1.2 - How markets work

Question 1

What is Price elasticity of demand (PED)?

Answer 1

This is the responsiveness of demand to a change in the price of the good.

Question 2

How do you calculate PED?

Answer 2

% change in quantity demanded
(over the)
% change in price

Question 3

What is meant by Unitary Elastic PED (PED=1)?

Answer 3

Quantity demanded changes by exactly the same percentage as price.

Question 4

What is meant by Relatively Elastic PED (PED>1)?

Answer 4

Quantity demanded changes by a larger percentage than price so demand is relatively responsive to price.

Question 5

What is meant by Relatively Inelastic PED (PED<1)?

Answer 5

Quantity demanded changes by a smaller percentage than price so demand is relatively unresponsive to price.

Question 6

What is meant by Perfectly Elastic PED (PED=infinity)?

Answer 6

A change in price means that quantity falls to 0 and demand is very responsive to price.

Question 7

What is meant by Perfectly Inelastic PED (PED=0)?

Answer 7

A change in price has no effect on output so demand is completely unresponsive to price.

Question 8

What factors influence PED?

Answer 8

• Availability of Substitutes
• Time
• Necessity
• How large of a % of total expenditure
• Addictivity

Question 9

How does the availability of substitutes influence PED?

Answer 9

If a product has lots of substitutes, people will just switch to other products when prices go up. Therefore, PED will be elastic. No substitutes mean the curve will be inelastic.

Question 10

How does time influence PED?

Answer 10

The longer the time, the easier it will be for a person to find an alternative product/supplier of the product so the more elastic the good is. In the short term, many goods are inelastic as people may not even notice the price difference.

Question 11

How do necessities influence PED?

Answer 11

If something is needed, the demand curve will be inelastic because even if the price goes up, you still need to buy it.

Question 12

How does the % of total expenditure influence PED?

Answer 12

If the product is a very small percentage of a person’s expenditure, a significant increase in price will have a relatively small impact on how much they buy of that product so it will be inelastic.

Question 13

How does addictivity influence PED?

Answer 13

If a product is addictive then the demand curve will be inelastic as, no matter how high prices are, people will still buy the good to fulfil their addiction.

Question 14

What is the significance of PED?

Answer 14

• Helps show a business if an increase or decrease in price will provide greater total revenue.
• If inelastic, any increase in the cost of production or taxes can be passed onto the consumer as the demand is less responsive to this increase in price.

Question 15

How is PED significant in relation to the imposition of indirect taxes?

Answer 15

PED and PES determine the effects of the imposition of indirect taxes and subsidies. The more elastic, the lower the incidence of tax on the consumer. So when PED is elastic, a tax will only lead to a small increase in price and the supplier will have to cover most of this cost of tax. When it is inelastic, the tax will be mainly passed onto the consumer since they are relatively unresponsive to the price and so demand will not greatly fall.

Question 16

How is PED significant in relation to the imposition of subsidies?

Answer 16

With subsidies, elastic demand means that the consumer sees a smaller fall in price whilst the producer gains a lot in extra revenue. The more inelastic, the more the price falls

Question 17

If a product is (PED) Elastic, should the price be increased or decreased?

Answer 17

It should be decreased as demand will increase and overall revenue would increase.

Question 18

If a product is (PED) Inelastic, should the price be increased or decreased?

Answer 18

It should be increased as demand isn’t greatly responsive to a change in price and so there should be greater revenue.

Question 19

What is income elasticity of demand (YED)?

Answer 19

This is the responsiveness of demand to a change in income.

Question 20

How do you calculate YED?

Answer 20

% change in quantity demanded
(over the)
% change in income

Question 21

What type of good is YED<0?

Answer 21

It is an inferior good as a rise in income will lead to a fall in demand for the good.

Question 22

What type of good is YED>0?

Answer 22

It is a normal good as a rise in income will lead to a rise in demand for the good.

Question 23

What type of good is YED>1?

Answer 23

A luxury good as it is a type of normal good but YED>1.

Question 24

What is the significance of YED?

