1.2 - How Markets Work

Question 1

Contraction vs extension along demand curve

Answer 1

Contraction - higher price, lower demand
Extension - lower price, higher demand

Question 1

Demand defenition

Answer 1

The quantity of a good or service that consumers are willing and able to buy at any particular price.

Question 2

Subsitution effect

Answer 2

Consumer have choice in any market. Higher price charged by one will make them less willing to buy from there and switch to rival seller. Switching away from firms that raise price = SE.

Question 3

Income effect

Answer 3

Price rises for goods mean with same income consumers cannot buy as much as previously. Cut in spending power and real income of buyer.

Question 4

Non price factors effecting demand

Answer 4

• Income of consumers
• Price of close substitutes
• Price of complements
• Degree/effectiveness of advertising
• Changing tastes and preferences
• Quality of the product
• Size and age distribution of pop.

Question 5

Reasons for changes in income

Answer 5

• Wage rates payed by employers altered
• Increase in state pension
• Increase in National Minimum Wage
• Increase in Jobseekers’ Allowance/benefits
• Altered rate of income tax (more disposable)

Question 6

Examples of inferior goods

Answer 6

Public transport, own brand supermarket food and charity shop purchases

Question 7

Substitutes vs complements defenition

Answer 7

Two goods/services in competitive demand
Two goods/services in joint demand

Question 8

Reasons for changing tastes

Answer 8

• Changes in fashion
• Good/bad PR
• Advertising
• Seasonal changes

Question 9

Cost and availability of credit affecting demand

Answer 9

Demand for some goods depends critically on this availability for purchase e.g houses, cars. Higher the rate of interest, the lower the demand for these products.

Question 10

Individual demand

Answer 10

Quantity of a good or service that an individual consumer is willing and able to buy at different prices.

Question 11

Market demand

Answer 11

Total quantity of a good or service bought buy all consumers in a particular market at different prices. E.g national demand for private education places

Question 12

Joint demand

Answer 12

When two goods are bought together as complements.

Question 13

Competitive demand

Answer 13

When two goods are rivals/subsitutes for consumer spending.

Question 14

Derived demand

Answer 14

When the demand for a factor of production is the direct result of the demand for the output it produces. E.g demand for Iron stems from demand for ships.

Question 15

Supply demand

Answer 15

The quantity of a good or service that a firm is willing and able to produce at any given price level

Question 16

Cost of production on shifting S

Answer 16

Any factor which raises production costs will reduce profits and make firms less willing and able to supply. Tertiary biggest is wage bill, secondary is machinery.

Question 17

Gov. on shfiting S

Answer 17

They can alter cost of production to private firms by use of taxes and subsidies. A tax raises costs so reduces supply and subsidies reduces cost so raises supply.

Question 18

Tax vs subsidy

Answer 18

A tax is a compulsory levy on an individual or firm by the gov.
Subsidy is a grant given to an individual or firm by gov.

Question 19

Productivity on shifting S.

Answer 19

Productivity - measure of the rate of change of output. If any of the firm’s resources begin to work harder or more efficiently then costs fall as output increases. E.g due to output per worker or improvement in quality of capital.

Question 20

Weather on shifting S.

Answer 20

Some sectors of economy e.g agriculture can be affected by changes in weather leading to falling activity during bad weather and increases during good.

Question 21

Joint supply on shifting S.

Answer 21

Some goods are bi-products from production of other goods. An increase in supply of one leads directly to increase in supply of other.

Question 22

Effect of increase in demand.

Answer 22

If there is a rise in demand then the demand curve will shift outwards from D to D1. There is now excess demand at the original price, p*, so the price must increase to a new equilibrium at p1 in order to remove the shortage. This increased price gives firms a greater incentive to produce so there is an extension along the supply curve. There is a new equilibrium at q1 where a higher quantity is traded.

Question 23

Effect of decrease in demand.

Answer 23

If there is a decrease in demand then the demand curve will shift inwards from D to D1. There is now a supply excess at the original price point p* so to remove the surplus the price will decrease to a new equilibrium at point p1. Suppliers now have less incentive to supply so there is a contraction along the supply curve to q1. Thus a new equilibrium is reached where there is a lower quantity traded.

Question 24

Effect of increase in supply.

Answer 24

If there is a rise in supply at all prices then there will be a rightward shift in the supply curve from S to S1. At the original price p* there is now excess supply. To remove this surplus price must fall to a new equilibrium at p1. This lower price gives consumers a greater incentive to buy and this results in an extension down the demand curve. The result is a new equilibrium in the market with a higher quantity traded at q1.

Question 25

Effect of decrease in supply.

Answer 25

If there is a decrease in supply at all prices then there will be a leftward shift in the supply curve from S to S1. At the original price p* there is now excess demand. To remove this shortage price must rise to a new equilibrium at p1. This higher price means consumers are less willing and able to buy so there is a contraction up the demand curve. The result is a new equilibrium in the market at q1 where a lower quantity is traded.

Question 26

Definition of price/income elasticity of demand.

Answer 26

The measure of the sensitivity of consumer demand to a change a) in the price of a good/service b) in consumer income.

Question 27

Factors determining PED.

Answer 27

Whether the good is a necessity or luxury, proportion of income spent on the good, number of close substitutes, time period (e.g more likely to be inelastic in a short period).

Question 28

PED formula

Answer 28

PED = %changeQD / %changeP

Question 29

PED values

Answer 29

-1 < Inelastic < 0
- ∞ < Elastic < -1

Question 30

Is elasticity the same everywhere?

Answer 30

No it is more elastic at the top like socks.

Question 31

What should a firm do to maximise profit if the good is inelastic?

Answer 31

Raise price.

Question 32

What should a firm do to maximise profit if the good is elastic?

Answer 32

Cut price.

Question 33

How to measure PED.

Answer 33

Change actual prices + observe impact on sales volume.
Look at secondary data e.g prices charged by rival firms and their respective market share.
Undertake market research e.g survey customers about potential reaction to a different prices.

Question 34

How useful are PED measurements?

Answer 34

Usually estimates: numbers are likely to be unreliable because of inaccuracies in data collection and are liable to changes over time.