UNIT 2

Question 1

Law of demand

Answer 1

there is a negative relationship between price and quantity demanded, c.p.

Question 2

Assumptions for demand

Answer 2

Income effect: an increase in income leads to an increase in demand

Substitution effect: consumers tend to substitute goods with similar, cheaper goods

Law of diminishing marginal utility: as we consume more of an item, the amount of satisfaction produced by each additional unit of that good declines

Question 3

Non-price determinants of demand

Answer 3

Change in real income (demand effect)

Change in the price of substitute goods (substitution effect)

Change in the price of complementary goods

Change in taste & preferences

Change in the number of consumers in a market

Future price expectations (speculation)

Question 4

Definition of demand

Answer 4

Demand is the amount of a good or service that a consumer is willing and able to purchase at a given price in a given time period

Question 5

Definition of supply

Answer 5

Supply is the amount of a good or service that producers are willing to supply to consumers at a given price in a given time period

Question 6

Assumptions of supply

Answer 6

Law of diminishing marginal returns = adding an additional factor of production results in smaller increases in output.

Increasing marginal costs = the cost added by producing one additional unit of a product or service.

Question 7

Non-price determinants of supply

Answer 7

Changes to the costs of production

Changes to indirect taxes & subsidies

Changes to technology

Changes to the number of firms in a market

Weather events/black swan

Future price expectations

Goods in joint and competitive supply

Question 8

What is market equilibrium

Answer 8

when demand = supply

Question 9

What is disequilibrium

Answer 9

a loss or lack of equilibrium or stability

Question 10

What is the price mechanism

Answer 10

The interaction between supply and demand in a free market

This interaction determines prices, which are the means by which scarce resources are allocated between competing wants/needs

Question 11

What is a Veblen good

Answer 11

As price goes up, Qd goes up
- usually luxury goods

Question 12

Resource allocation

Answer 12

As a signal: they give information to producers and consumers about where resources are wanted

As an incentive: when prices rise, it serves as an incentive for producers to produce that good instead of others to profit maximise

Question 13

Rationing

Answer 13

Prices ration scarce resources

When resources become scarce, prices increase so that only those who can afford them can consume them

Question 14

Consumer surplus

Answer 14

the difference between the price a consumer is willing to pay and the price they have actually paid
area on the top

Question 15

Producer surplus

Answer 15

the difference between the price a producer is willing to sell a good for, and the price it is sold at
area below

Question 16

social/community surplus

Answer 16

Consumer + Producer surplus

Question 17

competitive market equilibrium

Answer 17

marginal benefit = marginal cost

Question 18

price elasticity of demand

Answer 18

A measure of the responsiveness of quantity demanded to a change in price

Question 19

PED formula

Answer 19

%ΔQd/%ΔP

Question 20

meanings of different PED/PES values (0-1, 1-∞, 0, ∞)

Answer 20

0-1 = inelastic
1-∞ = elastic
0 = perfectly inelastic
∞ = perfectly elastic

Question 21

determinants of PED

Answer 21

Availability of substitutes

Addictiveness

Price as a proportion of income

Time period (in the short term, consumers are less price elastic)

The PED of primary commodities is lower than that of manufactured goods due to the decreased availability of substitutes

Question 22

significance of PED

Answer 22

Firms can use PED to maximise revenue: if their product is price inelastic in demand, they should raise their prices; and if it is price elastic in demand, then they should lower their prices

Governments can use PED to decide how to manage subsidies and taxes: if governments tax price inelastic in-demand products, they can raise tax revenue without harming firms too much

Question 23

PED along a linear demand curve

Answer 23

PED falls as we move down a demand curve (elastic above 1 (in the middle), inelastic below)

Question 24

YED

Answer 24

A measure of the responsiveness of quantity demanded to a change in income

Question 25

YED formula

Answer 25

%ΔQd/%ΔY

Question 26

Positive YED value meaning

Answer 26

A good with a positive YED value is considered to be a normal good (may be a necessity or luxury)

Question 27

Negative YED value meaning

Answer 27

A good with a negative YED value - i.e. the Qd decreases as income increases - is considered to be an inferior good (like fast food)

