1.2 How markets work (1.2.2 Demand, 1.2.3 Price, income & cross elasticities of demand)

Question 1

Define Demand

1.2.2

Answer 1

The quantity of a good/service consumers are willing and able to buy at a given price in a given time period.

Question 2

Define demand curve

1.2.2

Answer 2

A graph showing how much of a good will be demanded by consumers at any given price.

Question 3

What is the law of demand?

1.2.2

Answer 3

There is an inverse relationship between price of a good or service and quantity demanded, ceteris paribus.
As P increases, Qd decreases and vice versa, assuming ceteris parbius (all other variables remain unchanged).
Isolate impact of price changes to see its impact on Qd.

Question 4

What happens to the demand curve when price changes?

1.2.2

Answer 4

There is movement up/down the curve when we change price.
When P increases, we move up the curve and see a decrease in Qd, called a contraction of demand.
When P decrease, we move down the curve and see an increase in Qd, called an extension/expansion of demand.

Question 5

Reasons there is an inverse relationship

1.2.2

Answer 5

1. Income effect
   Assuming CP, as prices rise, the purchasing power of income falls and the proportion of income required to purchase a good/service increases.
   This reduces the consumer’s ability and willingness to buy the good/service so demand contracts & Qd reduces.
2. Substitution Effect
   Assuming CP, as prices rise, other goods/services become more price competitive - incentivising consumers to switch consumption to those goods/services.
   This reduces the willingness for consumers to pay for the higher priced item.

Question 6

What is the effect of removing the assumption of ceteris paribus on the demand curve?

1.2.2

Answer 6

Removing the assumption of ceteris paribus allows for non-price factors to affect demand.
Non-price factors shift the demand curve.
These non-price factors affect demand completely independent of price.

Question 7

What causes the demand curve to shift right/left?

1.2.2

Answer 7

Right -> non-price factor increases demand

Left -> non-price factor decreases demand

Question 8

What are the factors that shift the demand curve?

1.2.2

Answer 8

These non-price factors affect demand independent of price.
PASIFIC

1. Population (change in size & age)
   Greater pop, more D, shifts right
2. Advertising & branding
   Good advertising, increases Qd, shifts right
   Bad press/reports/newsarticles, decreases Qd, shift left
3. Substitute’s price & availability
   e. g. Coke & Pepsi
4. Income - Changes in real income
5. Fashion/tastes - (changes in)
   Affects willingness and sometimes ability.
6. Interest rates
   Can affect demand if consumers need to borrow to buy e.g. housing, furniture, cars.
   If they go down, cheaper to borrow, increase D, shifts right.
7. Complementary good’s prices
   Good often bought with another e.g. printer ink & printers.
   P for printer rises, D for printer ink falls.

Question 9

Define normal goods

1.2.2

Answer 9

One where Qd increases in response to an increase in consumer incomes
e.g. luxury cars, designer clothing, fine dining

Question 10

Define inferior goods

1.2.2

Answer 10

One where Qd decreases in response to an increase in consumer incomes
e.g. fast food, public transport, home holidays.

Question 11

Define Veblen good

1.2.2

Answer 11

A type of luxury good for which the demand for a good increases as the price increases, in apparent contradiction of the law of demand, resulting in an upward-sloping demand curve.

Question 12

Define Giffen good

1.2.2

Answer 12

A low income, non-luxury good for which demand increases as the price increases and vice versa

Question 13

Define substitutes

1.2.2

Answer 13

Two goods are said to be substitutes if the demand for one good is likely to rise if the price of the other good rises.

Question 14

Define complements

1.2.2

Answer 14

Two goods are said to be complements if an increase in the price of one good causes the demand for the other good to fall.

Question 15

What are demand decisions influenced by?

1.2.2

Answer 15

1. Price of the good
2. Price of other goods
3. Your income
4. Your preferences

Question 16

What are economists assumptions about consumers?

1.2.2

Answer 16

Act rationally, within their constraints to maximise their utility and self interest.
Utility - the satisfaction they get from purchases relative to the price, measured in utils.

Question 17

Define total utility

1.2.2

Answer 17

Complete amount of satisfaction gained from consumption of a good or service.

Question 18

Define marginal utility

1.2.2

Answer 18

The satisfaction gained from an extra unit consumed

Question 19

If marginal utility of the last consumption is ____ then total utility will be _____

1.2.2

Answer 19

If marginal utility of the last consumption is positive then total utility will be increasing.
If marginal utility of the last consumption is negative then total utility will be decreasing.

