1.2 - How Markets work

Question 1

Give an assumption of how consumers make rational economic decisions.

Answer 1

Typically, consumers would make rational economic decisions and consume goods with the aim to maximize their utility (this is satisfaction). This means that rational consumers would calculate utility from certain goods and choose the one with the most.

Question 2

Give an assumption of how firms make rational economic decisions.

Answer 2

Firms are assumed to make economic decisions with the aim of profit maximization as firms are owned by both the owners and shareholders who buy shares of the firm. Therefore, maximizing profit can keep shareholders happy and satisfied.

Question 3

Give an assumption of how governments make rational economic decisions.

Answer 3

Governments are assumed to be aiming to maximize social welfare and mobility. As the majority of the public voted for them, the government will work towards improving life for public so they will make decisions which will improve social welfare.

Question 4

Define the term ‘demand’.

Answer 4

Demand is defined as the quantity of goods or services that consumers can purchase at a given price in a certain time period.

Question 5

Give an assumption of how workers make rational economic decisions.

Answer 5

Workers are assumed to make rational economic decisions with the aim to maximize their wages/salary and income, and to also have free time.

Question 6

Evaluate whether consumers actually make rational economic decisions.

Answer 6

In reality, consumers don’t actually behave rationally; in fact there are 4 behavioral factors which hold them back from acting rational.

Question 7

Give the four behavioral factors which prevent consumers from acting rational.

Answer 7

• Habitual behaviour (this means routine behaviour)
• Weakness at computation
• Social norms
• Consumer inertia

Question 8

Evaluate whether firms actually make rational economic decisions.

Answer 8

Firms do make rational economic decisions in reality, with the aim to maximize profits, sales and revenue.

Question 9

Evaluate whether governments actually make rational economic decisions.

Answer 9

Not all governments make rational economic decisions as some may be corrupt, may not achieve many macro economical objectives or may greedily reward their supporters or members of government.

Question 10

State the two types of utility.

Answer 10

• Total utility

- Marginal utility

Question 11

Define total utility.

Answer 11

Total utility is the total satisfaction/overall benefit gained from consuming a good. Typically, this will increase with the more units of good consumed, unless the marginal utility turns negative.

Question 12

Define marginal utility.

Answer 12

Marginal utility is the satisfaction/benefit gain from consuming an additional unit of a good. Generally, for every additional unit consumed, this will decrease.

Question 13

Give the unit of utility which neoclassical economists use.

Answer 13

Utils is the unit of utility.

Question 14

Explain the law of diminishing marginal utility.

Answer 14

The law of diminishing marginal utility is a law where, for each additional unit of good consumed, the marginal utility gained decreases. E.g. when consuming a sandwich, for each additional sandwich you eat, your marginal unity falls as you may become full or feel sick.

Question 15

Define dissatisfaction/disutility in a utility graph.

Answer 15

Dissatisfaction is where the total utility decreases as a result of the marginal utility falling to a negative value.

Question 16

What is behavioral economics?

Answer 16

Behavioral economics is a branch of economics which deals with the psychological factors that influence economical decision making. Compared to our assumptions, people don’t act as rational as we think due to social and emotional factors, so behavioral economics tries to address these factors.

Question 17

Explain habitual behavior.

Answer 17

Habitual behavior is typically defined as the routine behavior we all do over and over again. This behavior is generally harmless yet if the consumer suffers from an addiction (tobacco, alcohol…) then habitual behavior can be destructive.

Question 18

Explain weakness of computation.

Answer 18

Weakness of computation is where the consumer doesn’t have the mental effort or willingness to research the product or service they are purchasing, possibly find cheaper alternatives or compare. E.g. buying in bulk instead of individual units.

Question 19

Explain social norms.

Answer 19

Consumers are commonly affected by social norms and influences from many social groups such as friends or colleagues; e.g. they may feel expected to buy a good to ‘fit-in’, prevent FOMO.

Question 20

Explain consumer inertia.

Answer 20

Consumer inertia is where consumers aren’t flexible and don’t want change; this could be as a result of a lack of information on the latest goods on the market, or the consumers may be too busy to make rational economic decisions.