Question 28

price elasticity of supply

Answer 28

A measure of the responsiveness of quantity supplied to a change in price

Question 29

PES formula

Answer 29

%ΔQs/%ΔP

Question 30

determinant of PES

Answer 30

Mobility of the factors of production Ability to store goods Spare capacity Time period

Question 31

primary commodity (HL)

Answer 31

a good directly arisen from the use of natural resources (i.e. land)

Question 32

why is the PED/PES for primary commodities generally lower than the PED/PES for manufactured products

Answer 32

PED: degree of necessity no close substitutes PES: decreased mobility, perishability, and time period

Question 33

reasons for government intervention

Answer 33

Correct market failure since the free market does not always allocate goods and services in the most socially optimal way Earn government revenue Promote equity (opportunity gap between the rich and poor) Support firms (key industries)

Question 34

what are the main forms of government intervention in markets?

Answer 34

price controls: floors and ceilings indirect taxes and subsidies direct provision of services command and control regulation and legislation consumer nudges (HL)

Question 35

indirect taxes (definition) what is a specific tax? ad valorem tax? what determines the incidence of tax?

Answer 35

An indirect tax is a tax levied on the consumption of goods and services Specific tax: a defined amount like $5.00 Ad valorem tax: a percentage of the purchase price The PED determines the incidence of tax: if a tax is levied on a good with inelastic PED, the burden of taxation falls largely on the consumer

Question 36

subsidies (definition? what is the aim?)

Answer 36

A producer subsidy is a per-unit amount of money paid to a firm by the government AIMS: To increase production (by decreasing the cost of production) Increase the production of a merit good

Question 37

price ceiling (definition, aim)

Answer 37

= maximum price A price, set by the government, above which a good or service cannot legally be sold Used by governments to increase the level of consumption or production A price ceiling is set below the equilibrium price, creating excess demand Often leads to the establishment of parallel (black) markets

Question 38

price floor (definition, aim)

Answer 38

A price, set by the government, below which a good or service cannot legally be sold Used by governments to decrease the level of consumption or production, typically of a demerit good A price floor is set above the equilibrium price, creating excess supply In agricultural markets, governments sometimes purchase the excess supply. This is not done in demerit goods Minimum wage is an example; DL and SL

Question 39

direct provision

Answer 39

Governments often provide services to improve the level of equity e.g. healthcare services ensure everyone can access the same medical treatment Typically accessible to everyone regardless of income Paid for through general taxation = opportunity cost

Question 40

regulation and legislation

Answer 40

Individuals and firms may be prosecuted for breaking the rules and fines generate government revenue May generate parallel markets

Question 41

consumer nudges (HL)

Answer 41

social advertising

Question 42

when does market failure occur

Answer 42

Market failure occurs when market forces fail to achieve a socially desirable allocation of goods and services

Question 43

MPC and MPB

Answer 43

MPB: the additional benefit received from the consumption of one additional unit of output MPC: the additional cost incurred through the consumption or production (output) of one additional unit of output

Question 44

MSB and MSC

Answer 44

MSB: the benefit to society received from the consumption or production (output) of one additional unit of output. It is the sum of the private benefits plus the external benefits MSC: the cost to society incurred through the consumption or production of one additional unit of output. It is the sum of the private costs plus the external costs

Question 45

demerit goods

Answer 45

Goods that have negative externalities in consumption, overproduced and overconsumed

Question 46

negative externalities of production

Answer 46

These are negative side-effects on third parties not involved in the economic transaction during the production process Air pollution, water contamination… (typically by-products) This occurs when MSC>MPC; overproduction

Question 47

negative externalities of consumption

Answer 47

These are negative side-effects on third parties not involved in the economic transaction during the consumption process; generally of demerit goods Cigarette consumption, fast food This occurs when MPB>MSB; overproduction

Question 48

merit goods

Answer 48

goods that are beneficial to society, but are underconsumed or underproduced

Question 49

positive externalities of consumption

Answer 49

These are positive side-effects on third parties not involved in the economic transaction during the consumption process

