BA1 Fundamentals of Business Economics - The market system and the competitive process

Question 1

How do we calculate PED?

Answer 1

PED= (Q2−Q1)/Q1 divided (P2-P1)/P1
Q1 = Initial quantity demanded
Q2 = New quantity demanded
P1 = Initial price
P2 = New price
​

Question 2

What is elastic demand?

Answer 2

Elastic demand occurs when the percentage change in quantity demanded is greater than the percentage change in price (PED > 1).

Question 3

What is inelastic demand?

Answer 3

Inelastic demand occurs when the percentage change in quantity demanded is smaller than the percentage change in price (PED < 1).

Question 4

When should a business lower its price?

Answer 4

A business should lower its price if demand is elastic because the increase in quantity sold will be greater than the decrease in price, leading to higher revenue.

Question 5

When should a business raise its price?

Answer 5

A business should raise its price if demand is inelastic because the decrease in quantity sold will be smaller than the price increase, leading to higher revenue.

Question 6

What happens to demand elasticity when there are more close substitutes for a good?

Answer 6

The demand becomes more elastic because consumers can easily switch if the price of one product changes relative to others.

Question 7

How do switching costs affect demand elasticity?

Answer 7

Higher switching costs make demand more inelastic, as consumers face barriers to changing products or services.

Question 8

How does the degree of necessity affect price elasticity of demand?

Answer 8

Necessities tend to have inelastic demand, while luxuries have more elastic demand since consumers can cut back on them during economic downturns.

Question 9

How does the percentage of income spent on a good affect its price elasticity?

Answer 9

Goods that take up a large share of income tend to have more elastic demand, as price changes significantly impact affordability.

Question 10

What happens to price elasticity over time after a price change?

Answer 10

Demand tends to be more elastic in the long run because consumers have more time to adjust their purchasing decisions.

Question 11

How does habitual consumption impact price elasticity?

Answer 11

Goods that are habitually consumed (e.g., cigarettes, alcohol) tend to have inelastic demand because consumers are less sensitive to price changes.

Question 12

How does peak and off-peak demand affect price elasticity?

Answer 12

Demand is more inelastic at peak times, allowing suppliers to charge higher prices. Off-peak demand is more elastic, leading to lower prices.

Question 13

How does the breadth of a good’s definition affect price elasticity?

Answer 13

Broadly defined goods (e.g., petrol or meat) have inelastic demand, while specific brands (e.g., Shell petrol, Angus beef) have more elastic demand.

Question 14

Perfectly Inelastic Demand

Answer 14

An extreme situation where a change in price will
have no effect on quantity demanded

Question 15

Perfectly Elastic Demand

Answer 15

An extreme situation where a market participant is
a price taker and has to accept the market price. If
they raise their price they will sell nothing.

Question 16

Unitary Elastic Demand

Answer 16

The elasticity of demand is 1 at any point on the
demand curve (known as a rectangular hyperbola).
A change in price will have no effect on revenue i.e.
Price × Quantity = constant.

Question 17

How can total revenue indicate demand elasticity?

Answer 17

If total revenue increases after a price cut, demand is elastic.
If total revenue increases after a price rise, demand is inelastic.

Question 18

What does price elasticity of supply (PES) measure?

Answer 18

PES measures the relationship between a change in quantity supplied and a change in price of a good.

Question 19

How does spare capacity affect price elasticity of supply?

Answer 19

If a firm has spare capacity, it can increase output quickly without raising costs, making supply more elastic.

Question 20

How do stock levels influence supply elasticity?

Answer 20

High stock levels allow firms to respond quickly to demand changes, making supply more elastic.

Question 21

What is the impact of factor substitution on supply elasticity?

Answer 21

If capital and labor can be easily switched to produce different goods, supply is more elastic. If not, supply is inelastic.

Question 22

How does time affect the price elasticity of supply?

Answer 22

Short-run: Supply is often inelastic as firms cannot easily adjust production.
Long-run: Supply is more elastic as firms have time to adapt.

Question 23

What is the “momentary time period” in supply?

Answer 23

A short period where supply cannot respond at all to demand changes, making supply perfectly inelastic.

Question 24

What does it mean if the supply curve passes through the origin?

Answer 24

The supply curve has unit elasticity, meaning PES = 1.

Question 25

What happens when supply is perfectly elastic?

Answer 25

A firm can supply any amount at the same price, meaning demand changes affect quantity but not price.

Question 26

What happens when a price ceiling (Pmax) is set below the equilibrium price (Pe)?

Answer 26

Demand rises to Qd (due to lower price). Supply falls to Qs (since producers are less willing to supply at a lower price). This creates excess demand (Qd - Qs).

Question 27

What problems can arise from excess demand caused by price ceilings?

Answer 27

Queuing for in-demand goods. The emergence of a black market, where goods are sold at high prices.

Question 28

What is a common example of a minimum price control?

Answer 28

The minimum wage, which sets a legal floor on wages to ensure workers receive a fair income.

Question 29

What happens to employment when a minimum wage (Pmin) is set above the equilibrium wage (Pe)?

Answer 29

Demand for labor falls to Q low (fewer jobs available). Supply of labor rises to Q high (more people willing to work). This creates excess labor supply (Q high - Q low), leading to unemployment.

Question 30

What is a potential downside of imposing a minimum wage?

Answer 30

It can lead to unemployment, as businesses may not be able to afford as many workers at the higher wage.

Question 31

What is an externality?

Answer 31

An externality is an impact (positive or negative) on a third party who is not directly involved in a transaction.

