Chapter 2: Allocation of Resources

Question 1

Compare a macroeconomy and a microeconomy [2]

Answer 1

Macro: deals at an economy level
Micro: deals with a product market

Question 2

Define an economic system [1]

Answer 2

The way in which a particular country attempts to solve the basic economic problem

Question 3

What are the fundamental economic questions? [3]

Answer 3

1. What to produce
2. To whom to produce
3. How to produce

Question 4

Name the types of economic systems [3]

Answer 4

1. Market economy
2. Planned economy
3. Mixed economy

Question 5

What is a free market economy? [2]

Answer 5

An economy where all decisions about allocation of resources are taken by private sectors by the producers and consumers with no government intervention

Question 6

Describe the features of a free market economy [5]

Answer 6

1. Decisions are made by individual sellers and buyers who can generally be expected to act in their own self interest
2. Main aim is to maximize seller profits
3. Consumers main aim is to maximize their satisfaction/utility giving rise to the idea of consumer sovereignty (providing what consumer desires)
4. Allocation of resources are determined by supply and demand
5. Government won’t interfere in functioning of the private sector

Question 7

Describe the advantages of a free market economy [3]

Answer 7

1. Government can focus on other important things
2. Profit motives give the seller incentives to be productively efficient that might otherwise not be the case
3. Cost effective produces could benefit through low prices

Question 8

Define price mechanism [1]

Answer 8

Allocation of resources determined by market forces of supply and demand

Question 9

Define demand [2]

Answer 9

Demand is the willingness and ability of a consumer to buy a product at a specific price during a specific period of time.

Question 10

Define quantity demanded [1]

Answer 10

The amount of goods or services consumers are willing and able to buy t a specific price.

Question 11

State the law of demand [2]

Answer 11

If the price of a product increases, quantity demanded decreases
If the price of a product decreases, quantity demanded increases
Ceteris Paribus

Question 12

When is there movement along the demand curve? [1]

Answer 12

When there is a change in price

Question 13

When is there a shift in the demand curve? [2]

Answer 13

1. A non price factor increases demand
2. A non price factor decreases demand

Question 14

What is a contraction and expansion along the demand curve? [2]

Answer 14

Contraction: increase in price and decrease in quantity demanded
Expansion: decrease in price and increase in quantity demanded

Question 15

State the non-price factors affecting demand [6]

Answer 15

1. Tastes and preferences: commodities which are out of fashion are less in demand as compared to those which are in fashion.
2. Advertising: a successful advertising campaign may affect the demand for a product
3. Climate: changes in climate affects the demand of certain goods and services
4. Changes in population: an increase in population will usually result in a rise for most products
5. Price of related goods: If the price of a substitute increases, the demand for the product will increase and vice verse. If the price of a complimentary or utility good (a good that enhances the quality of another good) increases, the demand decreases and vice versa.
6. Income: For normal goods, if the income increases, demand increases and vice versa. For inferior goods, if the income increases, demand decreases and vice versa (goods that are low-quality as compared to substitutes).

Question 16

Define an individual and and market demand [2]

Answer 16

1. Individual: demand of one consumer
2. Market demand: the total demand for that product from all its consumers willing and able to buy it

Question 17

Define supply [2]

Answer 17

The ability and willingness of producers to provide a product at a certain price during a specific period of time

Question 18

Define market supply [1]

Answer 18

The sum of all the individual supply curves of producers competing to supply the product

Question 19

Define quantity supplied [1]

Answer 19

The amount of a good or service producers are willing and able to make and sell to consumers in a market.

Question 20

Define the law of supply [2]

Answer 20

An increase in price leads to an increase in quantity supplied, and vice versa

Question 21

When is there movement along the supply curve [1]

Answer 21

When there is a change in price

Question 22

What is a contraction and extension on a supply curve [2]

Answer 22

1. Extension: increase in price and therefore quantity supplied
2. Contraction: decrease in price and therefore quantity supplied

Question 23

What are the non price factors affecting supply [7]

Answer 23

1. Increase in cost of production: supply decreases (leftward shift in supply curve)
2. Subsidy: financial aid provided by the government to producers. It reduces cost of production, and increases supply (rightward shift)
3. Indirect tax (tax on expenditure): cost of production increases, supply decreases (the money that may have been earned by the suppliers is taken by the government in the form of indirect tax)
4. Changes in quantity of resources available: increase in quantity increases supply
5. Technological change: advancements in technology, increase in supply
6. Profitability of other products: if another product seems more profitable than the one being produced, more resources are allocated to it, so supply reduces
7. Any supply shock

Question 24

Define a planned economy [2]

Answer 24

An economic system in which resources are owned by the government and allocation is based on social welfare. No private sector.

Question 25

Define a mixed economy [2]

Answer 25

An economic system in which resources are owned both by the government and private sectors. Allocation of resources in based on social welfare and market forces. Both public and private sectors.

Question 26

Define a market [1]

Answer 26

A place where buyers and sellers meet to make a transaction

Question 27

Define market equilibrium [2]

Answer 27

A market is said to be in equilibrium when where is a balance between demand and supply. If something happens to disrupt that equilibrium then the forces of demand and supply respond until a new equilibrium is established.

