1.2 - How Markets Work

Question 1

Rational decision making

Answer 1

Where consumers allocated their expenditure on goods and services to maximise utility and producers allocate their resources to maximise profits.

Question 2

What is demand?

Answer 2

The quantity of a good or service purchased at a given price over a given period of time.

Question 3

Shape of the demand curve

Answer 3

It is downward sloping because of the law of diminishing marginal utility. As successive units of a good are consumed, the utility gained from each extra unit will fall.

Question 4

Factors that can shift the whole demand curve

Answer 4

• real incomes
• size or age distribution of the population
• tastes, fashions or preferences
• prices of substitutes or complements
• amount of advertising or promotion
• interest rates
• income tax

Question 5

Price elasticity of demand

Answer 5

The responsiveness of the demand of a good/service to a change in its price.

Question 6

Interpreting PED

Answer 6

PED > -1 - elastic
-1 < PED < 0 - inelastic
PED = -1 - unit elasticity
PED = infinity - perfectly elastic
PED = 0 - perfectly inelastic

Question 7

Relationship between PED and total revenue

Answer 7

Inelastic:
-price decreases, total revenue decreases
-price increases, total revenue increases
Elastic:
-price decreases, total revenue increases
-price increases, total revenue decreases
Unitary:
-prices changes leaves total revenue unchanged

Question 8

Determinants of PED

Answer 8

• availability of substitutes: many then its elastic
• luxury and necessity goods
• proportion of income spent on good, if its a high proportion of income then it will be elastic
• addictive and habit-forming goods make demand inelastic
• time period spent: more elastic in the long run
• brand image, if its strong then demand will be inelastic

Question 9

Income elasticity of demand

Answer 9

The responsiveness of demand for a good or service to a change in real income.

Question 10

Normal and inferior goods

Answer 10

• normal goods: positive YED. As real incomes rise, so foes demand for the good
• inferior good: negative YED. As real incomes rise, demand fort the good falls

Question 11

Interpreting YED

Answer 11

• income inelastic: 0 < YED < 1
• unitary elastic: YED = 1
• income elastic (luxury): YED > 1

Question 12

Cross elasticity of demand

Answer 12

The responsiveness of demand for good A to a change in the price of good B.

Question 13

Substitute, complementary and unrelated goods

Answer 13

Substitutes: in competitive demand, positive XED
Complements: in joint demand, negative XED
Unrelated: XED is 0

Question 14

What is supply?

Answer 14

The quantity of a good or service that firms are willing to sell at a given price and over a given period of time.

Question 15

Shape of the supply curve

Answer 15

As firms raise output in the short run, they face rising production costs and so charge higher prices. As price rises, it encourages firms to supply more of a good to increase profits or more firms enter the market.

Question 16

Factors that shift the demand curve

Answer 16

• costs of production
• productivity of the workforce
• indirect taxes
• subsidies
• technology
• discoveries of new materials

Question 17

Price elasticity of supply

Answer 17

The responsiveness of the supply of a good or service to a change in its price.

Question 18

Interpreting PES

Answer 18

• elastic: PES > 1
• inelastic: PES < 1
• unit elasticity: PES = 1
• perfectly elastic: PES = infinity
• perfectly inelastic: PES = 0

Question 19

Determinants of PES

Answer 19

• level of spare capacity: lots then elastic
• state of the economy: recession then elastic
• level of stocks of finished goods: high means elastic
• perishability: high then inelastic
• ease of entry into an industry: barriers then inelastic
• time period: elastic in long run, inelastic in short run

Question 20

What are excess supply and demand?

Answer 20

Excess supply: where quantity supplied exceeds quantity demanded for a good at the current market price
Excess demand: where the quantity demanded exceeds the quantity supplied for a good at the current market price

Question 21

What’s the price mechanism?

Answer 21

The use of market forces to allocate resources in order to solve the economic problem of what, how and for whom to produce.

• rationing device
• incentive device
• signalling device

Question 22

Consumer and producer surplus

Answer 22

• consumer: the extra amount of money consumers are prepared to pay for a good or service above what they actually pay
• producer: the extra amount of money paid to producers above what they are willing to accept to supply a good or service

Question 23

What is an indirect tax?

Answer 23

A tax imposed on good and services supplied by businesses. It includes both specific and ad valorem tax.

Question 24

What is a subsidy?

Answer 24

A govt grant to firms, which reduces production costs and encourages an increase in output.

Question 25

Reasons explaining irrational behaviour

Answer 25

• considerations of the influence of other people’s behaviour: ‘social learning’ a person subconsciously learns from the behaviour of others as a guide to their own behaviour.
• the importance of habitual behaviour: they are difficult to change if repeated frequently and are associates with rewards. Incentives are needed to change habits
• consumer weakness at computation: people don’t think long term, struggle to calculate probabilities and are influences by how a choice is presented.