Question 20

Define diminishing marginal utility

1.2.2

Answer 20

The situation where an individual gains less additional utility from consuming a product, the more of it is consumed.
This suggests you will place a lower value on a product, the more you have already consumed.
Total utility reaches its highest point when marginal utility is zero as the curve then starts to decline.

Question 21

Ways to measure utility

1.2.2

Answer 21

Give utility a monetary value e.g. if i pay 90p for an ice cream, we can say utility is at least 90p.
Price reflects the scarcity of goods.

Question 22

What is the paradox of value?

1.2.2

Answer 22

The law of diminishing marginal utility explains why consumers will pay high prices for non-essential goods like diamonds but relatively little for life-saving water.
Price reflects the scarcity of goods.
The more scare a good the higher a consumer’s marginal utility.
Hence, demand curve is downward as the more we have of something, the lower the MU so the price we are willing to pay is lower.

Question 23

Define marginal utility price ratio

1.2.2

Answer 23

The ratio of the marginal utility obtained from consuming a good to the price of the good. This ratio is particularly important in determining consumer equilibrium, which is reached when the marginal utility-price ratios are the same for all goods.

Question 24

Define price elasticity of demand (PED)

1.2.3

Answer 24

A measure of the sensitivity to quantity demanded to a change in the price of a good or service.
Formula:
PED = % change in Qd / % change in P

Question 25

What are the factors affecting PED?

1.2.3

Answer 25

SPLATBC

1. Substitutes (availability) - few subs means price is higher
2. Percentage of income - 10% increase in the price of an apply versus a car
3. Luxury/necessity - necessity more price inelastic
4. Addicitve/habit forming - inelastic e.g cig
5. Time period - more time to find subs means more elastic e.g. price of petrol in short-run, long-run can buy diesel car etc.
6. Brand loyalty
7. Cost of switching

Question 26

Percentage change formula

Answer 26

new - old/old x 100

Question 27

Total revenue formula

Answer 27

Price of a good x quantity sold

Question 28

What is the significance of PED for firms and governments?

1.2.3

Answer 28

1. Understand effect on revenues
2. Deciding what price to charge a product
3. To price discriminate, can use differences in demand elasticities e.g. off-peak/peak train travel
4. When costs increase - can they increase price or must the firm reduce profit margins
5. Change of an indirect tax - can firm pass onto consumer
6. Government - impact on policy

Spec:

1. Imposition of indirect taxes/subsidies
2. Changes in real income
3. Changes in prices of substitute and complementary goods

Question 29

Demand is perfectly inelastic

1.2.3

Answer 29

PED is 0

Question 30

Demand is relatively inelastic

1.2.3

Answer 30

PED < 1
Remember technically -1
Raise price to increase revenue.
Increase in price means total revenue increases.
Decrease in price means total revenue decreases.
e.g. fuel, rice, cig

Question 31

Demand is unitary elastic

1.2.3

Answer 31

PED is 1
Remember technically -1
Total revenue is maximised at unit elasticity where there is no longer elastic/inelastic demand.

Question 32

Demand is relatively elastic

1.2.3

Answer 32

PED > 1
Remember technically -1
Lower price to increase revenue.
Increase in price means revenue decreases.
Decrease in price means total revenue increases.
e.g. restaurants, holidays

Question 33

Demand is perfectly elastic

1.2.3

Answer 33

PED is infinity

Question 34

Limitations of PED:

1.2.3

Answer 34

1. PED varies by region and over time
2. Rivals change strategies from time to time
3. Consumer price sensitivity changes over time
4. Elasticity varies within products
5. Data can be inaccurate or incomplete
6. Not all businesses are profit maximisers

Question 35

Why is PED always negative?

1.2.3

Answer 35

Demand curve is downward sloping and the changes in prices and quantity demanded will always be in opposite directions.

Question 36

How does PED vary along the demand curve?
How does change in PED affects total revenue?

1.2.3

Answer 36

Top point - perfectly elastic
Top half - relatively elastic
% change in Qd greater than % change in P
As price falls, revenue rises.

Mid point - Unitary elastic

Bottom half - relatively inelastic
Bottom point - perfectly inelastic
% change in Qd less % than change in P
As price falls, revenue falls.

Question 37

Define income elasticity of demand (YED)

1.2.3

Answer 37

A measure of the sensitivity of quantity demanded to a change in income.
Can serve to distinguish between normal, luxury and inferior goods.

