Chapter 2

Question 1

Define the law of demand.

Answer 1

When the price of a good rises, the quantity demanded will fall and vice versa.

Question 2

What does “quantity demanded” mean?

Answer 2

This is the amount consumers are willing and able to purchase at a given price over a given period, NOT what people would like to consume.

Question 3

What are the two reasons for the law of demand?

Answer 3

1. People will feel poorer as the purchasing power of their income has fallen. This is called the income effect of a price rise.
2. The good will now be dearer relative to other goods, and people will switch to alternative or substitute goods (substitution effect of a price rise).

Question 4

Define demand curve.

Answer 4

A graph showing the relationship between the price of a good and the quantity demanded over a given time period. They generally slope downward from left to right. Price goes on the Y axis. ||||

Question 5

List 6 determinants of demand (not including price).

Answer 5

1. Tastes. Affected by advertising, fashion, observing other consumers, etc.
2. The number and price of substitute goods. Substitute goods are considered by consumers to be alternatives to each other.
3. The number and price of complementary goods. A pair of goods consumed together (e.g., cars and petrol).
4. Income. If people’s income rises, their demand for most goods will also rise (for normal goods). However, an exception to this is inferior goods.
5. Distribution of income. If income were redistributed from low income to high income earners the demand for luxury goods would increase. At the same time, as poor people got poorer they would likely turn to more inferior goods, so the demand for inferior goods would also increase.
6. Expectations of future price changes. If people think the price will rise in the future they are more likely to buy now.

Question 6

What happens when the demand curve shifts?
GRAPH!

Answer 6

The demand curve is based on the assumption that “other things remain equal” (i.e., none of the other determinants except price changes). If a change in a determinant other than price causes demand to fall the whole curve will shift to the left. If a change causes demand to rise, the whole curve will shift to the right.
Remember! Changes in price are measured along the curve (on the line) and do not shift.

Question 7

What is the difference between a change in demand and a change in the quantity demanded?

Answer 7

Change in demand – a shift in demand
Change in the quantity demanded – movement along the demand curve as a result of a change in price.

Question 8

Define “utility”. How does it relate to economics?

Answer 8

Utility refers to the benefit we get from consumption. As you consume more of a product, and thus become more satisfied, so your desire for additional units of it will decline. This is the principle of diminishing marginal utility. The additional utility you get from consuming an extra unit of a product is the marginal utility.

Question 9

How can we measure marginal utility?

Answer 9

We can measure it in money terms i.e., the amount that a person would be prepared to pay for one more unit of a product.

Question 10

How does marginal utility relate to a downward sloping demand curve?

Answer 10

As price falls, you will buy more but as you buy more your marginal utility from consuming each extra unit becomes less and less. You will stop buying when the marginal utility has fallen to the new lower price of the good: MU = P.

Question 11

How do firms determine how much of any item they want to produce? 3 things

Answer 11

The r/s between supply and price is: when the price of a good rises, the quantity supplied will also rise. (e.g., the higher the price of a particular farm output, the more land will be devoted to it). There are 3 reasons for this:
1. As firms supply more costs will rise more rapidly after a certain point. It will only be worth incurring these extra costs if the price rises. E.g., workers have to be paid overtime.
2. In the case of a farm, more wheat will mean that land that is not suitable for wheat production will need to be used.
3. The higher the price of the good, the more profitable it becomes to produce. Thus, firms will switch and stop producing less profitable goods. If the price of a good remains high, new producers will enter the market and total market supply will rise.
The first 2 factors affect supply in the short run. The 3rd affects supply in the long run.

Question 12

Define the supply curve.

Answer 12

A graph showing the relationship between the price of a good and the quantity of the good supplied over a specified period of time. Tend to be positively (upward) sloping, but not always. Can be vertical, horizontal or even downward sloping.

Question 13

Define 7 determinants of supply (other than price).