Question 21

Give a statistic on human behavior.

Answer 21

Studies show that 40-95% of human behavior (this is what we see, do, how we think and all overall human actions) falls into the habit category. This shows how habitual behavior plays a big role in influencing our human actions.

Question 22

Define the law of demand.

Answer 22

The law of demand shows how the quantity demanded of a product or service falls when the price of the good increases.

Question 23

What is effective demand?

Answer 23

Effective demand is a component of demand represented on the demand curve, demonstrating the goods and services which consumers can afford to buy and which goods they would buy.

Question 24

Explain an extension in demand.

Answer 24

An extension in demand is typically defined as a rise in the quantity demanded as a result of the price of goods decreasing, causing the demand to extend.

Question 25

Explain a contraction in demand.

Answer 25

A contraction in demand is defined as a fall in the quantity of goods and services demanded because the price of goods rises, resulting in the demand contracting/decreasing.

Question 26

Define substitute product.

Answer 26

Substitute products are products which serve the same purpose and operate in the same market; competitor goods like Coca-Cola and Pepsi-Cola are substitutes of each other, Nike and Adidas are typically substitutes of each other…

Question 27

What are complement products?

Answer 27

Complement products are goods which must be brought alongside each other/consumed together; if you want to play basketball, you need to buy the ball and a net to shoot the ball in.

Question 28

Describe the conditions/determinants of demand.

Answer 28

The conditions/determinants of demand are factors which can cause a shift (increase or decrease) in the demand curve, with more or less of these goods or services being demanded at each and every price.

Question 29

List some conditions/determinants of demand.

Answer 29

• Price of substitute good
• Price of complement good
• Political, social and religious reasons
• Advertising
• Changes in tastes and fashion
• Changes in population (increase or decrease)

Question 30

What can a shift in the demand curve cause?

Answer 30

A shift in the demand curve can cause either an increase or decrease in demand.

Question 31

Explain the consumer income determinant of demand.

Answer 31

For a normal good, if consumer income increases then demand for the good will also increase as consumers can afford more goods but if income falls then demand for inferior goods. (e.g. canned soup) which are quite cheap, will increase.

Question 32

What did Scottish economist Sir Robert Giffen suggest?

Answer 32

Giffen suggested that by increasing the price of bread, poor Irish families couldn’t afford more expensive food so they would spend more of their income on bread. This supported the idea of Giffen goods - inferior goods whose demand rose with the rise in consumer income.

Question 33

Explain the prices of substitute products determinant of demand.

Answer 33

The prices of substitute products can largely affect demand for a good; substitutes act as alternatives to a good so the price of a substitute is directly proportional to the demand of another good; if the price of Pepsi Cola increases, the demand for Coca-Cola will also increase. This creates competitive demand.

Question 34

Explain the prices of complement products determinant of demand.

Answer 34

The prices of complement products can also affect demand for a good as complement products are typically consumed together so they have ‘joint demand’; if the price of good A increases, the demand for good B will decrease.

Question 35

Describe the changes in tastes and fashion determinant of demand.

Answer 35

The preferences and tastes of people change regularly so if a good becomes more fashionable then sales and demand of the good will rise but if tastes and fashion change again then demand can quickly fall.

Question 36

What is the PED (Price Elasticity of Demand)?

Answer 36

The PED (Price Elasticity of Demand), is a measure of the responsiveness of demand towards a change in price.

Question 37

What is the formula for the price elasticity of demand?

Answer 37

The formula for the PED is:
(% change in quantity demanded) / (% change in price)
or (% △qd) / (% △p).

Question 38

What does the + symbol represent in terms of the PED?

Answer 38

The + symbol represents a positive relationship where both variables increase; if income increases (+), then quantity demanded of a normal good also rises (+).

Question 39

What does the - symbol represent in terms of the PED?

Answer 39

The - symbol represents a negative relationship where one or both variables fall; e.g. if price increases by 5% (+), then quantity demanded decreases by 15% (-).

