price elastic. as consumers would have time to get information on substitutes, compared prices and adapt to taste and preferences

Question 41

Define cross price elasticity of demand

Answer 41

Measure of responsiveness of demand for one good to a change in price of another good. +ve and -ve

Question 42

XED>1

Answer 42

The two goods are substitutes where change in price of one food leads to change in demand for other goods in same direction. Max utility consumers within given budget are more w/a to switch to other one with similar utility to satisfy their wants

Question 43

XED<1

Answer 43

Complements which are goods consumed tgt to satisfy same want. Change in price of one good leads to change in demand of other in opp direction as consumers. eg. qdd for bread increase, demand for peanut butter also infrease

Question 44

What does XED magnitude say?

Answer 44

How closely related goods are, greater substitutability, larger value of XED, larger demand shift Greater complementarity, larger negative XED larger shift in demand curve

Question 45

Define income elasticity of demand

Answer 45

Measure of responsiveness of demand to changes in income +ve and -ve

Question 46

What sign of YED mean?

Answer 46

YED > 0 normal good whose demand changes in same direction as change in income due to higher pp YED < 0 inferior good whose demand changes in opposite direction as change in income despite increased pp as their more w/a to switch to goods that yield higher levels of utility

Question 47

What does magnitude of YED tell?

Answer 47

0 < YED < 1 income inelastic demand. Change in income produces less than proportionate change in qdd in same direction eg. necessities unresponsive to income changes YED > 1 income elastic demand, change in income produces MTP change in qdd in same direction eg. luxury goods which can only be consumed after the expenditure of necessities are accounted for, first to be given up when income goes down as max utility rational consumer more w/a divert additional income to necessities instead of

Question 49

Define price elasticity of supply

Answer 49

Measure of responsiveness of qss of good to change in price +ve

Question 50

PES > 1

Answer 50

price elastic where change in price of good gives a MTP change in qss in same direction

Question 51

0

Answer 51

Price inelastic, given change in price results in less than proportionate change in qss

Question 52

Determinants of PES

Answer 52

T- time period E- existence of spare capacity A- availability of stock M-mobility of FOP

Question 53

How does availability of stock affect PES?

Answer 53

Larger availability of stock, more responsive and larger increase in qss. non perishable is less elastic than perishable as they cannot be stored for long period of time and are unable to be drawn by producers when price increases

Question 54

How does existence of spare capacity affect PES?

Answer 54

firms have ability to increase production when existing capacity is not fully utilised, so when price increases they can quickly step up production with the unutilised FOP

Question 55

How does mobility of FOP affect PES?

Answer 55

degree that a FOP is w/a to switch between diff locations or uses. More mobile the more they can quickly employ more units of FOP to step up production

Question 56

How does diff magnitude of demand increase affect market?

Answer 56

Magnitude of increase in demand depend on YED, XED. larger the extent of increase in demand, larger the resultant shortage at original equilibrium price, prices need increase sharper to induce a sufficiently large reduction in qdd and increase in qss to established new market equilibrium. Price and quantity increases

Question 57

How does PES affect market?

Answer 57

price inelastic: less responsive qss to price changes, prices need to increase sharper to induce a sufficient large increase in qss to eliminate shortage price increase larger magnitude while quantity increase smaller magnitude price elastic: smaller magnitude change in price and larger magnitude change in quantity

Question 58

Factors affecting price and quantity to change in supply

Answer 58

PED, PES and magnitude of change in supply

Question 59

Effect on supply change on TR

Answer 59

Price elastic: a change in price leads to a MTP change in qdd in opposite direction. Decrease in consumer expenditure due to MTP decrease in qdd is greater than increase in consumer expenditure due to increase in spending per unit of output arising from increase in price. Price inelastic: less than proportionate change in qdd in opp direction when price change. Decrease in consumer expenditure due to decrease in number of units bought is less than increase in spending per unit output due to increase in price hence net increase