Chapter 2 - Supply and Demand: How Markets Work

Question 1

Types of goods

Answer 1

• Search goods: qualities of the good can be assessed prior to purchase
• Experience goods: qualities of the good are discovered only after purchase (used car)
• Credence goods: qualities of the good cannot be evaluated in normal use, even after purchase (e.g. health care, repair services, legal and financial advice)
• Giffen good: Increase in price increases demand because of the income effect: if the price of bread rises, poor workers have less income available for meat and need to substitute with more bread
• Veblen/Snob good (social prestige): We purchase things not because we need them but because we want to impress others with our purchasing power. à Price increases à demand increases

Question 2

Competitive Market

Answer 2

• many buyers and sellers
• Buyers and sellers are price takers
• Each buyer and seller has perfect information
• Goods and services are homogeneous
• Buyers and sellers act independently
• all costs and benefits are accounted for

Question 3

Monopoly (and Natural Monopoly)

Answer 3

o One seller that controls the price
o Barrier to entry the market

Question 4

Oligopoly

Answer 4

o Few sellers
o Not always aggressive competition

Question 5

Monopolistic Competition

Answer 5

o Many sellers
o Slightly differentiated products (e.g. market for magazines)
o Each seller may set price for its own product

Question 6

law of demand

Answer 6

the quantity demanded of a good falls when the price of the good rises

Question 7

Demand Function

Answer 7

Q = a - b*P (Q = demand, b = slope, P = price)

Question 8

Income effect

Answer 8

a fall in the price of milk means that consumers can now afford to buy more with their income

Question 9

Substitution effect

Answer 9

Milk is lower in price compared to other similar products so some consumers will choose to substitute the more expensive drinks with
the now cheaper milk

Question 10

Substitutes

Answer 10

two goods for which an increase in the price of one leads to an increase in the demand for the other (e.g. pencils and pens, CocaCola and Pepsi)

Question 11

Complements

Answer 11

two goods for which an increase in the price of one leads to a decrease in the demand for the other (e.g. coffee and sugar, cars and petrol)

Question 12

law of supply

Answer 12

he quantity supplied of a good rises when the price of the good rises

Question 13

Market supply

Answer 13

the sum of all individual supplies for all sellers of a particular good or service

Question 14

Shifts in the Demand Curve due to increased consumer income

Answer 14

o demand for a normal good will increase.
o demand for a luxury good will increase a lot.
o demand for an inferior good will decrease, e.g. bus

Question 15

Inelastic Demand

Answer 15

<1 22% decrease in price leads to 11% increase in demand

Question 16

Elastic Demand

Answer 16

> 1
22% increase in price leads to a 66% decrease in demand

Question 17

Perfectly Inelastic Demand

Answer 17

=0
an increase in price leaves the quantity untouched
vertical line

Question 18

Unit elastic Demand

Answer 18

=1
22% increase in price leads to a 22% decrease in demand

Question 19

Perfectly elastic Demand

Answer 19

= infinity
At exactly X price demand is infinite, above none is bought

Question 20

Availability of close substitutes (elasticity)

Answer 20

the more substitutes available the more elastic demand

Question 21

Necessities vs. luxuries (elasticity)

Answer 21

Necessities: more inelastic demand i.e. cigarettes to smokers Luxuries: more elastic demand i.e. holidays

Question 22

Definition of the market (elasticity)

Answer 22

narrow markets (vanilla ice-cream, special beer) are more elastic demand than broader (food)

Question 23

Proportion of income devoted to the product (elasticity)

Answer 23

inexpensive is less elastic as consumers are relatively indifferent about price changes

Question 24

Time horizon (elasticity)

Answer 24

the longer the horizon the more elastic

Question 25

Spatial differences (elasticity)

Answer 25

more time to come up with alternatives and adjust to the price change

Question 26

Total Expenditure (and elasticity)

Answer 26

Total Expenditure is the total amount paid by buyers and received by sellers (total revenue) of a good.
- demand is price elastic, price and total expenditure move in opposite directions (less money available for goods)
- demand is price inelastic, price and total expenditure move in same directions. (both increase)

Question 27

Cross Price Elasticity

Answer 27

< 0 Complements
>0 Substitutes
0 No effects

Question 28

Income Elasticity

Answer 28

> 0 normal good
1 luxury good
<0 inferior good