Formula
YED = % change in Qd / % change in income (Y)

YED can be positive or negative so sign matters!

Question 38

Normal goods and YED

1.2.3

Answer 38

Normal goods have a positive YED
As income rises, Qd increases.
The size of the elasticity indicates the extent to which a good is regarded as a necessity.

Normal necessity good has YED between 0 and +1.
Qd rises less than proportionally to income.
Income inelastic.
e.g. bread, TV license

Normal luxury good has YED greater than +1
Qd rises more than proportionally to income.
Income elastic.
e.g. smartphones, fine wine

The higher the positive value for YED, the greater the effect of a change in national income on consumer demand.

Question 39

Inferior goods and YED

1.2.3

Answer 39

Inferior goods have a negative YED
As income rises, Qd decreases.
e.g. consumers may switch to branded goods.

YED < 0
(Is a negative number)

Question 40

Why do firms use YED?

1.2.3

Answer 40

Look for relationship between demand & income.
Allows them to prepare for an economic change e.g. boom/recession.

Necessities see little change.

Normal luxury good - knowing this info allows firm to prepare & ensure stock levels, employment levels and output are high enough.
Firms may increase productivity through training/specialisation instead of increasing number of workers.

For inferior goods - stock levels, number of employees and output will be decreased.
Or demand may be stimulated through advertising/brand development.

Question 41

How YED affects business decisions

Answer 41

1. Businesses may sell products in each YED range (diversify) - can change their advertising depending on state of economy.
2. Allows firms to forecast sales - increase/decrease production.
3. Changes in real national income tend to be cyclical.
   Demand for normal goods increases when economy is expanding, decreases contracting.
   Demand for inferior goods is counter-cyclical.

The higher the positive value for YED, the greater the effect of a change in national income on consumer demand.

Question 42

Issue with YED

1.2.3

Answer 42

Subjective - what one person considers a luxury, another may consider a necessity e.g. second hand car.

Question 43

Uses for YED

1.2.3

Answer 43

1. Helps firms prepare for economic change e.g. recession/boom
2. Manage stock levels and employment levels.
3. Diversify across ranges: inferior, necessity, luxury.
4. Forecast sales.

Question 44

Define cross elasticity of demand (XED)

1.2.3

Answer 44

Measures the sensitivity of quantity demanded of a good or service to a change in the price of some other good or service.
Can serve to distinguish between substitutes & complements.

Formula:
XED = % change in Qd for good A / % change in P for good B

+ve XED -> increase in P of good B leads to increase in Qd of good A (substitutes)
-ve XED -> increase in P of good B leads to decrease in Qd of good A (complements)
XED = 0 -> unrelated, not sub or complements

Question 45

Substitutes and XED

1.2.3

Answer 45

XED +ve
As the price for one good goes up, the demand for the other increases.

Close substitutes > 1 XED
Strongly related as demand between goods is price elastic

Weak substitutes < 1
Weakly related as demand between goods is price inelastic

0 no relationship as demand between goods is perfectly price inelastic e.g. wool & picture frames.

Question 46

Complements and XED

1.2.3

Answer 46

XED -ve
As the price of one good goes up, the demand for the other decreases.

Strong complements > 1
technically -1
strongly related as demand between the goods is price elastic

Weak complements < 1
technically -1
weakly related as demand between the goods is price inelastic

0 no relationship between the goods is perfectly price inelastic e.g. napkins and dog leads

Question 47

Is -2 XED a complement or substitute and is it weak or strong?

Is -0.05 XED a complement or substitute and is it weak or strong?

1.2.3

Answer 47

1. Strong complement

2. Weak complement

Question 48

How do firms use XED?
How to reduce XED for substitutes?

1.2.3

Answer 48

1. To understand who their competitors are.
2. Helps in anticipating changes in demand if prices of other products are changing
3. Advertising, product differentiation & creating brand loyalty reduces XED for substitutes.
   Where there are no close substitutes, they can increase price.
4. The Competition and Markets Authority (CMA) will consider the level of competition in a market before allowing or blocking a takeover/merger.
   Their aim is to maintain competitive markets.

Question 49

Governments use of PED

1.2.3

Answer 49

Imposing an indirect tax will raise the price and lead to a fall in demand - knowing PED helps forecast the tax revenues expected.
Introducing a subsidy would reduce the selling price of a good - knowing PED allow gov to assess the impact of the subsidy.