Answer 24

• A business can see how their sales will be affected by changes in the economy (and therefore income).
• It may have an impact on the type of good that the business produces - during prosperity, they might product more luxury goods and less inferior goods for example.

Question 25

What is cross elasticity of demand (XED)?

Answer 25

This is the responsiveness of demand for one product (A) to the change in price of another product (B).

Question 26

How do you calculate XED?

Answer 26

% change in quantity demanded of A
(over the)
% change in price of B

Question 27

What is meant by XED>0?

Answer 27

The goods are substitutes, an increase in the price of good B will increase demand for good A.

Question 28

What is meant by XED<0?

Answer 28

They are complementary goods, an increase in the price of good B will decrease demand for good A.

Question 29

What is meant by XED=0?

Answer 29

The goods are unrelated, a change in the price of good B has no impact on good A.

Question 30

What is Price Elasticity Of Supply (PES)?

Answer 30

It is the responsiveness of supply to a change in price of the good.

Question 31

How do you calculate PES?

Answer 31

% change in quantity supplied
(over the)
% change in price

Question 32

What is meant by unitary elastic PES (PES=1)?

Answer 32

Quantity supplied changes by exactly the same percentage as price.

Question 33

What is meant by relatively elastic PES (PES>1)?

Answer 33

Quantity supplied changes by a larger percentage than price so supply is relatively responsive to price.

Question 34

What is meant by relatively inelastic PES (PES<1)?

Answer 34

Quantity supplied changes by a smaller percentage than price so supply is relatively unresponsive to price.

Question 35

What is meant by perfectly elastic PES (PES=infinity)?

Answer 35

A change in price means that quantity supplied falls to 0 and supply is very responsive to price.

Question 36

What is meant by perfectly inelastic (PES=0)?

Answer 36

A change in price has no effect on output so demand is completely unresponsive to price.

Question 37

What factors affect PES?

Answer 37

• Time
• Stocks
• Capacity Level
• Availability of factors of production
• Ease of entry into the market
• Availability of substitutes

Question 38

How does time affect PES?

Answer 38

Immediate term - a supplier can only sell the amount they have, no matter the price, so supply is perfectly inelastic.
In the short term (the period of time when at least one factor of production is fixed), they could sell more but will still be restricted by the factors, so it will still be relatively inelastic.
In the long term (when all factors of production are variable), they can increase production and therefore it will be elastic - the longer the supplier has to make a change and increase production, the more elastic the curve will be.

Question 39

How do stocks affect PES?

Answer 39

If a business has a stockpile of goods, when price increases, they will decide to use up some or all of their stockpiles and therefore supply will be more elastic.

Question 40

How does capacity level affect PES?

Answer 40

If a business is working below full capacity and there is an increase in price, they can easily respond by producing to their full capacity so the supply curve will be more elastic.

Question 41

How does the availability of factors of production affect PES?

Answer 41

For example, labour may need certain skills or training and so cannot be instantly increase. If the wages of a doctor rise by a large amount, it would still take years before there would be an increase in the number of doctors so it is inelastic.

Question 42

How does the ease of entry into the market affect PES?

Answer 42

Large costs of start-up equipment could make it difficult to increase supply, making it inelastic. Trade unions or professional associations can restrict entry.

Question 43

How does the availability of substitutes affect PES?

Answer 43

If a good has a lot of producer substitutes, it will have high elasticity. One model of car is a substitute for another model of car as producers can easily switch between the two meaning suppliers can alter the pattern of production if price ruses or falls so supply will change.

Question 44

What does it mean by consumers aim to maximise utility?

Answer 44

Utility is the satisfaction gained from consuming a product. The rational consumer makes decisions by calculating the utility gained from each decision and chooses the one which will give them the most satisfaction.

Question 45

What does it mean by governments aim to maximise social welfare?

Answer 45

Governments are voted in by the public and work for the public, so should aim to maximise their satisfaction by taking decisions which increase social welfare.

Question 46

What causes a movement along the demand curve?

Answer 46

A change in the price of the good.

