Chapter 2

Question 1

Define Demand

Answer 1

Willingness to buy a good or service at different prices. Demand can also demonstrate economic behaviour; in other words, it shows how the price can affect people’s incentive to buy a good or service. It is hypothetical.

Question 2

Define Effective Demand

Answer 2

Demand is constrained due to scarcity; people are uncapable of demanding everything, so this creates effective demand where willingness to buy a good is according to price, price of other goods, income. It can be referred as the “actual” quantity demanded.

Question 3

Factors that cause movement along the demand curve? Explain.

Answer 3

Price Factor.

Question 4

Factors that would cause shifting in demand curve

Answer 4

• Income level
• Quality
• Advertising
• Price of substitutes
• Price of complementary
• Change in tastes and lifestyles

Question 5

Define supply

Answer 5

Willingness to sell a good or service at different prices. It shows behaviour of sellers; they’re more willing to supply at higher prices. It is hypothetical.

Question 6

Define effective supply

Answer 6

This is the actual quantity supplied. It refers to willingness and capability to sell according to external factors like market conditions, costs and technology. This is more realistic and practical.

Question 7

Factors that cause a movement along the supply curve

Answer 7

Price factor.

Question 8

Factors that cause a shift in supply curve

Answer 8

• Cost of production
• Business expectations in terms of future profits and future rise in prices
• Advancements in technology
• Natural disasters

Question 9

Explain dual shifting, in terms of, what will happen to prices on the long-term after an increase in demand.

Answer 9

On the short-term, increase in demand will lead to an increase in prices, since the value of product has increased, so people are more likely to pay higher prices to obtain it. Suppliers will capitalize on this and supply more to earn higher profits; on the long-term, this increase in supply would allow price to return to its original low price since there is more availability in market.

Question 10

Define PED

Answer 10

Responsiveness of quantity demand towards change in price

Question 11

Define inelastic demand

Answer 11

Inelastic demand is where a big change in price will have a small impact on quantity demanded; this is since people are not sensitive towards changes. This can be due to a good being a necessity or medicine.

-> Extreme case is perfectly inelastic demand

->PED<1

Question 12

Define perfectly inelastic demand

Answer 12

A huge change in price will have 0 impact on quantity demanded; people will still demand it no matter what. People are willing to meet the extreme high prices just to obtain the good.

-> PED=0

Question 13

Define elastic demand

Answer 13

People are highly sensitive towards a price change; small change in price will greatly affected quantity demanded; this might be due to the product having high number of substitutes.

-> Extreme case is perfectly elastic demand

-> PED>1

Question 14

Define perfectly elastic demand

Answer 14

A small change in price will cause the quantity demanded to drop to 0. People lack the incentive to pay any higher for the product; this might be the case in a perfect competition market.

-> PED=∞

Question 15

Factors that affect demand elasticity

Answer 15

• Existence of substitutes
• Long-term vs. short-term (people are inelastic on the short-term)
• Brand loyalty
• Necessity or not
• Addictiveness
• Proportion it takes from income (normal vs. inferior good)

Question 16

Significance of PED in decision making

Answer 16

PED could be used by the business to predict revenues, and set prices smartly.

If inelastic-> set high prices since Q.D will barely be affected, so profits rise.

If elastic-> set low prices to attract more customers and increase profits

Question 17

Drawbacks of PED in decision making

Answer 17

• Difficult to change nature of product
• If elastic and in a perfect competition market, business won’t be able to decrease price since it is at its lowest.
• Would be useless to lower price of a merit/necessity good as they’re inelastic. People’s intake will not change

Question 18

Why do firms aim to be inelastic demand. How, and what are the drawbacks of these methods?

Answer 18

If the business’s main objective is to maximize profits, they’d aim to become inelastic to set highest price possible and reach consumer surplus to have an increased profit margin, and gain higher per unit.

This can be done through:
- Investing in R&D to improve quality, and gain higher consumer satisfaction and develop brand loyalty.

• Taking over other businesses to increase market share, and lower number of competitors. There are no other options besides buying from this specific business.
• Selling addictive goods or necessities

Drawbacks of these methods
- R&D requires high amounts of funding, and not all enterprises are able to achieve it. Only large ones.

• Even if the business becomes a monopoly, government can set maximum price to lower prices.
• Difficult to change nature of good.

Question 19

What is tax incidence?

Answer 19

Refers to extend to which tax burden is borne on consumer and producer

-> It depends on elasticity + consumer surplus:
If business is price inelastic, taxes are passed on to consumers as they’ll pay no matter what.

If business is price elastic, taxes cannot be levied onto consumers as they’re extremely sensitive to price change. So, business must pay them.

Question 20

Define PES

Answer 20

Measures responsiveness of quantity supplied towards change in price (that is caused by demand). It shows how flexible and how quickly a business can adjust their production towards changes in demand.

Flexible and quick -> Elastic
Not flexible and slow -> Inelastic

Question 21

Define inelastic supply

Answer 21

A huge change in price (profits earned) will barely affected quantity supplied, since producer may not have sufficient time to produce or not enough resources.

-> Extreme case is perfectly inelastic

Question 22

Define elastic supply

Answer 22

A small change in price will greatly affect quantity supplied; a business is flexible and adjusts quickly so they capitalize on any opportunity to gain higher profits.

