Module 3

Question 1

Define arc elasticity

Answer 1

Measurement of elasticity between two points on a curve.

Question 2

Define point elasticity & what is the formula

Answer 2

Measurement of elasticity at a point on the curve.
Forumla is dQ/dP * P/Q

Where dQ/dP is the inverse of the slope of the tangent to the demand curve the point in the question.
dy/dx = gradient, dX/dY = inverse gradient (slope) tangential to the point

Question 3

Define price elasticity of demand (Pε_D)

State general formula in terms of % change for Pε_D.
Formula for arc elasticity using original and average (midpoint) methods.

small D to the ε

Answer 3

Price elasticity of demand measures the responsiveness of quantity demanded to change in price.

General formula in terms of % => PεD = % change in QD/ % change in P

Expressed using original/average method:
PεD = (change in QD/original QD) / (change in P / original P)

PεD = (change in QD/average QD) / (change in P / average P)

Convention is to use average values.

Question 4

Describe elastic demand

Answer 4

Situation where the quantity demanded is relatively sensitive to a change in price.
Absolute value of PED (Price Elasticity of Demand) > 1

Question 5

Describe inelastic demand

Answer 5

Situation where quantity demanded is relatively insensitive to change in price.
|PED|< 1

Question 6

Describe unit elasticity of demand

Answer 6

Situation where the price and quantity change by the same percentage.
PED = -1, |PED| = 1

Question 7

• Price of Good X increases from £6 to £9.
• Quantity demanded decreases from 100 to 90.

Calculate and interpret PED of demand using the average method.

Answer 7

PεD = (change in QD/average QD) / (change in P / average P)
(6, 100) to (9, 90), dQ = -10, dP = +3
(-10/95) / (+3/7.5) = -10.5%/+40% = -0.26

-ve sign indicates downward sloping demand curve
Absolute value |-0.26| = 0.26 < 1 indicates demand is relatively inelastic.

i.e., increase in price has led to less than proportionate decrease in quantity demanded.

Question 8

Describe three determinants of price elasticity of demand (PED)

Answer 8

1. Number and closeness of substitute goods, which may depend on broadness of the product definition. More substitutes general means a more elastic demand.
2. Proportion of income spent on the good. A larger proportion generally means more elastic demand.
3. Time period, as it takes time to find alternative goods. The longer the time period, the more elastic the demand.

PED = price changes first.

Broadness of product/product breadth = Total number of different product lines a company offers

Question 9

Define ‘total revenue’ and effect on total revenue if there is an increase in price if the demand is:
1. Perfectly inelastic - PED = 0
2. Relatively inelastic - |PED| < 1
3. Of unit elasticity - |PED| = 1
4. Relatively elastic - |PED| > 1
5. Perfectly elastic - |PED| = infinity

Answer 9

Total Revenue (TR) is total amount received by firms from sale of a product, before tax deductions or other costs.
TR = P x Q
Total revenue = Price of good x Quantity sold.

When price increases, and if demand is:
1. Perfectly inelastic - TR increases in proportion to increase in price.
2. Relatively inelastic - TR increases
3. Of unit elasticity - TR remains constant
4. Relatively elastic - TR decreases
5. Perfectly elastic - TR decreases to 0.

Question 10

Draw with unit elasticity of demand

Answer 10

Refer to notes (M3-7)
PED = -1. Downward sloping demand curve.

Question 11

Draw demand curve with 0 elasticity

Answer 11

Refer to notes (M3-7)
PED = - infinity. Straight horizonal line at some P.

Question 11

Quantity supplied of a good given by:
Qs = 2P - 10
Calculate and interpret the point price elasticity of supply when price is £15

Answer 11

PES = dQs/dP * P/Qs
= 2 * P/Qs = 2* P/(2P - 10)
= 2* 15/(2*15 -10) = 30/20 = +1.5
(2 because Qs = 2P - 10, so Qs is the y and P is the x, gradient is dy/dx = dq/dp so 2 instead of having to do inverse)

+ve sign means upward sloping supply curve.

PES value > 1, indicates supply is relatively elastic.
I.e, an increase in price leads to a more than proportionate increase in quantity supplied.

Question 11

Draw demand curve with infinite elasticty

Answer 11

Refer to notes (M3-7)
PED = 0. Straight verticle line at some Q.

