1.2 Market

Question 1

Price and quality demanded

Answer 1

Price is what the buyer pays for a specific good or service.
Quantity demanded is the total number of units purchased at that price.
The demand curve is downward sloping and shows the relationship between price and quantity demanded.
This means that the higher the price is, the lower demand is.
The law of demand shows the inverse relationship between price and quantity, assuming all other variables are constant.

Question 2

Willingness and ability to pay

Answer 2

Willingness to pay - desire to pay based on tastes and preferences.
Ability to pay - factors in a person’s income, and whether they can afford the good or service or not.

Question 3

Substitutes and complements

Answer 3

Substitute goods - an increase in the price of one good will increase the quantity demanded of the other.
E.g Persil and Ariel washing pods.
Complement goods - an increase in the price of one good will cause a decrease in the quantity demanded of the other.
E.g flights to Spain and suncream.

Question 4

Income and substitution effects

Answer 4

Two theories that explain the relationship between price and quantity are:

Income effect - when prices fall, consumers can afford a greater quantity of goods and services (assuming income is fixed). So the quantity demanded for these goods and services increases.

Substitution effect - when the price of one good falls, consumers will buy more of the cheaper good or service and less of the more costly good or service. So the quantity demanded for the cheaper good will increase; demand for the costlier good decreases.

Question 5

Change in demand

Answer 5

The demand curve will shift right when there is an increase in demand for the good at each price level.
E.g if a product were to suddenly become more popular, the demand curve would shift right.
The demand curve will shift left when there is a decrease in demand for the good at each price level.

Question 6

Change in income

Answer 6

The effect of a change in income depends on the type of good.
For a normal good, increased income will lead to an increase in quantity demanded.
E.g new cars.
For an inferior good, increased income may lead to a reduction in quantity demanded.
E.g rice (if more expensive products like meat can be afforded).

Question 7

Changes in prices cause a move along the curve

Answer 7

Movements along the curve happen in response to a price change.
A rise in price will lead to a demand contraction.
A fall in price will lead to a demand extension.

Question 8

Efffect of tax on supply

Answer 8

The U.S. government imposes a tax on alcoholic drinks that collects eight billion dollars per year from producers.
Taxes are treated as a cost by businesses.
Higher costs decrease supply.
So taxes decrease supply.

Question 9

Incentive to expand production

Answer 9

When a firm’s profits increase, it is incentivised to produce more output. This is because the more it produces, the more profit it will earn.
So, when costs of production fall, a firm will be incentivised to supply a higher quantity at a given price.
This is shown by a rightward shift in the supply curve.
Subsidies can lower a firms average cost per unit, encouraging them to expand production also.

Question 10

Causes of supply curve shifts

Answer 10

Changes in the price of inputs (these will affect the cost of production).
A discovery of a new technology (allowing the firm to produce at a lower cost).
Changes in Government policy.
E.g taxes, regulations and subsidies.

Question 11

Price of the good

Answer 11

A rise in price will almost always lead to an increase in the quantity supplied of that good or service. This is also called an extension in supply.
This is because the increase in price incentivises the firm to increase output.
Economists call this positive relationship ‘the law of supply’.

Question 12

Technology and production

Answer 12

A reduction in the costs of production will lead to an increase in supply because producer profits have risen.
Technological improvements can increase the efficiency of the productive process.
This will reduce the costs of production, shifting supply to the right.

Question 13

Productivity and tax

Answer 13

Increases in productivity means the output per input of a factor of supply increases, so supply shifts right.
An indirect tax on supply raises the overall cost of production, shifting supply left.

Question 14

Equilibrium price

Answer 14

This is the only price where the amount consumers want to buy is equal to the amount producers want to sell.
If the market is at equilibrium, there is no reason to move away.
Supply and demand (market forces) dictate the equilibrium quantity and price in a free market.

Question 15

Disequilibrium

Answer 15

Disequilibrium is when the market is not at a stable price and quantity.
If the market is not at equilibrium, economic pressure arises to move the market towards a stable price and quantity.
E.g if petrol prices were to rise above their equilibrium level, the market would respond and the quantity demanded would fall.

Question 16

Excess supply and demand

Answer 16

Excess supply and demand occur at disequilibrium.
The higher price makes it more profitable for petrol producers, so output expands.
The difference between the quantity demanded and quantity supplied is now the excess supply.
When quantity demanded exceeds quantity supplied, there is excess demand.

Question 17

Pressure to reach equilibrium

Answer 17

The market price is unstable when there is excess demand or supply.
Excess supply will force producers to cut the price because it is better to sell at a lower price than not at all. Others will follow.
Excess demand will signal to producers they can generate more profit by raising the price and they will raise price.
So excess demand and supply can lead to price change.

