Chapter 2A

Question 1

Price mechanism

Allocating scarce resources between competitive uses

Answer 1

1. Signaling function
2. Incentive function
3. Rationing function

Question 2

The three economic questions

Answer 2

1. What and how much to produce
2. How to produce
3. For whom to produce

Question 3

Key features of the free market economy

Answer 3

1. Private ownership of property
2. Freedom of choice and enterprise
3. Pursuit of self interest
4. Competition

Question 4

Theory of demand

Answer 4

The quantity of a well defined commodity that consumers are both willing and able to buy at a given price during a given period of time ceteris paribus

Question 5

What does the price mechanism determine

Answer 5

Market equilibrium

Question 6

The law of diminishing marginal utility

Answer 6

As a consumer consumes more and more of a good the additional satisfaction he derives from each additional unit of good decreases beyond a certain point of consumption

MU= change in TU (total utility) - change in quantity of good

Question 7

The demand curve

Answer 7

Shows the relationship between price and quantity demanded of a well defined commodity shows quantity demanded of a WDC consumers both willing and able to buy at a given price at a given period of time ceteris paribus

Question 8

The law of demand

Answer 8

In a given period of time the quantity demanded of a product is inversely related to its price ceteris paribus

Question 9

The types of relationships between goods

Answer 9

1. Substitutes in consumption
   Goods that can be used in place of one another in the satisfaction of a similar/particular purpose

2.derived demand
Describes a market in which a good is demand not for its own sake but for the purpose of production of another good. Not both goods are final products

3.Complements in consumption
Goods that are used in conjunction with one another in the satisfaction of a particular purpose

Question 10

Types of goods

Answer 10

1. Normal
   increased income leads to increased demand
   2.Luxury
   increased income leads to increase in percentage increase in demand
   3.Inferior
   increased income leads to fall in demand e.g: cheap substitutes like supermarket coffee

Question 11

Change in quantity demanded versus change in demand

Answer 11

Change in quantity demanded is affected by price determinants, it is the shift along the demand curve

Change in demand is affected by non price determinants it is complete shift of the demand curve

Question 12

Non price determinants of demand

Answer 12

1. Govt policies
   Policies that influence taste and preferences like the implementation of taxes/subsidies/campaigns
   2.Changes in consumer income
   Increased–> increasing purchasing power
   3.Changes in prices of related goods
   decrease in price of a related which serves a similar purpose reduces the demand for a specific good. The two goods are alternatives or substitutes in consumption
2. Changes in consumer expectation
   A consumer whom expects that in the future price may rise might choose to increase his consumption now

5.Changes in taste and preferences

6. Increase in number of consumers in the market (population growth)
   increased demand for good

G4CI

Question 13

Individual demand

Answer 13

Demand of a single individual

Question 14

Market demand

Answer 14

Demand of all consumers in the market

the horizontal summation in a table

Question 15

Shortage

Answer 15

When the quantity demanded exceeds quantity supplied it causes an upward pressure on prices

Question 16

Supply

Answer 16

the quantity of a well defined commodity that a producer is both willing and able to supply at a given time and at a given price level ceteris paribus

Question 17

The law of supply

Answer 17

In a given period of time as the quantity supplied of good is directly related to its price ceteris paribus

Question 18

Law of increasing opportunity cost

Answer 18

As more and more of a good is produced the opportunity cost of the additional output increases, increasing marginal cost

Question 19

Supply curve

Answer 19

Shows the relationship between price and quantity supplied of a well defined commodity shows quantity supplied of a WDC producers both willing and able to produce at a given price at a given period of time ceteris paribus

Question 20

Non price determinants of supply

Answer 20

1. Govt policies (indirect taxes; indirect subsidies)
2. Change in price of related goods
   Goods that are substitutes in production. The quantity of good that producers put up for sale depends on price of related good
3. Change in costs of relevant resources
   an increase in the cost of resources will cause increase in production costs which will render suppliers reducing their supply of a good

4.Natural disasters
Can cause massive destruction to production firms and supply chains which will destroy raw materials required in the production of goods

5. Expectations of future price changes
   If prices are expected to rise producers may reduce the supply of the good in the short term and build up stocks and only release them into the market when price rises
   6.Changes in technology
   Increased productive efficiency which will increase rate of production increases qty of good supplied
6. No.of sellers in the market
   Increased supply

Question 21

What and how much to produce

Answer 21

(bring in the signaling and incentive function)
relies on the demand for a good which reflects which goods consumers are willing and able to pay for. Which enables a producers to divert resources to supply a good that has a greater demand

Producers respond to price signals by changing quantity of good supplied

Producers divert resources from goods with lower prices relative to costs and hence lower profits, to goods that are more profitable

Question 22

How to produce

Answer 22

In a free market competition forces firms to use least cost combination of inputs to produce a given level of output as least cost combination maximises profits.

Any firm that does not employ least cost combination technique will find other firms that can undercut its price, losing customers and going out of business

Question 23

For whom to produce

Answer 23

The distribution of finished goods to consumers based on their ability and willingness to pay for the market price of the product

Since prices help in rationing available resources, the answer to this question can be answered by the purchasing power of consumers. Resources are allocated to the production of a good depending on its ‘dollar-votes’

Question 24

Signaling function

Answer 24

Prices are signals to reflect what is relatively scarce what is relatively abundant providing information to buyers and sellers what should be bought and what should be produced
Prices also act as signals to determine which goods are demanded

Question 25

Rationing function

Answer 25

There is a need to ration resources due to scarcity. Changes in price allows for scarce resources to be rationed for parties who are most willing and able to buy

Question 26

Incentive function

Answer 26

Changes in prices act as an incentive for changes in quantity of goods supplied/consumed to maximise profits/marginal utility. Provides suppliers with incentives to reallocate their resource