Question 11

Explain how PED varies along a straight line demand curve of form P = a - bQ

Answer 11

P = a - bQ where a and b are constants. Thus dP/dQ = -b (gradient).

Point elasticity is given by PED = dQ/dP * P/Q = -1/b * P/Q

Since b is constant, elasticity alnog demand curve varies directly with the ratio of P to Q.

Question 12

Explain intended effect of advertising on demand curve.
Diagram in notes.

Answer 12

1. Shift product’s demand cruve to the right by bringing product to more consumers; attention, increasing attractiveness and marginal utility of product. Benefit gained per additional unit of product
2. Make product’s demand less price-elastic (make quantity demanded less reliant on price changes) by creating brand loyalty (people will still buy because of brand even if price goes up), thus reducing number of perceived substitute goods.

Question 12

Define price elasticity of supply PES

State general formula in terms of % then formula for arc elasticity using origina/average methods.

Answer 12

PES = measure of responsiveness of quantity supplied to price change.

% changes:
PES = % change in Qs / % change in P

Expressed using original/average method:
PεS = (change in QS/original QS) / (change in P / original P)

PεS = (change in QS/average QS) / (change in P / average P)

Question 13

Two main factors that influence value of Price Elasticity of Supply

Answer 13

1. Amount that firms’ costs rise as output rises - i.e., the firms’ marginal cost (cost to output additional unit of product), if costs very little to produce each extra unit of output, supply will be very elastic. If it is expensive to supply another unit, supply will be very inelastic.
2. Time Period - It takes time to increase factor, thus time to increase outputs, thus time to increase supply, therefore supply will be more elastic in the long run rather than the short run.

Question 14

Define Income Elasticity of Demand (YED)
State % change general formula and arc elasticity using original and average methods.

Answer 14

Income Elasticity of demand (YED) measures responsiveness of demand to change in consumer incomes (Y).
General formula;
YED = % change in QD/ % change in consumer income.

Expressed using original/average method:
YεD = (change in QD/original QD) / (change in Y / original Y)

YεD = (change in QD/average QD) / (change in Y / average Y)

Convention to use average values.

Question 15

Define ‘normal goods’:

Answer 15

Goods whose demand increases as consumer income increases.
Has positive income elasticity of demand.

Question 16

Define ‘inferior goods’:

Answer 16

Goods whose demand increases as consumer incomes increase.
E.g. store brand items, used cars, etc.

Things you typically can get/want upgrades on once you have more money

Question 17

How does income elasticity of demand for luxury goods compare to that of basic goods.

Answer 17

Luxury goods have higher income elasticity of demand (YED) than more basic goods.
Consumer will increase demand if they have the money for it because it is a luxury good - demand linked to brand rather than price.

Question 18

• Income increases from £18,000 to £22,000.
• Quantity of goods demanded increases from 40 to 60.
• Interpret income elasticity of demand (YED) using average method.

Answer 18

YεD = (change in QD/average QD) / (change in Y / average Y)

YED = (20/50) / (4000/20,000) = 40%/20% = 2
+ve sign indicates normal good.

Question 19

Describe main factor that influences the value of income elasticity of demand (YED)

Answer 19

• Degree of necessity of the good.
• In developed countries, demand for luxury goods expand rapidly as consumer income rises, so demand will be very income elastic.
• In contrast, demand for basic goods rises only a little (if at all) as consumer incomes rise, so demand will be very income inelastic.

Probably because already buying basic items as necessity. Won’t need to buy more depending on the item. E.g. toothpaste.

Question 20

Define cross-price elasticity of demand (CεD)
State % general formula and arc elasticity using original and average methods.

Answer 20

Cross-Price Elasticity of Demand (CεD_AB) measures responsiveness of demand for one good (Good A) to change in response to change in price of another (Good B)
(I.e. how does Good A demand change as Good B price changes)

CεD_AB = % change in QD_A / % change in P_B => % change in quantity of Good A demanded / % change in Price of Good B (how does top change according to bot)

CεD_AB = (change in QD_A/original QD_A) / (change in P_B / original P_B)

CεD_AB = (change in QD_A/average QD_A) / (change in P_B / average P_B)

Convention is to use average values.

Question 21

Use cross-price elasticity of demand (CεD_AB) and define substitute goods.