Question 28

Define shortage/excess demand and surplus/excess supply [2]

Answer 28

1. Shortage: when quantity demanded is greater than quantity supplied 2. Surplus: when quantity supplied is greater than quantity demanded

Question 29

Define price elasticity of demand (PED) [1]

Answer 29

The measure of responsiveness of quantity demanded to a change in price

Question 30

What is the formula for PED? [1]

Answer 30

percentage change in quantity demanded/percentage change in price OR (((QDf-QDi)/QDi)*100)/(((Pf-Pi)/Pi)*100)

Question 31

Why is PED always negative? [1]

Answer 31

Due to the law of demand, which states that price and quantity demanded move in opposite directions

Question 32

State the values of PED and what they mean [5]

Answer 32

1. PED = 0: demand is perfectly price inelastic (demand is not effected by change in price) 2. PED between 0 & 1: demand is price inelastic 3. PED = 1: demand is unitary price elastic 4. PED is between 1 & ∞: demand is price elastic 5. PED = ∞: demand is perfectly price elastic (any change in price will affect demand)

Question 33

Factors affecting PED [8]

Answer 33

1. Number of close substitutes: if number of substitutes is low, demand is price inelastic 2. Time period/how long the consumer has to search for a substitute: in the short run demand is price inelastic and in the long run it is elastic 3. Proportion if income spent of commodity: if it is low, demand is inelastic 4. Degree of necessity: if it is essential, demand is price inelastic 5. Brand loyalty: strong loyalty, demand is price inelastic 6. Cost of switching: if cost is high, demand is price inelastic 7. Breadth of definition of product: narrowing the definition of the product means the demand is price elastic 8. Addictive nature: more addictive, demand is inelastic

Question 34

Why is PED useful? [2]

Answer 34

Knowledge of PED allows firms to optimize the pricing and promotional strategies for their products to best achieve their sales, revenue or profit targets.

Question 35

Define price elasticity of supply (PES) [1]

Answer 35

The measure of responsiveness of quantity supplied to a change in price

Question 36

What is the formula to calculate PES? [1]

Answer 36

percentage change in quantity supplied/percentage change in price

Question 37

Why is PES always positive? [1]

Answer 37

Price and quantity supplied always move in the same direction according to the law of supply.

Question 38

State the values of PES and what they mean [5]

Answer 38

1. PES = 0: supply is perfectly price inelastic (supply is not effected by change in price) 2. PES between 0 & 1: supply is price inelastic 3. PES = 1: supply is unitary price elastic 4. PES is between 1 & ∞: supply is price elastic 5. PES = ∞: supply is perfectly price elastic (any change in price will affect supply)

Question 39

State the factors affecting PES [5]

Answer 39

1. Durability/ability to maintain stock of the product: high - supply is price elastic 2. Time taken to produce: high - supply is price inelastic 3. Availability of spare capacity: high - supply is price elastic 3. Occupational mobility: low - supply is price elastic 5. Technological advancements: supply becomes elastic

Question 40

What is the most desirable PES for a firm?

Answer 40

For it to be highly responsive because a high PES makes the firm more competitive leading to more revenue and profits.

Question 41

How can we improve the PES for a product? [10]

Answer 41

1. Creating spare capacity 2. Using the latest technology 3. Keeping sufficient stocks 4. Developing better storage system 5. Prolonging the shelf life of products 6. Developing better distribution systems 7. Providing training for workers 8. Having flexible workers who can do a range of jobs 9. Locating production near to the market 10. Allowing inward migration of labor if there is a labor shortage

Question 42

If there is an increase in price of coffee, explain with a diagram the impact on the market for tea [3]

Answer 42

Tea and coffee are substitutes because they serve the same purpose. If the price of coffee increases, there might be a rise in demand for tea because the tea is relatively cheaper now and people may prefer tea to coffee. As there is an increase in demand due to a non-price factor, it leads to a rightward shift in demand curve as shown in the diagram. Demand curve shifts from D1 to D2 which increases the price from P1 to P2 and the quantity traded from Q1 to Q2.

Question 43

Disadvantages of a market economic system [5]

Answer 43

1. Overconsumption of demerit goods 2. Inflation 3. Unemployment because only the most skilled workers are hired 4. Price uncertainty 5. High risk of market failure

Question 44

Define market failure [1]

Answer 44

Market failure is when a free market fails to allocate resources efficiently

Question 45

Define social cost and social benefit [2]

Answer 45

Social cost = private cost + external cost Social benefit = private benefit + external benefit

Question 46

Define a merit and demerit good [2]

Answer 46

Merit good: have positive externalities of consumption (eg: avocado, education) Demerit good: have negative externalities of consumption (eg: fast food, gambling)

Question 47

Define a public good [2]

Answer 47

Public goods are those goods which are non-excludable and non-rival. Eg: street lighting, army

Question 48

Define a private good [2]

Answer 48

Private goods are those goods which are excludable and rival.