Question 47

What factors cause the demand curve to shift?

Answer 47

• Population
• Income
• Related goods
• Advertising
• Taste/fashion
• Expectations
• Seasons
• Legislation

Question 48

What is the Law of Diminishing Marginal Utility?

Answer 48

It states that the satisfaction derived from the consumption of an additional unit of a good will decrease as more of a good is consumers, assuming the consumption of all other goods remains constant. This explains why the demand curve slopes downwards; if more is consumed, consumers are less willing to pay high prices at high quantities since they are gaining less satisfaction.

Question 49

What factors cause the supply curve to shift?

Answer 49

• Costs of production
• Price of other goods
• Weather
• Technology
• Goals of the supplier
• Government legislation
• Taxes and subsidies
• Producer cartels

Question 50

What is excess demand?

Answer 50

If price is set below equilibrium, then there is excess demand. At the lower price, suppliers are willing to supply the lower quantity but consumers demand the higher quantity.

Question 51

What is excess supply?

Answer 51

If the price is set higher than the equilibrium, then there is excess supply. At the higher price, suppliers are willing to supply the higher quantity but consumers demand the lower quantity.

Question 52

How does the market resolve excess demand?

Answer 52

Since there is a shortage in demand, firms know that they can charge higher prices and still sell their goods, so this will cause a movement in the supply curve to a higher price, leading to a contraction in demand. So the price and quantity are now in equilibrium.

Question 53

How does the market resolve excess supply?

Answer 53

Since firms have unsold goods, they will be encouraged to put them on sale to sell the excess, causing prices to fall and a movement in the supply curve to a lower price, therefore demand will expand. So the price and quantity are now in equilibrium.

Question 54

What is the rationing function?

Answer 54

When the price increases, some people will no loner be able to afford to buy the product and others may no longer have the desire to buy the good. The limited resources can be rationed and allocated to the people who are able to afford them and those who value them most highly.

Question 55

What is the incentive function?

Answer 55

Buyers realises that the more money they have, they are able to buy more products. Suppliers realise that if they produce more of the goods, they will make more money. Also, low prices act as an incentive for consumers to buy more of a good and high prices act as an incentive to suppliers to sell more of a good.

Question 56

What is the signalling function?

Answer 56

When prices rise, producers move resources into the manufacture of that product. The change in price indicates to suppliers and consumers that market conditions have changed so they should change the quantity bought and sold - when price equilibrium moves, output equilibrium moves with it.

Question 57

The price mechanism in the context of a local market.

Answer 57

British supermarkets for example have faced less imports meaning there are fewer goods on supermarket shelves due to Covid-19. As the demand for the food is high but the supply is low, the price of food rises to ration off the excess demand so that only the consumers who value the food most highly buy them. This is an example of the rationing function.

Question 58

The price mechanism in the context of a national market.

Answer 58

The price of housing differs across the UK - high in south, low in north. As the population of London is high relative to the rest of the UK, house prices will rise through the rationing function. The high prices in London also offer and incentive for firms to allocate resources to the production of more houses as there is profit to be made in this industry. This is an example of the incentive function.

Question 59

The price mechanism in the context of a global market.

Answer 59

In 1973, OPEC restricted the supply of oil on an insurmountable scale. This sent the price of oil at record-breaking levels across the planet as oil was an invaluable resource to countries. This perfectly exemplifies the rationing function because the disequilibrium of supply and demand meant the high prices deterred consumers who didn’t value oil highly, which left the market open only to those consumers who did. By raising the price of oil, the market once again returned to a state of equilibrium.

Question 60

What is a consumer surplus?

Answer 60

A consumer surplus is the difference between the price the consumer is willing to pay and the price they actually pay, set by the price mechanism. The demand curve shows the price that consumers are willing to pay, and so the difference between the demand curve and the price shows the consumer surplus.

Question 61

What is a producer surplus?

Answer 61

A producer surplus is the difference between the price the supplier is willing to produce their product at and the price they actually produce at, set by the price mechanism. The supply curve shows the price suppliers are willing to sell the good for, and so the difference between the supply curve and the price shows the consumer surplus.

