1.2 How do markets work

Question 1

Define rational behaviour

Answer 1

When economic agents maximise their own self interest and are able to assess economic costs and benefits to themselves of making alternative choices

Question 2

Why is switching from tobacco to e-cigarettes rational behaviour

Answer 2

Reasons rational
 Smokers computationally aware of financial gains of switching
 Smokers informed of private health gains
 Reducing health external costs e.g. passive smoking
 Smokers aware that regulations will increasingly make it difficult for them to gain utility of nicotine consumption through tobacco smoking

Question 3

3 marks

Why is switching from tobacco to e-cigarettes irrational behaviour

Answer 3

Reasons against being rational
-Smokers lack information and computational skills to accurately assess full costs and benefits of switching. May underestimate long-term gains of switching (bounded rationality)
-Information overload
-Both products contain nicotine which is addictive and habit forming.
-Switch may be only short-term (impulse buying)
-E-cigarettes complements tobacco smoking resulting in an overall increase in nicotine consumption
-PED for tobacco remains lower than e-cigarettes so a price rise in the latter may result in a switch
back

Question 4

3 marks

Explain how Bitcoin fulfils one function of money, apart from as a medium of exchange.

Answer 4

A measure of value (1) e.g. prices can be measured in
satoshis (1) people can compare prices of goods and
services (1)
OR
A store of value (1) when an individual saves bitcoin (1)
they are confident they will receive the equivalent value
back (1)
OR
A standard of deferred payment (1) when an individual
loans another person bitcoin (1) they are confident they will
receive the equivalent value back (1)

Question 5

Define demand

Answer 5

The quantity of a good or service that consumers are able and willing to. buy at a given price during a given period of time.

Question 6

Define law of diminishing marginal utility

Answer 6

As each additional unit of a product is consumed, the marginal benefit to the consumer from each additional unit falls.
Satisfaction decreases and consumers are less likely to pay at a higher price

Question 7

2 marks

The price elasticity of demand for petrol is -0.2. Explain the change to the total revenue of petrol stations as a result of cutting their prices.

Answer 7

Total revenue is the revenue recieved from the sale of a given level of output.
The % rise in QD is lower than % fall in price as demand is price inelastic

Question 8

If theres a 100% increase in P of coffee in Uganda which leads to 33% increase in QS. What does this suggest about supply of coffee in Uganda.

Answer 8

PES= %∆ in QS/ %∆ in P
PES= 33/100= 0.33
Coffee is price inelastic since the answer is less than 1
It may be price inelastic supply as it takes a long time to grow

Question 9

3 marks

Explain one reason why income elasticity of demand is significant to the producer of Freddos if YED= -2.5%.

Answer 9

YED= responsiveness to a change in quantity demanded given a change in income
YED is negative= inferior good= inelastic
Sales revenues fall as incomes rise

Question 10

What is SIRA

Answer 10

Prices perform a signalling function – they adjust to demonstrate where resources are required.
Prices act as an incentive function – for consumers and/or suppliers
Prices perform a rationing function.
This leads to allocative effiency where a new market clearing equilibrium is reached

Question 11

SIRA

Discuss the functions of the price mechanism with a rightward shift in demand

Answer 11

S) D↑ as P1= excess demand
I)↑P1-P2 = eraadicated excess demand
R) Contraction along D as P↑= impacts utility
Extension along S = profit maximisers
A) Allocate scarce resources
* New market clearing equilibrium has been reached (S=D) P2Q2

Question 12

Define Producer surplus

Answer 12

The difference between the price a supplier is willing to produce a good at and the price they actually produce at, set my the price mechanism

Question 13

Define consumer surplus

Answer 13

The difference between the price a consumer is willing to pay for a good at and the price they actually pay, set my the price mechanism

Question 14

Why may consumers not switch to cheaper brands

Answer 14

• Computation issues eg. consumers do not understand their pricing structure
• Habitual behaviour/ brand loyalty- may have a tendency to purchase same G/S over time
• Consumers dont have time to shop around or look for better deals- want to avoid disruption of changing provided (inertia)
• Strong brand= inelastic demand

Question 15

How will PED affect incidence of tax

Answer 15

• Price inelastic- Greater tax revenue, producers pass on much higher propotion of tax to consumers and pay the rest themselves
• Price elastic- Producers pass on much smaller proportion of tax to consumers and pay the rest themselves
  QD falls by a larger proption than increase in P

Question 16

Example of price mechanism when there is low demand

Answer 16

• Low demand indicates to firms to produce less
• Therefore not waste scare resources
• Contraction along S curve
• New clearing market equilbrium

Question 17

Purpose of market forces

Answer 17

• Ensures effiency due to competition and profit incentive
• Competition has a potential to drive up standards of provision and increase opportunity for consumer choice
• Inceased competition= firms are incentivised to produce at lowest average cost (productive effiency) so to compare with rest of market and not lose market share

Question 18

Disadvantage of incentive funtion in SIRA

Answer 18

Incentives lack perfect information or exhibit
asymmetric information

Question 19

Effect on consumer and producer surplus if theres an
* Increase in demand
* Decrease in demad

Answer 19

Increase in demand= CS↑ PS↑

Decrease in demand= CS↓ PS↓

Question 20

Effect on conumser and producer surplus if theres an
* Increase in supply
* Decrease in supply

Answer 20

Increase in supply= CS↑ PS↓

Decrease in supply= CS↓ PS↓

Question 21

Define supply

Answer 21

The quantity of a good or service that producers are willing and able to supply at a given price in each time period

Question 22

Define specific tax

Answer 22

Specific tax is a set amount per unit of a product sold

Question 23

Define indirect tax

Answer 23

• Imposed on producers by the government
• Tax on consumer expenditure

Question 24

Incidence of tax effect

Answer 24

• PS and CS fall
• Increases CoP
• P increases, QD decreases
• Firms are less competitive on international markets- may relocate of leave market
• Tax improves govt finances- tax funds could be used to reduce external costs
• Tax internalise external CoP
• Eradicates deadweight loss = closer to social optimum P

Question 25

Whats the effect in consumer difficulty in computation

Answer 25

Dont have full understanding in order to make a judgment on whether to change consumption in relation to a change in price
Consumers find considerable difficulty in calculating the profitability of something happening

Question 26

Optimising our own self interest

Tragedy of the commons

Answer 26

The pursuit of individual self interest is often not good for social efficiency, which leads to long term depletion of resources

Question 27

Why may consumers not switch to cheaper brands

Answer 27

• Computation issues eg. consumers do not understand their pricing structure
• Habitual behaviour/ brand loyalty- may have a tendency to purchase same G/S over time
• Consumers dont have time to shop around or look for better deals- want to avoid disruption of changing provided (inertia)
• Strong brand= inelastic demand