Answer 13

1. The cost of production. The higher the cost of production, the less profit will be made at any price. The main reasons for a change in costs are:
   * Change in input prices: e.g., wages, rent, raw material prices, etc.
   * Changes in technology: technological advances can fundamentally alter the costs of production.
   * Organisational changes: various cost savings can be made by reorganising production.
   * Government policy: costs can be lowered by government subsidies and raised by various taxes
2. The profitability of alternative products (substitutes in supply). i.e., where an increased production of one good means diverting resources away from producing the other.
3. The profitability of goods in joint supply. Sometimes when one good is produced another good is also produced at the same time (e.g., petrol, diesel, etc.). Thus, if more petrol is produced due to a rise in demand, the supply of other fuels will rise too.
4. Nature, “random shocks” and other unpredictable events. E.g., weather and diseases affecting farm output, wars affecting the supply of imported raw materials, floods, breakdown of machinery, etc.
5. The aim of producers. A profit maximising firm will supply a different quantity from a firm that has a different aim, such as maximising sales.
6. Expectations of future price changes. If price is expected to rise, producers may temporarily reduce the amount they sell. They may also plan to produce more by getting new machines/more workers so they are ready to supply more when the price has risen.
7. The number of suppliers. If new firms enter the market, supply is likely to rise.

Question 14

What happens when the supply curve shifts?

Answer 14

The supply curve is based on the assumption that “other things remain equal” (i.e., none of the other determinants except price changes). If a change in a determinant other than price causes supply to fall the whole curve will shift to the left. If a change causes supply to rise, the whole curve will shift to the right.
Remember! Changes in price are measured along the curve (on the line) and do not shift.

Question 15

What is the difference between a change in supply and a change in the quantity supplied?

Answer 15

Change in supply – a shift in supply
Change in the quantity supplied – movement along the supply curve as a result of a change in price.
Define market clearing.
When supply matches demand the market is said to clear, there is no shortage and no surplus.

Question 16

Where is the equilibrium price on a graph?

Answer 16

Where the two curves intersect.

Question 17

What happens to the equilibrium price when demand or supply curves shift?

Answer 17

If a determinant of demand or supply changes (other than price) the whole demand/supply curve will shift. You need to look at examples for this one!

Question 18

What are the five main factors that affect the demand for shares?

Answer 18

1. The dividend yield. The higher it is, the more attractive as a form of savings.
2. The price of and/or return on substitutes. E.g., interest rates in bank account, property as a form of savings.
3. Incomes. If income is rising people are more likely to buy shares.
4. Wealth. Accumulated value of peoples financial and physical assets, less financial liabilities. With increased wealth people buy more shares.
5. Expectations. Positive sentiments about the future encourage people to buy shares.

Question 19

What are the factors that affect the supply for shares?

Answer 19

Largely the same as those affecting demand, but in the opposite direction. However, movements in the price of a share are also influenced by the performance of the company.

Question 20

What are three advantages of a free-market economy?

Answer 20

1. It functions automatically – no need for costly and complex bureaucracy to coordinate.
2. Economy can respond quickly to changing demand and supply conditions.
3. When markets are highly competitive, no one has great power. This acts as an incentive for firms to be as efficient as possible in order to keep their costs down. In turn, the more efficient workers are the more likely they are to keep their jobs. The more carefully people choose what to buy the more value for money they will receive. Thus, people looking out for their own self-interest can help to minimise scarcity by encouraging efficient use of the nations resources.

Question 21

What are eight problems with a free-market economy?

Answer 21

1. Most do not achieve maximum efficiency, so some government intervention is necessary to rectify this.
2. Competition between firms is often limited. Might be a few giant firms who dominate.
3. Lack of competition and high profits may remove the incentive for firms to be efficient.
4. Power and property may be unequally distributed.
5. The practice of some firms may be socially undesirable or have adverse environmental consequences (e.g., pollution)
6. Some socially desirable goods would simply not be produced (e.g., building and operating a lighthouse)
7. Might lead to macroeconomic instability. May be periods of recession with high unemployment and falling output and other periods of rising prices.
8. Could argue that a free-market economy rewards self-interest and promotes selfishness/greed/materialism.

Question 22

What is behavioural economics?

Answer 22

Recognises that peoples emotions and impulses can result in “errors” and biases in their decision making. By recognising this we can gain a greater understanding of economic systems and of individuals behaviour.

Question 23

What three things can explain “irrational” consumer choices?

Answer 23

1. Context – people will make different decisions when they are presented or framed in different ways (e.g., special offer).
2. Too much choice – consumers more likely to buy when there is less choice. Alternatively, they may just make the best guess (i.e., bounded rationality: when the ability to make rational decisions is limited by lack of information or the time necessary to obtain such information).
3. Sunk costs – costs that cannot be recouped. People are influenced by this (e.g., reading a novel you don’t enjoy but continuing).