3. Microeconomic Theory

Question 0

Name three reasons why a demand curve might shift.

Answer 0

1. The price of other goods changing; the direction of the shift depends on whether these other goods are substitutes that may be purchased instead, or complimentary goods that are typically purchased in conjunction with a particular product.
2. Growth in consumers’ income
3. Changing consumer tastes

Question 1

What is the law of demand?

Answer 1

If all other factors remain equal, then the higher the price of a product, the less it will be demanded; people will buy less of a product as the price rises, as it will force them to forgo the consumption of something else.

Question 2

What is supply?

Answer 2

Supply is the amount of a good that producers are willing to supply when receiving a certain price.

Question 3

Why would the supply curve shift to the left or right?

Answer 3

Left: an increase in the cost of production resulting from rising resource prices.
Right: more efficient production process, resulting from utilising new production technology, or increased competition from new firms entering the industry.

Question 4

What is Equilibrium?

Answer 4

The point where demand and supply are equal.

When a market is allowed to operate freely, the price mechanism always brings supply and demand back into equilibrium.

Question 5

What is Say’s Law?

Answer 5

Supply creates its own demand

Question 6

What’s the term for when a demand or supply curve reacts to a change in price?

Answer 6

Elasticity

Question 7

When is a product highly elastic?

Answer 7

If a slight change in price leads to a sharp change in the quantity demanded or supplied such as luxury goods.

Question 8

When is a product inelastic?

Answer 8

When changes in price bring about only modest changes in the quantity demanded or supplied as with products that are a necessity such as food and heating.

Question 9

What are the three types of elasticity?

Answer 9

1. Price elasticity of demand
2. Cross elasticity of demand
3. Income elasticity of demand

Question 10

What is price elasticity of demand?

Answer 10

PED quantifies the extent to which the demand for a particular good changes in proportion to small changes in its price.

Calculation = % change in quantity (over) % change in price

Question 11

When is demand said to be elastic?

Answer 11

If a 1% rise in price brings about a contraction in demand of more than 1%.

Question 12

When is demand said to be inelastic?

Answer 12

When a 1% change brings about less than a 1% change in demand.

Question 13

What is it called when demand and price changes are in equal proportions?

Answer 13

Unit elasticity.

N.B. total revenue is maximised at the point of unit elasticity.

Question 14

Name some examples of factors that determine the PED for a good.

Answer 14

1. Substitutes
2. The percentage of an individual’s total income devoted to the good.
3. Habit forming goods

Question 15

What does cross elasticity of demand (XED) measure?

Answer 15

The change in quantity demanded against the change in price of either a substitute or complementary good.

Calculation = % change in quantity demanded (over) % change in price of substitute or complimentary good.

Question 16

Do substitute goods have a positive or negative XED?

Answer 16

Positive XED

Question 17

Do complimentary goods have a positive or negative XED?

Answer 17

Negative XED

Question 18

What does income elasticity of demand (YED) measure?

Answer 18

The sensitivity of demand to consumers’ disposable income & shows the percentage change in the quantity demanded given a small change in income.

Calculation = % change in quantity (over) % change in income

Question 19

What sort of goods have a YED greater than 1?

Answer 19

Luxury goods

Question 20

What sort of goods have a YED of 1 or less?

Answer 20

Necessities of life

Question 21

How does knowing the YED for a particular good or service help firms?

Answer 21

It helps firms plan for future production and assists government in deciding how to raise revenue from applying indirect taxes, such as VAT, given forecasts of income growth.

Question 22

How do firms maximise profit?

Answer 22

By equating marginal revenue (MR) to marginal cost (MC):

A firm will manufacture units of a product until the marginal revenue generated by the sale of one additional unit equals the cost of producing this one additional unit.

Question 23

What will happen when the MR curve cuts the horizontal axis (total average and marginal revenue diagram)

Answer 23

At this point any additional sales will detract from the firm’s total revenue. By producing and selling the quantity of goods at this point, the firm maximises its revenue (this is called unit price elasticity)

Question 24

What is a fixed cost?

Answer 24

Stock of capital equipment, premises etc… Cost will be incurred regardless of production.

Question 25

What are variable costs?

Answer 25

Labour and raw materials

Question 26

How is the short run average total cost faced by a firm calculated?

Answer 26

Fixed cost + variable cost divided by the number of units produced.

Question 27

Why does the marginal cost of producing one additional unit become greater than the average total cost when a certain level of output is reached?

Answer 27

Diminishing returns to labour begin to set in as the increased use of labour becomes less productive given that the firm’s productive capacity is constrained by a fixed amount of capital equipment.

Question 28

What are fixed costs also known as?

Answer 28

Sunk costs

Question 29

What are sunk costs?

Answer 29

Fixed costs that will be incurred regardless of any production decision.

Question 30

What is perfect competition?

Answer 30

It is a theoretical representation of how a perfectly free market would operate when no one buyer or seller is able to influence the price of a single homogeneous product.

Question 31

What is a perfectly competitive firm?

Answer 31

One that operates in an industry containing an infinite number of firms, each of which accepts the market price for a homogeneous product set by the interaction of consumer demand for the industry’s total supply.

In the long run, perfectly competitive firms only generate normal profits.

Question 32

What market comes close to that of a perfectly competitive industry?

Answer 32

The grain market - the actions of a grain farmer or a grain merchant are unlikely to influence the market price of grain.

Question 33

What is a price taker?

Answer 33

Someone/a firm who are unlikely to influence the market price through their actions.

Question 34

What are the characteristics of a perfectly competitive industry? (6 points)

Answer 34

1. No one firm dominates the industry, which contains an infinite number of firms.
2. Firms do not face any barriers to entry or exit from the industry.
3. A single homogeneous product is produced by all firms in the industry
4. There is a single market price at which all output produced by any one firm can be sold
5. There are an infinite number of consumers who all face the same market price.
6. Perfect information about the product, it’s price and each firm’s output is freely available to all.

Question 35

What is an oligopoly?

Answer 35

When a limited number of highly independent firms dominate an industry, typically through either implicit or explicit collusion on price and output.

Question 36

What is a monopoly?

Answer 36

A monopoly is a market structure where there is only one producer or supplier and entry into the industry is restricted due to high costs or economic, political or social restrictions - aka barriers to entry.

Question 37

What are some examples of how firms can generate profits between normal and supernormal levels?

Answer 37

1. Subtle product differentiation
2. Defensive advertising to increase brand loyalty (thus reducing the elasticity of demand for their product)
3. Through limited price competition