1.2 How Markets Work LS12-16

Question 1

Price elasticity of demand definition?

Answer 1

Measures the responsiveness of demand given a change in price

Question 2

When is demand said to be price elastic?

Answer 2

When a change in price causes a proportionately larger change in demand

Question 3

When is demand said to be price inelastic?

Answer 3

When a change in price causes a proportionately smaller change in demand

Question 4

Determinants of price elasticity of demand

Answer 4

• Number of substitutes: more substitutes = more price elastic
• Time available: more time = consumers can find alternatives = more price elastic
• Addictivness of product: more addictive = consumers less likely to be deterred by changes in price = more price inelastic
• Luxury/Necessity: if necessity, likely to be price inelastic as people need it no matter the price
• Proportion of income on the product: greater proportion of income on product = more price elastic as consumers less able to afford any price increases

Question 5

Price elasticity of demand formula

PED

Answer 5

%△D / %△P

Question 6

When is supply said to be price elastic?

Answer 6

When a change in price causes a proportionately larger change in supply

Question 7

When is supply said to be price inelastic?

Answer 7

When a change in price causes a proportionately smaller change in supply

Question 8

Price elasticity of supply definition?

Answer 8

The responsiveness of supply given a change in price

Question 9

Determinants of price elasticity of supply?

Answer 9

• Time required to produce the product: greater time = more price inelastic supply
• Level of spare capacity: greater spare capacity = more price elastic supply, factors of production will be available to use
• Number of stocks/finished goods available: more finished goods available = more price elastic supply
• Time: time available to suppliers to reduce or expand their production, greater time period = more price elastic supply
• Perishability of product: more perishable = less stock = more price inelastic supply

Question 10

PES/PED greater than 1 means..

Answer 10

Price elastic

Question 11

PES/PED equal to 1 means..

Answer 11

Unitary elasticity

Question 12

PES/PED between 0 and 1 means..

Answer 12

Price inelastic

Question 13

PES/PED equal to 0 means..

Answer 13

Perfectly inelastic

Question 14

Consumer surplus?

Answer 14

The extra amount of money consumers are prepared to pay for a good or service above what they actually pay

Question 15

Producer surplus?

Answer 15

The extra amount of money paid to producers above what they are willing to accept to supply a good or service

Question 16

What is the incidence of a tax?

Answer 16

• The distribution of the tax between consumers and producers
• Depends on the elasticity of both demand and supply

Question 17

When demand is price elastic, who will the burden of the tax mostly fall on?

Answer 17

Producers

Question 18

When demand is price inelastic, who will the burden of the tax mostly fall on?

Answer 18

Consumers

Question 19

What is the incidence of a subsidy?

Answer 19

• How the gains of the subsidy are distributed between consumers and producers
• Depends on the elasticity of both supply and demand

Question 20

When demand is price elastic, who will most of the gains of a subsidy go to?

Answer 20

Producers

Question 21

When demand is price inelastic, who will most of the gains of a subsidy go to?

Answer 21

Consumers

Question 22

Income effect?

Answer 22

With fixed level of income, income effect means that as price falls, the amount that consumers can afford increases and so demand increases

Question 23

Marginal utility?

Answer 23

The utility or satisfaction obtained from consuming one extra unit of a good or service

Question 24

Diminishing marginal utility?

Answer 24

As successive units of a good are consumed, marginal utility gained from each extra unit will fall

Question 25

What does cross price elasticity of demand (XED) measure?

Answer 25

The responsiveness of demand for one good to changes in the price of another good

Question 26

XED formula

Answer 26

%Δ in quantity demanded of product A /
%Δ in price of product B)

Question 27

What type of goods have a positive XED?

Answer 27

Substitute goods

As price of B goes up, QD for A goes up as consumers switch

Strong 0.6 Weak 0.2

Question 28

What type of good has a negative XED?

Answer 28

Complementary goods

As price of B goes up, QD for A falls as they are purchased together

Strong 0.6 Weak 0.2

Question 29

What does income elastictity of demand (YED) measure?

Answer 29

The responsiveness of demand to changes in income

Question 30

YED formula?

Answer 30

%Δ in quantity demanded /
%Δ in income

Question 31

What type of goods have a negative YED?

Answer 31

Inferior

Question 32

What type of goods have a positive YED?

Answer 32

Normal goods

Question 33

Normal goods with a YED between 0 and 1 are..

Answer 33

…income inelastic
* tend to be necessities

Question 34

Normal goods that have a YED larger than 1 are…

Answer 34

…income elastic
* tend to be luxurious goods

Question 35

What are the functions of the price mechanism?

Answer 35

• Signalling: if prices increase, it is a signal to firms to produce more of that product
• Incentive: if prices increase, firms are incentivised to switch production to that product
• Rationing: if demand > supply, prices increase so the product is rationed to those who can afford to pay

Question 36

What are the effects on total revenue given an increase in price when demand is elastic vs inelastic?

Answer 36

• Elastic: an decrease in total revenue
• Inelastic: an increase in total revenue

Question 37

What are the effects on total revenue given a decrease in price when demand is elastic vs inelastic?

Answer 37

• Elastic: an increase in total revenue
• Inelastic: a decrease in total revenue