Question 40

Define the PED coefficient.

Answer 40

The PED coefficient is simply the value of the price elasticity of demand.

Question 41

Describe the PED coefficient of 0.

Answer 41

The PED coefficient of 0 is where the goods are perfectly inelastic. Here, the firm can increase its prices as much as possible as the quantity demanded wouldn’t be affected by a change in price, allowing perfectly inelastic products to be charged high prices.

Question 42

What is the PED coefficient of 0 < 1?

Answer 42

The PED coefficient of 0 < 1 is where a good is price inelastic. Here, a change in price will cause a lesser change in demand, so the business should increase its prices, which will cause a decrease in demand but will also increase total revenue.

Question 43

Describe the PED coefficient of 1.

Answer 43

The PED coefficient of 1 is where the business has achieved unitary (constant) elasticity. Here, the business can increase or decrease its prices with no change to the total revenue.

Question 44

Describe the PED coefficient of 1 > ∞.

Answer 44

The PED coefficient of 1 > ∞ is where the products are price elastic. If a business is price elastic, changes in price will cause a greater change in quantity demanded. This is why the firm should decrease its prices as it will cause an increase in demand and also a rise in total revenue.

Question 45

Describe the PED coefficient of ∞.

Answer 45

The PED coefficient of ∞ is where the product is perfectly elastic. This is where, if the firm increases its prices way too much and the prices surpass a certain point, demand will completely disappear.

Question 46

What is the design for a perfectly inelastic graph?

Answer 46

A perfectly inelastic graph is shown as a straight, vertical line extending from 0 to the very top of the graph. The x-axis will always be quantity demanded and y-axis will be the price.

Question 47

Describe the design for a price inelastic graph.

Answer 47

Unlike a perfectly inelastic graph where there is a straight, vertical line, a price inelastic graph will also have a vertical line, but the line will be diagonal due to the small change in quantity demanded from the change in price. The diagonal line will usually extend to the left.

Question 48

Describe the design for a price elastic graph.

Answer 48

A price elastic graph will show a diagonal horizontal line extending downwards due to the change in price causing a greater change in quantity demanded.

Question 49

Describe the design for a perfectly elastic graph.

Answer 49

A perfectly elastic graph will demonstrate a straight horizontal line extending from a certain price value, indicating the infinite quantity demanded of a product.

Question 50

Describe and explain the significance of PED for firms.

Answer 50

Firms typically produce products with price inelastic coefficients as these are generally close to perfect inelasticity, where the firm can charge as high a price as possible. Also, high prices translate to high profits and high revenue incurred by the business, and by branding these goods, the business is further differentiated from other firms.

Question 51

Describe and explain the significance of PED for governments.

Answer 51

Governments raise revenue via taxing price inelastic products as the high tax of this type of good is passed onto the consumer, and price inelastic goods are also known to be big money earners for the government. Unsurprisingly, the chancellor of the exchequer tends to increase tax on price inelastic goods so the government can earn more money.

Question 52

What is the YED?

Answer 52

The income elasticity of demand (YED) is a measure of responsiveness of demand towards a change in income.

Question 53

Give the formula for the YED.

Answer 53

Formula for income elasticity of demand is:
(% change in quantity demanded) / (% change in income)
or (%△qd) / (%△y)

Question 54

What is the YED coefficient of 0 or 1?

Answer 54

If the YED coefficient is 0 or 1, then it will be income inelastic; this means the change in income will cause a change in quantity demanded but this change in quantity will be at a lower proportion.

Question 55

What is the YED coefficient of >+1?

Answer 55

If the YED coefficient exceeds +1, the title will be income elastic; this is where the change in income will cause a greater proportion change in quantity bought/demanded.

Question 56

What is the YED coefficient of 0?

Answer 56

If the YED coefficient is 0, the quantity demanded will stay the same regardless of any change in income.

Question 57

Give examples of inferior goods.

Answer 57

Bread, vegetables, frozen foods, public transport such as buses and railway.

Question 58

Give examples of luxury goods.