-> Extreme case is perfectly elastic

Question 23

Factors that determine PES

Answer 23

• Storage capacity
• Time allotted for production
• Amount of resources available

Question 24

Significance of PES

Answer 24

• Helps plan production in advance, if a business is inelastic then they can take precaution to avoid shortages
• Helps setting smarter prices; inelastic businesses avoid setting low prices to avoid having excessive demand and being unable to meet demand
• Manage inventory
• Prepare for busy seasons
• Be more competitive; if elastic supply, can easily take advantage of high prices and sell way more. (Contestable markets)

Question 25

Define YED

Answer 25

Responsiveness of quantity demanded towards change in income. Mainly inferior and normal goods.

Question 26

YED Formula analysis

Answer 26

If the YED result is in positive, this indicates that the business is selling a normal good because there's a positive relationship between both variables. As incomes increase, people are more likely to determine more luxurious goods since they can afford them. Like, if your income increases, you're more likely to afford a car than a bike. If YED result is in negative, this indicates that the business is selling an inferior good since there is an inverse relationship between both variables. If incomes increased, people will demand inferior goods less because they are more capable of achieving higher quality goods.

Question 27

Significance of YED

Answer 27

YED helps the business determine the nature of its product, and decide which type of good to product in which economic condition. Growth -> Normal Good Recession -> Inferior Good

Question 28

Drawbacks of YED

Answer 28

- Difficult to change nature of product. - Difficult to calculate change in incomes of customers.

Question 29

Elasticity and YED Values

Answer 29

Below -1 -> Elastic Inferior Good Between -1 and 0 -> Inelastic Inferior Good 0 -> Unitary and no change Between 0 and 1 -> Inelastic Normal Good Above 1 -> Elastic Normal Good

Question 30

Define XED

Answer 30

Responsiveness of quantity demanded of good A towards a change in price of good B. It helps determine relationships between goods.

Question 31

XED Formula Analysis

Answer 31

XED could be used to determine whether a good is complementary or a substitute to another good. If XED value is in positive, then it's a substitute good because there is a positive relationship between both variables. As price of good B increases, people are more likely to demand good A since it's the cheaper alternative. If XED value is in negative, then it's a complementary because there is an inverse relationship between both variables. As price of good B decreases, people are more likely to demand good A since the full package is now cheaper.

Question 32

Significance of XED

Answer 32

XED could be used by businesses to determine whether they're substitutes to another business or complement their goods. If two goods are substitutes, this helps business to either: - Lower prices - Fix prices - Takeover through horizontal integration If two goods are complements, this helps the business to either: - Fix bundles - Subsidize relevant industry - Takeover through vertical integration

Question 33

Common disadvantages between elasticities

Answer 33

- Relies on historical data, so might be inaccurate and difficult to find - Can get outdated, so needs to be constantly reupdated which might be costly and time-consuming. - Differs on the long and short-run - Relies on ceteris paribus assumption - Limited use w/o supporting analysis; it doesn't give the business enough insight to take a correct decision. It must be combined with other tools, like market research.

Question 34

Alternative Demand

Answer 34

A situation by which the demand for a good is effected by the change in price of another good. [Substitutes]

Question 35

Joint Demand

Answer 35

A situation where two products are purchased together. [Complements]

Question 36

Joint Supply

Answer 36

A situation where two products are produced together.

Question 37

What is meant by the price mechanism?

Answer 37

Resources are allocated in a free market through demand and supply; they determine quantity and price. There are 3 stages: - Signaling - Incentives - Rationing A price mechanism is operating correctly when people actually adjust behaviour towards price, like high supply during high prices.

Question 38

Describe the price mechanism process

Answer 38

1- Signal Price acts a signal to consumers and producers to adjust their consumption and production. If prices increase, this suggests that there's an increase in demand, so suppliers must start supplying more to earn higher profits. Meanwhile, a rational consumer would be less likely to want expensive goods. 2- Incentives Both parties trying to maximize their economic well-being; an increase in price will motivate suppliers to supply more to achieve higher revenues and profits, while a consumer will seek an alternative that is cheaper; this encourages economic efficiency. 3- Rationing Resources are limited and scarce, so price mechanism rationings resources according to willingness and ability to pay. Only those people who can afford it, and truly value the product will be able to purchase the good. This will severely drop quantity demanded, and overcome shortage in market.

Question 39

Drawbacks of price mechanism

Answer 39

- Does not always lead to efficient allocation of resources as private sector are unlikely to offer private and merit goods. - Cannot react to economic shocks - Fails to account for externalities (Not reflected on price) - Monopoly firms can easily exploit market

Question 40

Define consumer surplus

Answer 40

Difference between maximum amount the consumer is willing to pay versus how much they actually pay. The higher the price; the lower.

Question 41

Define producer surplus

Answer 41

Difference between the minimum price that the seller is willing to accept for his product versus how much he actually sells the product for.

Question 42

How are consumer and producer surplus affected when the good is elastic?

Answer 42

Consumer surplus is particularly small since consumers are incredibly sensitive towards price change, and they lack the incentive to pay much higher than market price. Consumer surplus is barely affected when levying taxes.

Question 43

How are consumer and producer surplus affected when the good in inelastic?

Answer 43

Consumer surplus is infinite since people are willing to match increase in prices just to acquire the good.