Question 18

Perfectly elastic PED

Answer 18

Perfectly elastic demand - PED = +/- infinity.
Any price increase will cause demand to drop to zero.

Question 19

Perfectly inelastic PED

Answer 19

Perfectly inelastic demand - PED = zero.
Any price change won’t affect demand.

Question 20

‘I’ for inelastic

Answer 20

A perfectly inelastic demand curve would look vertical on a diagram as the quantity demanded would be the same regardless of the price.
An easy way to remember this is that the more inelastic demand is, the more the demand curve looks like an ‘i’ for ‘inelastic’.

Question 21

Elasticity in numbers

Answer 21

For most goods, the quantity demanded rises as price falls, so they would have a negative price elasticity of demand.
A good or service with a price elasticity of -1 is unitary price elastic.
A good or service with a price elasticity between 0 and -1 is price inelastic.
A good or service with a price elasticity of less than -1 (e.g. -2 or -3) is price elastic.

Question 22

Type of good

Answer 22

The nature of the good can influence how elastic the demand is.
Addictive goods tend to be more price inelastic because a change in price is unlikely to affect quantity significantly (if users feel they have a need for the product).
E.g. cigarettes.
But items that are not absolutely essential are more elastic.
E.g. kitchen roll.

Question 23

Impact of subsidies

Answer 23

The impact of a subsidy depends on the PED of the good or service.
Effectively, a subsidy shifts the supply curve to the right. This means demand should increase.
If the good or service has an inelastic demand, the price will drop more than the quantity increases.
If the good or service has an elastic demand, the price will drop less than the quantity increases.
Therefore PED is central to the impact of a subsidy.

Question 24

Availability of substitute goods and services

Answer 24

The more substitutes there are available, the more price elastic a good is.
This is because it is easy to find an alternative product as a replacement if the price of one good rises.
E.g. washing detergents are fairly price elastic. If the price of one goes up, you can easily swap it for an alternative.

Question 25

Impact of indirect taxes

Answer 25

The impact of an indirect tax depends on the PED of the good or service.

Picture a tax as effectively shifting supply to the left. This leads to a fall in demand.

However, if the good has inelastic demand, the reduction in consumption will be small. The consumer burden is significantly higher than the producer burden.

The reverse is true for an indirect tax on a good or service with elastic demand.

Therefore PED is central to the impact of an indirect tax.

Question 26

Percentage of income and time

Answer 26

The higher the proportion of income spent, the more elastic the good or service is. People are more sensitive to the price of a TV vs a Mars bar.
Goods tend to be more price elastic in the long run because time can be devoted to searching for appropriate alternatives.

Question 27

Total revenue

Answer 27

Total revenue = price per unit * quantity

Question 28

Straight-line demand curve

Answer 28

This is how price elasticity of demand (PED) changes along the demand curve:
At zero demand or high price - minus infinity.
At midpoint - elasticity is minus one.
At zero price or high quantity - elasticity is zero.
PED of +/- one = maximised total revenue.
The closer a product’s price is to the midpoint, the higher the revenue.

Question 29

Price elastic in demand

Answer 29

If a product is price elastic in demand:
Decreasing price = increases total revenue.
Increasing price = decreases total revenue.

Question 30

Price inelastic in demand

Answer 30

If a product is price inelastic in demand:
Decreasing price = decreases total revenue.
Increasing price = increases total revenue.

Question 31

Income elasticity of demand (YED)

Answer 31

Income elasticity of demand (YED) measures the responsiveness of quantity demanded to a change in consumer income.
Businesses can use income elasticity of demand to understand how the quantity demanded by customers will change in response to income.

Question 32

Formula for YED

Answer 32

YED = (% change in quantity demanded) ÷ (% change in income)

Question 33

YED coefficients

Answer 33

The larger the income elasticity of demand coefficient (number) the greater the responsiveness of quantity demanded to a change in income.
If the coefficient is positive, an increase in income will increase demand and a fall in income will decrease demand.
If the coefficient is negative, an increase in income will decrease demand and a fall in income will increase demand.

Question 34

Interpreting YED

Answer 34

If the income elasticity of demand is less than 1 then this is described as inelastic. This means that a change in income will lead to a change in quantity demanded which is less than the change in income.
If the income elasticity of demand is greater than 1 then this is described as elastic. This means that a change in income will lead to a change in quantity demanded which is greater than the change in income.

Question 35

Change in YED

Answer 35

For example, the income elasticity demand for premium cars is relatively elastic as consumers may decide they cannot purchase a new vehicle if their income reduced, so quantity demanded is likely to change by more than the change in income.