Answer 58

Luxury international holidays, finest wines and spirits, high quality chocolates, smartphones, sports cars.

Question 59

Describe the graph of a normal good.

Answer 59

A normal good graph will demonstrate direct proportion due to the increasing income causing quantity demanded to rise. Positive YED will also occur here due to the two variables increasing.

Question 60

Describe the graph of an inferior good.

Answer 60

An inferior good graph will indicate inverse proportion due to the decreasing income (-) resulting in quantity demanded of inferior goods to rise (+). Negative YED will occur here due to one of the variables decreasing.

Question 61

What YED coefficient(s) will necessity goods be classed as?

Answer 61

For necessities, the YED coefficients will be between 0 and 1.

Question 62

What YED coefficient will luxury goods be classed as?

Answer 62

Luxury goods have YED coefficients more than 1, so they are income elastic products.

Question 63

What is the PED determinant of substitutes?

Answer 63

The more close substitutes are in the market, the more elastic demand will be as consumers will have more choice so changes in price will be more sensitive; air travel and train travel are close substitutes in terms of travel between major cities in a large country.

Question 64

Explain the PED determinant of time.

Answer 64

Generally, in the short term demand will be more inelastic due to consumers finding it hard to abandon any shopping habits so they won’t be so sensitive to changes in price but in the long term, there will be more elastic demand due to consumers adjusting to changes in market conditions.

Question 65

Explain the PED determinant of the good being subject to habitual consumption.

Answer 65

Typically consumers will be quite inelastic (less sensitive towards changes in price) to goods which aren’t usually purchased as part of a habit as these goods aren’t bought so frequently, so consumers won’t mind of the price.

Question 66

What is the PED determinant of consumer income?

Answer 66

Generally, goods which take up a high % of income will cause a more elastic demand as consumers will ensure they won’t overspend so they will be more sensitive towards the price of goods.

Question 67

Describe and explain the significance of YED on standards of living.

Answer 67

For consumers who have high disposable incomes, they will have greater spending power which allows them to afford more luxury goods and services. This causes firms to produce superior goods to help meet the needs of these wealthy consumers. On the other hand, poor consumers won’t afford so much so their income will be spent on necessities.

Question 68

Describe and explain the significance of YED on the economic cycle (economic growth).

Answer 68

If the economy is in recovery mode and it’s growing, then disposable incomes will rise, causing a rise in the demand for luxury goods; initially, a higher proportion of the income will be spent on necessities to ensure consumers will survive then due to more affordability, some of the income is spent on luxury goods.

Question 69

Describe and explain the significance of YED on the economic cycle (economic recession).

Answer 69

For an economic recession, disposable incomes will fall which will result in a fall of the demand for luxury goods as consumers will focus more on spending their income for necessity goods so they can safely survive the recession without any significant damage.

Question 70

What is XED?

Answer 70

The cross elasticity of demand, also known as XED, is simply a measure of the responsiveness of the demand of good X towards a change in the price of good Y.

Question 71

Give the formula for XED.

Answer 71

XED = (% change in demand of good X) / (% change in price of good Y)

Question 72

Describe and explain the substitute goods determinant of XED.

Answer 72

Substitute goods will have a positive cross elasticity of demand because a change in the price of one good will typically cause a similar change in consumer demand of the substitute; if the price of good Y increases, the quantity demanded for good X also increases. The closer the substitutes, the higher the XED as the relationship between the price of good Y will be more elastic towards the demand of good X.

Question 73

Describe and explain the complement goods determinant of XED.

Answer 73

Complement goods have a negative XED as a change in the price of a good will cause the opposite to occur in the change in consumer demand of another good; if the price of good Y increases, the quantity demanded for good X will decrease. Generally, the closer the complements, the higher the XED due to joint demand of the goods and the relationship between the price of good Y will be more elastic towards the demand of good X.

Question 74

Describe and explain how goods with no relationship is a determinant of XED.

Answer 74

Goods with no relationship will not have an XED as the goods will be completely different so a change in price of one of the goods will have no impact on the consumer demand of the other good.