Answer 21

- Alternative goods, e.g two different brands of coffee/water. - CεD_AB is POSITIVE - increase in price of one good leads to decrease in demand for that good (since there are alternatives) and increase in demand for the other (because more people switch to that).

Question 22

Use cross-price elasticity of demand (CεD_AB) and define complementary goods.

Answer 22

- Goods consumed together, e.g. cars and petrol. - CεD_AB is NEGATIVE - increase in price of Good A leads to decrease in demand for that good, thus a decrease in demand for Good B (since they go hand in hand).

Question 23

- Price of Good X, Px = £2.50, Good Y, Py = £5 - QDx = 120 and CεD_XY = +3. (How demand of X changes wrt price changes of Y) What will be effect of demand for Good X (Change in QDx) if price for Good Y increases to £5.50

Answer 23

Using CεD_AB = (change in QD_A/original QD_A) / (change in P_B / original P_B), can't calculate averages so using method at a point. CεD_XY = +3 = (change in QDx / 120) / (+0.5/5) Rearrage: QDx = +3 * 0.5/5 * 120 = +36 Therefore QDx, demand for Good X will increase from 120 to 156 units. Because CεD_XY = +3 which is +ve, Goods X and Y are likely to be substitutes.

Question 24

Describe main factor that influences the value of CεD_AB ## Footnote Cross Price Elasticty of Demand, where demand of A changes responsiveness is measured against price changes of B

Answer 24

- Main factor is *closeness of the substitute* or *complement* - Closer the goods are as substitutes or complements, the bigger the effect on Good A when there is a change in price of Good B. - Substitute - Good A demand increases a lot since it's an even closer substitute of B (almost like a replacement) - Complement - Good A demand decreases a lot since B is such a good complement I.e They go hand in hand together so well that if demand for B falls or can't buy as much anymore due to price increase, people don't really want to buy A anymore since they go together so well so not being able to buy A is like an incomplete product/set

Question 25

Diagram to show how an increase in demand may lead to: - Short-run rise in price - A subsequent fall in price in the long-run

Answer 25

Refer to notes. Starting from intitial equilibrium (P1, Q1), increase in demand from D1 to D2 (shift up, right), results in price increase to P2 in the short run then fall to P3 in the long run. | WHY?

Question 26

Diagram to show how increase in supply may lead to: - Short-run fall in price. - A subsequent rise in price in the long run

Answer 26

Refer to notes. Starting from initial equilibirum (P1,Q1), an increase in supply from S1 -> S2 (higher quantity at given price) results in initital price decrese from P1 -> P2 then rise to P3 in the long-run. | WHY?

Question 27

Define 'spectulation'

Answer 27

Where people make buying or selling decisions based on their anticipations of future prices.

Question 28

Define 'self-fulfilling speculation'

Answer 28

Where the actions of speculators tend to cause the very effect they had anticipated. | Get an example.

Question 29

Define 'stabilising speculation'

Answer 29

Arises where the actions of speculators tend to reduce price fluctuations. Occurs when suppliers and/or buyers believe that a change in price is only temporary (so they don't react?) | Get an example.

Question 30

Define 'destabilising speculation'

Answer 30

Arises where the actions of speculators tend to make price movements larger. Occurs when suppliers and/or buyers believe that an initial change in price means further price chamges are to come. | Get an example.

Question 31

Draw diagram to illustrate the effect of stabilising speculation in response to an initial fall in demand, which leads to an initial fall in price.

Answer 31

Refer to notes. - Starting from initial equilibrium (P1, Q1), demand falls to D2. - @D2, the absence of speculation, new equilibirum (demand = supply) is @ (P2, Q2) - If suppliers speculate fall (in price or demand?) is temporary, they cut supply so S1 to S2 to sell later. - If demanders speculate fall is temporary, they will increase demand back to D3, to buy goods whilst cheap. ## Footnote Why would demanders speculate drop is temporary when they're the ones causing the drop? Well, because they can't control what the drop, but then how can they all collectively decide to drive up demand again? Confused. How can demanders who caused demand to fall, see it has fallen and then drive it up again, or demand happened to fall, so price fell so mroe people want to buy it now whilst price is lwoer which drives up demand and prices a bit but not back to the same level as before?