Question 50

positive externalities of production

Answer 50

These are positive side-effects on third parties not involved in the economic transaction during the production process

Question 51

common pool resources

Answer 51

Resources that are non-excludable but rivalrous Non-excludable: anyone can access this resource without having to pay for it Rivalrous: it can run out (finite supply) - competitive consumption

Question 52

tragedy of the commons

Answer 52

When common pool resources are managed in an unsustainable way, there are negative externalities of production; e.g. overfishing, unsustainable use of grazing land, deforestation

Question 53

collective self-governance

Answer 53

Working together to sustainably manage common pool resources

Question 54

indirect tax (market failure)

Answer 54

a tax levied on a demerit good (i.e. with negative externalities) as to increase its price and reduce its Qd or supply shifts the supply curve (because the tax is collected by the producer and then paid to the government) inwards to reduce the externality internalises the externality by increasing the cost/price may create parallel markets effectiveness depends on the PED

Question 55

carbon taxes (market failure)

Answer 55

a tax levied on a producer that emits greenhouse gases, by setting a tax on the CO2 volume emitted increases the cost of production and decreases the supply forces producers to innovate may cost unemployment

Question 56

subsidies (market failure)

Answer 56

a government payment to producers aimed at lowering the cost of production and increasing the quantity produced shifts the supply curve outwards opportunity cost can be targeted to help domestic industries

Question 57

legislation and regulation (market failure)

Answer 57

Legislation can influence the consumer or producer side, or both Shifts the corresponding demand or supply curve

Question 58

education (market failure)

Answer 58

Raising awareness of the benefits or costs of consumption or production Internalise the externality

Question 59

tradable permits (market failure)

Answer 59

An “optimum” level of pollution is calculated and each producer is allowed to pollute this amount, and the price of the permit changes by demand and supply Limits the total amount of pollution emitted Difficulty of calculating CO2 emissions Still provides permission to pollute

Question 60

international agreements (market failure)

Answer 60

Collective self-governance

Question 61

Government provision (market failure)

Answer 61

Public goods (beneficial for society and not produced by firms due to the free rider problem) Free at the point of consumption, paid for through general taxation May result in excess demand

Question 62

public goods

Answer 62

Beneficial to society, but not produced by firms due to the free-rider problem They are non-excludable and non-rivalrous: the price mechanism cannot be used to exclude, and they are not competitively consumed

Question 63

solution for public goods

Answer 63

Do nothing Government provision Contract out

Question 65

rational consumer choice (HL)

Answer 65

Rationality means that economic agents are able to consider the outcome of their choice and will pick the one that presents the highest utility Many economic theories assume that economic agents (individuals, firms and governments) make decisions that result in maximising their satisfaction

Question 66

assumptions of rationality (HL)

Answer 66

Consumer rationality Individuals use rational calculations for their own best interest Utility maximisation Individuals select choices that maximise their utility to the highest level Perfect information Assumes information is easily accessible about all goods and services, and have the same information as producers do

Question 67

limitations of rationality (HL)

Answer 67

Biases Rule of thumb: default choice Anchoring: reliance on initial information Availability bias: recency bias Bounded rationality People make decisions without gathering all the necessary information to make a rational decision within a given time period Bounded self-control Influence of emotions and desires into decision making Bounded selfishness Consumers do not always make the choice that is in their own best interest Imperfect (asymmetrical) information People make decisions based on limited information meaning they may not make the best choice

Question 68

behavioural economics in action (HL)

Answer 68

Choice architecture: an intentional design of choices to influence decision making Nudge theory: designed to guide consumers toward particular choices

Question 69

profit maximisation as a business objective (HL)

Answer 69

This is the rational producer decision; also benefits shareholders Marginal Cost =MRevenue

Question 70

growth/market share as a business objective (HL)

Answer 70

Increase market share After a certain size it may not be profit maximising

Question 71

satisficing as a business objective (HL)

Answer 71

Pursuing a satisfactory/acceptable outcome Minimum threshold/standard, e.g. for a sole trader owner who wants a work-life balance

Question 72

corporate social responsibility as a business objective (HL)

Answer 72

Enhance business image Expensive