Question 75

Assuming goods A and B are substitutes, what will happen to the demand of good A if the price of good B increases?

Answer 75

If the price of good B rises then consumers will look for an alternative which will be good A, so the demand for good A will increase, and there will be a shift to the right in the demand curve for good A.

Question 76

Assuming goods A and B are complements, what will happen to the demand of good A if the price of good B increases?

Answer 76

As both goods are complements, they will have joint demand where the relationship between the price of one good and the demand of another will be more sensitive. This means if the price of good B rises, this will result in the demand of good A falling, resulting in a shift to the left in the demand curve for good A.

Question 77

Explain the importance of XED.

Answer 77

XED estimates are crucial for businesses so they can assess how the pricing strategies of firms can affect the demand of the firm’s own goods, and they can also assess pricing strategies of complementary goods; e.g. cinema and popcorn are complementary goods and if XED estimates are reliable then firms can estimate effect of certain situations; how a 2-for-1 ticket will affect the demand for popcorn.

Question 78

Give some applications of XED.

Answer 78

Examples of XED applications include international flights; e.g. if the price of flights to Dubai from several airlines decrease, then there will be an increase in quantity demanded of hotel rooms, and another application includes effect of higher indirect taxes placed on goods such as tobacco and how this will affect demand of nicotine patches.

Question 79

What is supply?

Answer 79

Supply is the amount of a good or service which producers are willing to sell for a given price over a certain time period.

Question 80

How do you find the quantity supplied at a certain price on the supply curve?

Answer 80

For this, select a price at the y-axis and carefully draw a straight dotted line towards the demand curve, then from there, go straight down onto the x-axis to find out the quantity supplied.

Question 81

What does the law of supply state, for an extension in supply?

Answer 81

The law of supply states that, as the price increases, the supply will extend and quantity supplied will rise resulting in an extension of supply, ceteris paribus. This is shown as a movement along the supply curve to the right.

Question 82

What does the law of supply state, for a contraction in supply?

Answer 82

The law of supply states that, as the price decreases,
the supply will contract, and quantity supplied will fall resulting in a contraction of supply, ceteris paribus. This is shown as a movement along the supply curve to the left.

Question 83

When does a supply curve shift?

Answer 83

The supply curve shifts if supply increases or decreases due to a factor excluding price.

Question 84

Describe an increase in supply.

Answer 84

An increase in supply is typically shown as a shift to the right from S to S1 on the supply curve, caused a factor other than price such as new technology, or cheaper production costs.

Question 85

Describe a decrease in supply.

Answer 85

A decrease in supply is shown by a shift to the left from S to S1 on the supply curve, caused by a factor excluding price such as increasing production costs.

Question 86

Give some conditions of supply which may cause a shift in supply.

Answer 86

Changing costs of production, government policies (taxes and subsidies), prices of goods and services, technological progress, other factors (e.g: the weather, trade union activities)

Question 87

How do production costs impact supply?

Answer 87

If production costs increase, this will make it more expensive to supply the good or service, resulting in firms reducing output of that specific good as the selling price decreases, causing a fall in supply. On the other hand if factor inputs like production costs decrease, it will be cheaper to supply the good, resulting in a rise in supply.

Question 88

How do improvements in technology impact supply?

Answer 88

As technology advances further and further, this helps generate efficient productivity and cost-effective capital in firms, very useful as the fixed costs of the capital are spread over the greater quantity of output which results in cheap costs per unit of production. As the technology improves, firms find these goods very profitable, resulting in an increased supply.

Question 89

How do the prices of other goods and services impact supply?

Answer 89

If a business is supplying good A, but sees that good B is increasing in price; the firm will see that the increased price of good B will translate to higher supply and higher profit, so the firm will switch to supplying good B as it seems more profitable. Also, new firms typically enter markets charging high prices, with the aim to generate plenty of profit so they can survive.

Question 90

How do government policies regarding indirect taxes impact supply?

Answer 90

Indirect taxes are additional sums of money added to a product such as VAT (Value Added Tax), which cause a rise in production costs, making it more expensive to produce and supply a good which contributes to a fall in supply.