Question 32

What is an example of a negative externality?

Answer 32

Air pollution from manufacturers Accidents caused by alcohol or drug abuse Noise pollution from loud music

Question 33

What are demerit goods?

Answer 33

Goods that have negative externalities affecting society as a whole, such as alcohol, tobacco, and pollution-producing products.

Question 34

How can governments correct market failure caused by negative externalities?

Answer 34

Sales tax on harmful goods Fines for environmental damage Regulations to limit production of harmful goods

Question 35

How does a sales tax reduce negative externalities?

Answer 35

Increases costs for producers, shifting the supply curve upward Raises prices (from Pe to P1) Reduces demand & supply (from Qe to Q1)

Question 36

How does elasticity affect tax burden?

Answer 36

Inelastic demand → Consumers bear more of the tax Elastic supply → Producers bear less of the tax

Question 37

What is a merit good?

Answer 37

A merit good is a product with positive externalities, meaning its benefits extend beyond those who purchase or consume it.

Question 38

Give examples of merit goods.

Answer 38

Education → Increases efficiency and productivity Healthcare → Reduces absenteeism & extends life expectancy Attractive gardens → Improve neighborhood property values

Question 39

What is the effect of a subsidy on supply and price?

Answer 39

Shifts supply curve from S0 to S1 Lowers price (from Pe to P1) Increases quantity supplied (from Qe to Q1)

Question 40

How does elasticity affect the impact of a subsidy?

Answer 40

Inelastic demand or elastic supply → More of the subsidy is passed to consumers as a lower price. Elastic demand or inelastic supply → Producers retain more of the subsidy.

Question 41

What are public goods?

Answer 41

Public goods are goods that would not be provided in a market economy without government intervention.

Question 42

What are the two key properties of public goods?

Answer 42

Non-excludability → One person’s use does not prevent others from benefiting (e.g., street lighting). Non-diminishability (non-rivalry) → More people using the good does not reduce its availability.

Question 43

What is the free rider problem?

Answer 43

The free rider problem occurs when people can benefit from a public good without paying, leading to underfunding.

Question 44

What is a barrier to entry?

Answer 44

A factor that makes it harder for new firms to enter a market.

Question 45

What is product differentiation, and how does it act as a barrier to entry?

Answer 45

Firms distinguish their products from competitors. Reduces price elasticity of demand. Creates brand loyalty, making it harder for new entrants.

Question 46

What is an absolute cost advantage, and how does it prevent new entrants?

Answer 46

Existing firms have lower costs due to: Cheaper raw materials. Exclusive knowledge or skills.

Question 47

How do legal barriers act as a barrier to entry?

Answer 47

Patent protection prevents copycat products. Government-protected monopolies restrict competition. Common in new technology industries.

Question 48

How do economies of scale create barriers to entry?

Answer 48

Large firms benefit from lower average costs. New firms lack scale, making it hard to compete. Seen in utilities like water & electricity.

Question 49

What are economies of scale?

Answer 49

Economies of scale occur when a business reduces average costs by increasing the scale of production.

Question 50

What are internal economies of scale?

Answer 50

Bulk buying (trading) Use of larger, more efficient machinery (technical) Cheaper finance for lower loan costs (Finance) Management specialization (managerial)

Question 51

What is perfect competition?

Answer 51

In perfect competition, no producer or consumer can influence prices. Prices move to economic equilibrium instantly.

Question 52

What does atomicity mean in perfect competition?

Answer 52

Atomicity refers to a market with many small producers and consumers, each having no significant impact on others. Firms are price takers, meaning they accept the market price.

Question 53

What is homogeneity in perfect competition?

Answer 53

Homogeneity means goods are identical across firms, with no product differentiation. All firms sell the same product at the same price.

Question 54

What does perfect and complete information mean in perfect competition?

Answer 54

It means that all firms and consumers know the prices set by all firms, allowing for informed decision-making.

Question 55

What is a monopoly?

Answer 55

A monopoly occurs when there is only one supplier of a good or service with no close substitutes

Question 56

What does it mean that buyers and sellers act independently in perfect competition?

Answer 56

It means there is no collusion or cartels. Buyers and sellers do not coordinate to change prices. Each acts on their own without influencing the market.

Question 57

What are the characteristics of a monopoly market?

Answer 57

One supplier dominates the market. No close substitutes for the product. High barriers to entry for new firms.

Question 58

What defines an oligopoly market structure?

Answer 58

A few suppliers dominate the market. Effective barriers to entry. Strong interdependence between market participants. Producers offer similar goods, often acting in collusive or non-collusive ways.

Question 59

What conditions are necessary for a cartel to be created?

Answer 59

Firms must be able to control supply to the market. Firms must agree on a price. Firms must agree on how much output each should produce.

Question 60

What is the difference between outsourcing and off-shoring?

Answer 60

Outsourcing: External parties perform certain activities or functions for a business. Off-shoring: Part or all of a business is transferred to another country with a lower cost base.

Question 61

What are search and information costs in transaction cost theory?

Answer 61

Search and information costs are the costs associated with finding out whether a product is available, identifying suppliers, and comparing prices.

Question 62

What are bargaining and decision costs in transaction cost theory?

Answer 62

Bargaining and decision costs are the costs related to formulating an agreement, such as the costs of drawing up contracts, legal fees, and negotiating terms.

Question 63

What are policing and enforcement costs in transaction cost theory?

Answer 63

Policing and enforcement costs are the costs involved in ensuring that the other party sticks to the terms of a contract, including monitoring quality, service, and delivery.