Question 62

How does a shift in demand affect the consumer and producer surplus?

Answer 62

A decrease in demand will lead to a fall in consumer and producer surplus as both price and output decrease.
An increase in demand would have the opposite effect and increase consumer and producer surplus.

Question 63

How does a shift in supply affect the consumer and product surplus?

Answer 63

A decrease in supply will lead to a fall in consumer and producer surplus.
An increase in supply would have the opposite effect and increase consumer and producer surplus.

Question 64

What is an indirect tax?

Answer 64

An indirect tax is a tax on expenditure where the person who is ultimately charged the tax is not the person responsible for paying the sum to the government. The business is required to pay the tax but the consumer is charged instead.

Question 65

What are the two types of indirect tax?

Answer 65

• Ad valorem - where tax payable increases in proportion to the value of the good. The tax is a percentage of the cost of the good, for example VAT.
• Specific tax - where an amount is added to the price. The tax increases with the amount bought rather than the value of goods, for example excise duties on alcohol, tobacco, and petrol.

Question 66

What are the impacts of a tax?

Answer 66

The introduction of tax causes supply to shift inwards because it leads to an increase in the cost of production. This leads to a rise in price and a fall in output. The consumer sees higher prices and suffers from a tax burden. The government gains tax revenue. The size of the tax is the vertical distance between supply curve 1 and 2. The revenue the government raises will be equal to the area of the consumer burden and producer burden.

Question 67

What is the incidence of tax?

Answer 67

The incidence of tax is the burden on the taxpayer. If the PED curve is perfectly elastic, or the PES curve is perfectly inelastic, the supplier will pay all the tax. If the PED curve is perfectly inelastic, or the PES curve is perfectly elastic, all the tax will be passed on to the consumer. In general, the more elastic the demand curve, or the more inelastic the supply curve, the lower the incidence of tax on the consumer, meaning the supplier has to pay more. This means that the more inelastic the demand curve, the higher the revenue of tax for the government because quantity demanded falls less and the more goods that are bought, the higher the tax revenue.

Question 68

What are subsidies?

Answer 68

A subsidy is a grant given by the government and is the opposite of a tax, an extra payment to encourage production/consumption of a good or service. They could be given to necessities, companies employing disadvantages workers, or those manufacturing in the UK to keep them competitive with imported goods.

Question 69

What does the subsidy graph show?

Answer 69

Since the producer sees a fall in production costs due to the subsidy, supply shifts outwards. As a result, there is a rise in output and a fall in price. The total shaded area represents government spending; this is equal to the size of the subsidy times the new output.

Question 70

How might the consideration of the influence of other people’s behaviour be a reason as to why consumers may not behave rationally?

Answer 70

Rationality assumes people act individually to maximise their own benefits but sometimes individuals are influences by social norms, known as a bias. Consumers become unwilling to change the bias, even if doing so will benefit them, if it goes against the norms of society. ‘Herding behaviour’ occurs when an individual copies the actions of a large group. One example is the stock market, and this causes huge market bubbles.

Question 71

How might the influence of habitual behaviour be a reason as to why consumers may not behave rationally?

Answer 71

Habits reduce the amount of time it takes to do something, because consumers no longer have to consciously think about their actions. Habits create a barrier to decision making since they limit or prevent consumers considering an alternative. Habitual behaviour includes addiction and so this influences people’s decisions. Another habit many consumers have is buying products at eye level so supermarkets tend to keep higher priced products near the top and lower priced products lower.

Question 72

How might consumer weakness at computation be a reason as to why consumers may not behave rationally?

Answer 72

Many consumers aren’t willing or able to make comparisons between prices and so they will buy more expensive goods than needed. Also, consumers are sometimes poor at self-control and so do things they know they shouldn’t. Similarly, consumers will make decisions without looking at the long term effects, and so make irrational decisions. One example of this is consumers saving up for their pensions; many put off doing this because they fail to look long term.