Question 91

How do government policies regarding subsidies impact supply?

Answer 91

Subsidies are finance given to producers to encourage production of goods and services; these subsidies make production costs cheaper, making it cheaper to produce and supply a good which contributes to a rise in supply.

Question 92

What is PES?

Answer 92

Price Elasticity of Supply (PES) is a measure of the responsiveness of the quantity of goods supplied towards a change in price.

Question 93

Give the formula for the price elasticity of supply.

Answer 93

PES = (% change in quantity supplied) / (% change in price)

Question 94

Give the 5 coefficients of PES.

Answer 94

Perfectly inelastic = 0
Price inelastic = 0 < PES < 1
Unitary elastic (constant) = 1
Price elastic = 1 < PES < ∞
Perfectly elastic = ∞

Question 95

Explain the price elastic supply coefficient in PES.

Answer 95

In terms of PES, the price elastic supply coefficient is where a change in price will cause a change in quantity supplied at a greater proportion, indicating that supply is sensitive to changes in price. It has a coefficient of 1 < PES < ∞.

Question 96

Explain the unitary elastic coefficient in PES.

Answer 96

In terms of PES, if the coefficient is unitary elastic this will mean that the change in price is equal to the change in quantity supplied. It has a coefficient of exactly 1.

Question 97

Explain the price inelastic coefficient in PES.

Answer 97

In terms of PES, a price inelastic coefficient is where a change in price will cause a change in quantity supplied at a lower proportion, indicating that supply is insensitive to changes in price. It has a coefficient of 0 < PES < 1.

Question 98

Give examples of goods with elastic supply.

Answer 98

Elastic supply goods include goods which are relatively easy to make and require few, basic raw materials such as plastic. Generally to increase supply of these goods, manufacturing firms can easily adapt production.

Question 99

Give examples of goods with inelastic supply.

Answer 99

Inelastic supply goods include nuclear reactors and flood defences, both of which require a considerable amount of time to plan and build with lots of expertise, so in times of high demand, very few businesses would be able to build these in a quick time. As harvest occurs once a year, fruit and veg supply is inelastic in the short-term.

Question 100

Give one reason why supply could be inelastic (change in price is insensitive to change in quantity supplied).

Answer 100

In the short-term, supply may be inelastic due to capital being fixed; if more capital is required, firms may not have time to get more capital or build a larger factory.

Question 101

Describe one reason why supply could be inelastic (change in price is insensitive to change in quantity supplied).

Answer 101

The firm may not fulfill all factors of production; capital may not work properly, or the firm may not have enough highly skilled workers so labour can be affected.

Question 102

Define market equilibrium.

Answer 102

Market equilibrium is a point in the market where the quantity demanded of goods = quantity supplied of goods. The price at where the quantities are the same is the ‘market clearing price’.

Question 103

What is clearance?

Answer 103

Clearance is an event which occurs during market equilibrium, where, because quantity demanded and supplied are equal all goods are sold at the same price, so no goods are left over.

Question 104

How can you distinguish between a supply and demand curve?

Answer 104

A supply curve is upward sloping from left to right (/), while a demand curve tends to downward slope from left to right ().

Question 105

Describe excess supply.

Answer 105

Excess supply is an event occurring during disequilibrium, where the extension in supply massively exceeds the contraction in demand caused by an increase in price from Pe to P1.

Question 106

Describe excess demand.

Answer 106

Excess demand is an event occurring during disequilibrium, where the extension in demand massively exceeds the contraction in supply caused by a decrease in price from Pe to P1.

Question 107

What effect will increasing or decreasing demand or supply have on the equilibrium price?

Answer 107

If demand or supply rise or fall, this will create a new equilibrium price.

Question 108

What would happen if changes in equilibrium prices caused an increase in demand?

Answer 108

There would be an outward shift to the right in the demand curve (ceteris paribus) to represent the increase, and this would cause a higher new equilibrium price as well as an expansion in market supply.