Question 32

Draw diagram to illustrate the effect of destabilising speculation in response to an initial fall in demand, which leads to an initial fall in price.

Answer 32

Refer to notes. - Starting from initial equilibrium (P1, Q1), demand falls to D2. - @D2, new equilibrium is (P2, Q2). - If suppliers speculate that there will be a further fall in price, then they will increase supply to S2 (to gain sales now) *but wouldn;'t that drive price down?* - If demanders speculate that there will be further fall (in price?), they will decrease demand again (how? By waiting?) to D3 (to wait for an even lower price). | M3-25

Question 33

Define Risk:

Answer 33

Risk refers to situation in which a (desirable) outcome of an action may or may not occur, but we know the probability of it occuring. The lower the probability of it occuring, the greater the risk involved in taking the action.

Question 34

Define Uncertainty:

Answer 34

Refers to a situation in which an outcome may or may not occur and it's probability is also unknown.

Question 35

Outline four ways in which a firm can deal with uncertainty when supplying goods.

Answer 35

1. Holding stocks of goods and services - which can be supplied to market when prices are favourable. 2. Purchasing information - e.g. market research and trade publications. 3. Using futures and forwards 4. Using insurance.

Question 36

Define short selling/shorting

Answer 36

Shorting is where investors borrow an asset, e.g. shares, oil contracts, foreign currency - Sell the asset hoping price would fall - Buy back later at the lower price and return it to lender. Assuming price has fallen, short seller willl make profit = to difference (minus fees). Danger is price may rise in which case seller makes a loss to buy back at a higher price.

Question 37

Advantage(s) of shorting:

Answer 37

Enables investors to make a profit from a fall in price of an asset.

Question 38

Disadvantage(s) of shorting:

Answer 38

- Can lead to losses for the investor - Can make markets and price of individual assets more unstable, e.g. by driving down market share prices that are anticipated to fall.

Question 39

Define futures or forwards market

Answer 39

Market in which contracts are made to buy or sell goods at some future date at a price agreed today.

Question 40

How firms and individuals reduce uncertainty by using futures/forwards?

Answer 40

Futures and forwards enable firms/individuals to fix prices for transactions takng place in the future, thereby removing uncertainty (unknown probability of an outcome happening)

Question 41

How speculators try to make profits using futures/forwards?

Answer 41

Futures and forwards enable speculators to gamble on prices changing - if speculators are correct in their predictions they can make profit. ## Footnote Think price of asset will increase in future, agree to buy it in future for current (lower) price. Sell after buying in future = profit.

Question 42

# T Difference between spot price and future price of an asset?

Answer 42

Spot price = current market price, i.e. price agreed now to exchange an asset now. (Price now, exchange at that price now) Future price = price agreed now to exchange an asset at an agreed date in the future. (Price now, exchange at that price later)

Question 43

Define "minimum price" or "floor". Draw diagram to illustrate effect on quantity demanded and supplied of a minimim price set above the equilibrium price.

Answer 43

Refer to notes. Minimum price is a price floor set by the goverment or some other agency. The price is not allowed to fall below this level (though it i allowed to rise above it), Price floor of Pmin leads to quantity demanded Q1, and quantity supplied Q2, hence a surprise of Q2 - Q1

Question 44

Define "maximum price" or "ceiling". Draw a diagram that illustrates effect on quantity demanded and supplied of a maximum price set below the equilibrium price.

Answer 44

Refer to notes. A maximum price is a price ceiling set by the government or some other agency. Price is not allowed to rise above this level, although allowed to fall below it. Price ceiling of Pmax leads to a quantity demanded of Q2, a quantity supplied of Q1 and hence a shortage of Q2-Q1.

Question 45

Explain and illustrate how price elasticity of supply and demand will affect the size of a surplus arising from a maximum price.

Answer 45

Refer to notes. Card M3-31

Question 46

Explain and illustrate how price elasticity of supply and demand will affect the size of a shortage arising from a maximum price.

Answer 46

Refer to notes. Card M3-32

Question 47

Possible reasons for imposing a minimum price (4)

Answer 47

1. *Protect Producers' Incomes* - This might be appropriate where the industry is subject to supply fluctuations, thus price fluctuations. 2. *Create a surplus* - Might be appropriate when it is desirable to store output in prepartion for potential potential future shortages. 3. *Deter the consumption of particular goods* - This may be appropriate when, e.g. consumers do not fully appreciate (realise) the future costs of cosuming the food on their health. 4. *Prevent workers' wage rates from falling below a certain level* - this may be part of a government's policy on poverty and inequality.

