3. Demand in a Perfectly Competitive Market

Question 1

What is decreasing marginal utility?

Answer 1

Implies that the utility from consuming an extra unit of a given good decreased with the number of units that have been previously consumed

Question 2

What is the substitution effect?

Answer 2

This captures the change in quantity demanded of a given good following a change in its relative price 


Question 3

What is the income effect?

Answer 3

This captures the change in the quantity demanded of a given good following the reduction or increase in the consumer’s purchasing power
o For a normal good (e.g. luxury goods), a reduction in income reduces the quantity consumed and vice versa 

o For an inferior good (e.g. Public transport), a reduction in income increases the quantity consumed and vice versa 


Question 4

What is the horizontal interpretation of the demand curve?

Answer 4

Indicates how many units the consumer is willing to buy at that price

Question 5

What is the vertical interpretation of the demand curve?

Answer 5

indicates the maximum amount of money the consumer is willing to pay for the marginal unit THIS IS THE CONSUMER RESERVATION PRICE

Question 6

What are the determinants of price elasticity of demand?

Answer 6

• Availability of substitutes: the larger the number of substitutes, the more elastic demand tends to be (consumers can easily switch to other products)
• Definition of a good: this depends on how you define a certain good. If you take a good as a whole category, then this broad category will be likely to have no substitutes (i.e. salt) and thus, demand will be inelastic. However if you consider a certain brand of salt, then the elasticity for that particular brand is likely to be high as there are many substitutes
• Income share: the larger the share of income required to purchase a good, the higher the elasticity
• Time horizon: the longer the time horizon, the higher the elasticity because this provides time for buyers to find alternative substitutes