Microeconomics (2.1 - 2.3)

Question 1

Define demand

Answer 1

Demand is the willingness and ability of consumers to pay a sum of money for a good or service at a given price and at a given point in time.

Question 2

State the law of demand

Answer 2

The law of demand states that there is a negative relationship between price and quantity demanded. For example, as the price of a good falls, the quantity demanded rises (ceteris paribus).

Question 3

State the law of diminishing marginal utility

Answer 3

The law of diminishing marginal utility states that for each extra unit of a good consumed by an individual, the marginal utility they receive from consuming the good falls.

Marginal utility is the benefit gained from consuming one additional unit of a product or service

Question 4

Define substitute

Answer 4

A substitute for a good is an alternative product that can be used to satisfy a similar want in place of a good. If the price of a substitute increases, the demand for the main good increases and vice versa.

Question 5

Define complementary goods

Answer 5

A complement is a good that can be consumed together with another good. If the price of a complementary good falls, the demand for the main good increases.

Question 6

Define normal goods

Answer 6

Normal goods are goods which demonstrate a positive relationship between income and demand. Meaning, the demand for normal goods increase as income increases and vice versa.

Question 7

Define necessity goods

Answer 7

Necessity goods are a type of normal good. They are goods required for consumers to maintain a normal standard of living, such as electricity and rice. As household incomes rise, demand for necessity goods will increase, but at a less than proportionate rate than the increase in income. Necessity goods have PED < 1.

Question 8

Define luxury goods

Answer 8

Luxury goods are a type of normal good. As household incomes increase, the demand for luxury goods increases by a greater than proportionate amount relative to the rise in income. Luxury goods have PED > 1.

Question 9

Define inferior goods

Answer 9

Inferior goods are goods which demonstrate a negative relationship between income and demand. Meaning, the demand for inferior goods decrease as income increases and vice versa. Examples of inferior goods include lower-price goods such as tinned fruit and instant noodles.

Question 10

Determinants of demand

Answer 10

Number and closeness of substitutes and complements

Population: Population growth can influence demand because it affects the number of consumers in a market.

Consumer preferences: Consumer preferences change over time, and alters the demand of goods and services. Firms can influence consumer preferences through advertising

Price expectations: The demand for a good or service in the present can be affected by consumers’ expectations of what the price for that product might be in the future.

Question 11

Define supply

Answer 11

Supply is the willingness and ability of producers to offer a given quantity of a good for sale at a given price in a given time period.

Question 12

State the law of supply

Answer 12

The law of supply states that there is a positive relationship between price and quantity supplied of a good or service. Meaning a decrease in price leads to a fall in quantity supplied (ceteris paribus).

Question 13

Non-price determinants of supply

Answer 13

Factors of production: Any change in the costs of the factors of production (land, labour, capital, entrepreneurship) leads to a shift in the supply curve.

Joint supply: When a production process yields two or more goods at the same time this is called joint supply. This means increasing the supply of one good directly leads to an increase in the supply of a good it is in joint supply with.

Competitive supply: When allocating scarce resources to produce one good decreases the supply of another good.

Technology: As technological advances in production occur, the production capacity of firms increases.

Price expectations: Producer expectations of prices in the future can influence the supply. If they expect prices to increase in the future, they may decrease their supply now to save inventory for a higher price in the future

Number of producers in the market: As more firms enter a market, the supply in the market increases and as firms leave a market, the supply falls.

Question 14

Define equilibrium

Answer 14

Equilibrium in markets occurs when market supply and demand balance each other. This occurs when demand equals supply.

Question 15

Define price mechanism

Answer 15

The price mechanism is the means by which decisions of consumers and businesses interact to determine the allocation of resources.

Question 16

Define the rationing function of price

Answer 16

The rationing function is a function of the price mechanism. It means that price distributes goods so there are no surpluses or shortages. In other words, everyone who has effective demand for a good can buy it, and any firm which has effective supply can sell all of it.

Question 17

Define the signalling function of price

Answer 17

The signalling function of price is a function of the price mechanism. It defines how prices convey information about market conditions to consumers and producers. For example, if prices are rising due to increasing demand, it signals to producers to allocate more resources to capitalise on the increase in demand. For consumers, when prices rise, it signals that demand is high, and they can adjust their purchasing decisions accordingly.

Question 18

Define the incentive function of price

Answer 18

The incentive function is a function of the price mechanism. That is, price functions as an incentive for consumers and producers to change their behaviour. For example, firms are incentivised produce more if the price is high.

Question 19

Define consumer surplus

Answer 19

Consumer surplus is the difference between the price the consumer is willing to pay for a good and the market price of that good.

Question 20

Define producer surplus

Answer 20

Producer surplus is the difference between the price the producer is willing to sell their good and the market price of that good.

Question 21

Define allocative efficiency

Answer 21

Allocative efficiency is the best allocation or resources to produce goods and services from society’s point of view. It occurs when social surplus is maximised (producer surplus + consumer surplus) and when marginal social benefits equals marginal social costs.