Question 109

What would happen if changes in equilibrium prices caused a decrease in demand?

Answer 109

There would be an inward shift to the left in the demand curve (cereris paribus) to represent the decrease, and this would cause a lower new equilibrium price as well as a contraction in market supply.

Question 110

What would happen if changes in equilibrium prices caused an increase in supply?

Answer 110

An outward shift to the right in the supply curve (cereris paribus) would occur to represent the increase, as well as a lower new equilibrium price and an expansion in market demand.

Question 111

What would happen if changes in equilibrium prices caused a decrease in supply?

Answer 111

An inward shift to the left in the supply curve (cereris paribus) would occur to represent the decrease, as well as a higher new equilibrium price and contraction in market demand.

Question 112

What would too much supply lead to?

Answer 112

Too much supply leads to lower prices.

Question 113

What would too much demand lead to?

Answer 113

Too much demand leads to higher prices.

Question 114

Define price.

Answer 114

Price is simply the value a good or service is exchanged.

Question 115

What is the price mechanism?

Answer 115

The price mechanism is a system discussing how the many decisions made between producers and consumers influence the allocation of scarce resources impersonally between competing uses.

Question 116

Give the 3 functions of resource allocation using the price mechanism.

Answer 116

• Signalling function
• Incentive function
• Rationing function

Question 117

Describe the signalling function.

Answer 117

The signalling function demonstrates how price acts as a signal to prompt buyers and sellers to change their supply and demand; these signals include an increase or decrease in price, which will cause a shift in the supply or demand curve.

Question 118

Describe the incentive function.

Answer 118

The incentive function is focused on price acting as an incentive to both buyers and sellers.
Higher prices will influence buyers to sell more goods and thus, attain higher profits.
Lower prices encourage consumers to maximise utility gained via pound spent.
(This will cause a movement along demand or supply curve)

Question 119

Describe the rationing function.

Answer 119

Rationing function is where there is a shortage of a product, but the prices of the good rise so consumers are deterred from purchasing the good. Therefore, the market price here plays the role of a rationing device to help equate demand and supply (e.g. rising food prices, rising rent costs, auctions).

Question 120

Explain an increase in demand in terms of the price mechanism functions.

Answer 120

As demand increases, there will be an outward shift to the right in the demand curve, resulting in excess demand (this is a signal that the firm should increase its prices as it has too much demand and too little supply). So the firm’s incentive will be to increase its prices so market supply can rise, and this will result in an extension of supply and rationing of excess demand. So a new equilibrium will be successfully established.

Question 121

Explain a decrease in demand in terms of the price mechanism functions.

Answer 121

As demand falls, there will be an inward shift to the left in the demand curve, resulting in excess supply. This is a signal that the firm’s supply has exceeded the demand largely so the firm’s incentive should be that prices must be decreased so demand can recover and increase. This will result in an extension in demand, and rationing of excess supply so a new equilibrium will be successfully established.

Question 122

Explain an increase in supply in terms of the price mechanism functions.

Answer 122

As supply increases, there will be an outward shift to the right in the supply curve, resulting in excess supply. This is a signal that the firm’s supply exceeds demand by a bit too much so the firm’s incentive should be to decrease price in the hope of decreasing the supply, and reviving demand. The fall in price will lead to a contraction in supply and rationing of excess supply, so a new equilibrium will be established.

Question 123

Explain a decrease in supply in terms of the price mechanism functions.

Answer 123

As supply decreases, there will an inward shift to the left in the supply curve, resulting in excess demand. This signals that the supply has weakened so much that the demand exceeds the market supply by a large amount, so the firm’s incentive must be to increase price so supply can recover. This rise in price will cause an extension in supply, and ration excess demand, successfully establishing a new equilibrium.

Question 124

Define consumer surplus.

Answer 124

Consumer surplus is a measure of welfare gained by consumers through consuming goods and services.
It is the difference between the total price consumers are willing to pay for a good or service and market price consumers actually pay for that good or service

Question 125

Where is consumer surplus situated on a demand and supply curve?

