Demand

Question 1

What is the substitution effect?

Answer 1

Quantity demanded decreases with an increase in price

Question 2

What is the income effect?

Answer 2

Quantity demanded increases with an increase in income

Question 3

How do market and individual demand curves differ?

Answer 3

The market demand curve is flatter than the individual demand curve

Question 4

What affects demand elasticity?

Answer 4

-The number of substitutes: if there are few substitutes then demand will be inelastic
-The proportion of income spent on the good: If a higher proportion of income is spent on the good then demand will be more elastic
-Timescale: In the long run demand will be more elastic as consumer habits can adjust

Question 5

What is the income elasticity of a normal good?

Answer 5

• Normal goods have a positive income elasticity of demand

Question 6

What is the elasticity of an inferior good?

Answer 6

-Inferior goods have a negative income elasticity of demand

Question 7

What is the elasticity of a luxury good?

Answer 7

• Luxury goods have an income elasticity of demand >1

Question 8

What is the elasticity of a necessity?

Answer 8

• Necessities have an income elasticity of demand <1

Question 9

What happens to a firm’s revenue if it decreases the price of an elastic good?

Answer 9

Revenue increases as the relative change in quantity is greater than the relative change in price

Question 10

What happens to a firm’s revenue if it decreases the price of an inelastic good?

Answer 10

Revenue decreases as the relative change in quantity demanded is less than the change in price
-Therefore it is better for firms to charge more for inelastic goods

Question 11

What is the consumer surplus?

Answer 11

The area bounded by the demand curve and the equilibrium price (above)

Question 12

What is price discrimination and what is the condition for it to be effective?

Answer 12

-It is when firms charge different prices to different consumers
-In order for it to work, it must be impossible to resell the good

Question 13

What is first degree price discrimination?

Answer 13

-Perfect price discrimination
-Charge a different price to each customer according to their maximum reservation price (WTP), thus capturing the entire consumer surplus
-This would require the firm to hold a lot of information about each consumer and is therefore impractical, it is only really useful for bespoke goods

Question 14

What is second degree price discrimination?

Answer 14

-Price depends on quantity bought
-Higher order quantities yield a lower price

Question 15

What is third degree price discrimination?

Answer 15

-The market is divided into two segments with different demand functions
-The price charged varies per segment