Question 48

What is the main effect of imposing minimum price, and what are other effects? (1+3)

Answer 48

1. Main effect is creating a surplus. 2. Firms may try to evade the price control and lower their prices. 3. Articificially high prices may support inefficiency (inefficient to produce) 4. discourage firms from producing alternative goods they can produce more efficiently or which are in higher demand ## Footnote Explain 3. & 4. Don't understand

Question 49

How does government address the surplus (main effect)? (3)

Answer 49

1. Buying the surplus itself and storing it / destroying it / selling it abroad in another market. 2. (artificially) lowering supply by restricting producers to particular quotas. 3. Raise demand through advertising / finding alternative uses for the good / reducing consumption of substitute goods.

Question 50

What are reasons for imposing a maximum price? (4)

Answer 50

They do this in order to prevent prices from rising above a certain level, the rationale for this is usually fairness. 1. Ensure people on lower incomes can afford basic goods. 2. Ensure accommodation is affordable. 3. Ration scarce goods in times of famine or conflict. 4. Reduce risk of price gouging (sellers raising their price excessively to take advantage of a crisis). | Could be used for resellers maybe?

Question 51

What is the main effect of imposing maximum price, and what are other effects? (2 + 2)

Answer 51

1. Main effect is creation of a shortage so firms have to allocate the good amongst potential customers using methods like "first-come, first-serve", favoured customers, a measure of merit or a rule or regulation. 2. Gov't might adopt a system of rationing to address this. Other effects of imposing maximum price: 4. illegal markets (underground/shadow markets) moght emerge 5. Reduces the quantity produced of an already scarce comodity ## Footnote Why reduce quantity? Because can't produce more/inefficient to produce more to sell at that max price?

Question 52

How government might address shortage? (2)

Answer 52

1. Encouraging supply, e.g. through direct production, subsidies 2. Reducing demand, e.g. producing alternative/substitute goods or reducing people's incomes.

Question 53

Define indirect tax:

Answer 53

Tax on the expenditure on goods. Includes: - VAT (Value Added Tax) - Duties on tobacco/alcohol, petrol Not paid directly by consumers. Paid indirectly via sellers of the good. Different to direct tax which is paid directly out of people's incomes.

Question 54

Define specific tax:

Answer 54

An indirect tax of a fixed sum per unit sold. (fixed tax amount) | Number taxed

Question 55

Define 'ad valorem tax'

Answer 55

An indirect tax of a certain % of the price of good. | % taxed

Question 56

Explan with aid of a diagram, the impact of a specific tax on equilibrium quantity and price. Mark price paid by consumers, price received by producer and area that represents total tax revenue raised by te tax, indicating what is shared by consumers and producers.

Answer 56

Refer to notes. Card M3-38

Question 57

Explain with aid of diagram the impact of an ad valorem tax on equilibrium quantity and price. Mark price paid by consumers, price received by producer and area that represents total tax revenue raised by te tax, indicating what is shared by consumers and producers.

Answer 57

Refer to notes. Card M3-39

Question 58

Define incidence of tax

Answer 58

The distribution of the burden of tax between sellers and buyers. | Shared tax between buyer and seller.

Question 59

How do price elasticities of demand and supply (PED / PES) affect tax incidence and tax revenue? When price rises by more?

Answer 59

Price rises more = consumer pays a larger % of the tax. - less elastic demand (demand does not react to price change as much) - more elastic supply (supply reacts to price change more)

Question 60

How do price elasticities of demand and supply (PED / PES) affect tax incidence and tax revenue? When price rises by less?

Answer 60

Price rises less = producer pays a larger % of the tax. - more elastic demand (demand reacts to price change more) - less elastic supply (supply reacts to price change less)

Question 61

How do price elasticities of demand and supply (PED / PES) affect tax incidence and tax revenue? When quantity falls by less?

Answer 61

Quantity falls by less = tax revenue will be larger - less elastic demand (demand reacts to price change less) - less elastic supply (supply reacts to price change less)