Answer 125

The region of consumer surplus is located below the demand curve and above the area of market price.

Question 126

Give an example of how market price affects consumer surplus.

Answer 126

If supply/production costs rise, this will contribute to an increase in market prices and shift to the left in the supply curve, causing the area of consumer surplus to decrease.

Question 127

Give another example of how market price affects consumer surplus.

Answer 127

If consumer demand rises, this will contribute to a shift to the right in the demand curve, as well as an increase in market price, causing the area of consumer surplus to increase.

Question 128

How does price elasticity of demand affect consumer surplus if demand was inelastic?

Answer 128

If demand was inelastic, and price increased then demand would fall at a lower proportion so there would still be some buyers willing to pay a high price for the good or service. This means that there will be a high consumer surplus.

Question 129

How would PED affect consumer surplus if demand was elastic?

Answer 129

If demand was elastic and price increased, then demand would fall at a significantly larger proportion so there would be very few buyers willing to pay a high price. This indicates a low consumer surplus.

Question 130

Define producer surplus.

Answer 130

Producer surplus is the difference between the price which producers are willing to supply a good or service at and the market price that producers actually receive.

Question 131

Where is producer surplus demonstrated on a demand and supply curve?

Answer 131

Producer surplus is located below the current market price but above the supply curve.

Question 132

In terms of the producer surplus, what role do higher prices play?

Answer 132

Higher prices are seen as an incentive by firms to increase their supply of goods and services, allowing them to get higher profits.

Question 133

Give one example of how market price affects producer surplus.

Answer 133

If supply costs decreased, because supply costs and market price are directly linked, the market price will also decrease so this will contribute to a shift to the right in the supply curve. This will lead to an increase in equilibrium quantity supplied, and rise in producer surplus.

Question 134

Give another example of how market price affects producer surplus.

Answer 134

If market demand increased, this would cause a rise in market price so there would be a shift to the right in the demand curve as a result of the increase in demand and extension of supply as a result of the increase in price. This would result in a rise in quantity and increase in producer surplus.

Question 135

Define tax.

Answer 135

Tax is a charge imposed on a product, organisation or individual through government intervention.

Question 136

Give the 3 types of taxes.

Answer 136

• Indirect tax
• Direct tax
• Incidence (burden) tax

Question 137

Describe ad valorem tax.

Answer 137

Ad valorem tax is a type of indirect tax which is percentage tax which is added to a good or service based on the value added by the producer.

Question 138

Describe specific tax.

Answer 138

Specific tax is another type of indirect tax which is of monetary value, and used as a fixed amount of tax per unit of good sold.

Question 139

What is direct tax?

Answer 139

Direct tax is a type of tax on an individual or organisation imposed mainly as income (e.g. income tax or corporate tax).

Question 140

What is indirect tax?

Answer 140

Indirect tax is a type of tax which is imposed on goods or services.

Question 141

Define incidence (burden) tax.

Answer 141

Incidence tax is a type of tax which producers or consumers have to pay.

Question 142

Give an example of subsidies.

Answer 142

• Biofuel subsidies for farmers

- Apprenticeship schemes

Question 143

Describe the effect subsidies have on consumers and producers.

Answer 143

Because subsidies increase supply, producers and consumers will receive a benefit gain with the gain depending on the PED and PES.

Question 144

Describe the effect of imposing tax on equilibrium price.

Answer 144

Imposition of a tax will increase equilibrium price but the new equilibrium price won’t be as high as the total amount of tax.

Question 145

If PED coefficient was >1, who will absorb the burden?

Answer 145

If coefficient of PED > 1, the producer/supplier will absorb the burden of the indirect tax (the region of the burden for producers is under the region for consumers).

Question 146

If PED coefficient was <1 who will absorb the burden?

Answer 146

If coefficient of PED < 1, the consumer will absorb the burden of the indirect tax (the region of the burden for consumers is over the region for producers)

Question 147

What effect does the imposition of subsidies have on equilibrium price?

Answer 147

By imposing subsidies, this will contribute to a lower equilibrium price and a higher equilibrium quantity traded.