Demand and supply in product markets

Question 1

What is a product market

Answer 1

A product market refers to a place where goods and services are brought and sold.
- Demand for the product primarily comes from households.
- The main sellers of goods come from firms
- The market facilitates the exchange of goods and services in the economy, it is based on voluntary transactions across a range of places.

Question 2

Objectives of economic agents

Answer 2

Firms seek to maximise profits and consumers seek to maximise satisfaction, benefit and utility.

Firms and consumers are assumed to beahve rationaly, so if they deviate from this than the above asummption is not the case.

Question 3

Market demand

Answer 3

The various quantities of a good/services consumers are willing and able to buy at any given price over different periods, ceteris paribus.
- The law of demand state that as price rises quantity of demand falls.

Question 4

Why does the demand curve slope downwards?

Answer 4

1. The income effect, as the price of a good falls, the purchasing power of your income rises.
2. The substitute effect, as the price of a good rises, people will switch to the relatively cheaper product and therefore the demand for the relatively more expensive product will fall.
3. The law of diminishing marginal utility, as we consume more of a good the total amount of utility/satisfaction also increases however the additional utility provided by an extra unit of consumption falls. As Q increase the additional benefit falls, so willingness to pay falls. Demand falls

Question 5

Market supply

Answer 5

Market supply is defined as the quantity of a good or service that firms are willing and able produce and sell at any given price, during a particular time period.

Question 6

Why is the supply curve upward sloping

Answer 6

1. A higher price acts as an incentive to produce more, as price rises firms are incentivised to increase supply in order to increase profits.
2. The law of diminishing marginal productivity, as firms attempt to increase their production they will employ more FOP, the additional output provided by the extra unit of labour or capital will get smaller.
3. Higher levels of output will mean increased marginal costs in the short run and therefore higher prices for consumers.

Question 7

Non price determinants of demand changes

Answer 7

• Population, increase in population will mean demand rises for some products.
• Advertising, good advertisement campaign can cause demand for a product to rise. And vice versa.
• Substitutes, a substitute is a good that meets the same economic need as another one, if the price for one good rises, demand for substitute goods will rise.
• Income, rise in income will cause demand for goods to increase as more people can afford to buy them. NORMAL goods demand will more likely rise, INFERIOIR good demand will fall.
• Fashion/trends, organic goods, e-bikes for example.
• Interest rates, fall in interest rates means the costs of borrowing money falls, this may increase demand for items.
• Complements, these are goods that are consumed together. E.G cars and petrol. If the price for petrol rises then the demand for cars will fall. If the demand for cars rise then the demand for petrol will also rise.

Question 8

Non price determinants of supply changes

Answer 8

• Changes in production costs – We assume firms are rationale and want to maximise profits. Firms buy various factors of production which they use to produce its product. If products costs increase then firms will become less profitable and firms will produce less. Supply curve shifts INWARDS.
• Indirect taxes, these are taxes on spending. For example V.A.T. The initial tax is paid by the producer which raises costs of production. A increase in indirect tax will result in a inward shift in supply.
• Number of firms, more competition in the market will incentivise firms to increase supply, shift OUTWARDS.
• Technology, new technology may be more can be produced with the same amount of labour. Economists call this an increase in productivity. This will mean falling costs of production and therefore supply will increase.
• Subsidies, payments from the government to encourage the production of certain goods. Govt. payments make it more profitable for firms to produce, therefore they may increase supply.
• Joint supply, this happens when two or more products are derived from a single product. So a increase in the supply of one product, will lead to a increase in supply for another. E.G Beef and leather.
• Expectations, if firms expect the price of a product to rise they may withhold some supply from the market. The expectation is they can sell it for a higher price in the future. INWARD shift in supply

Question 9

Shift in the demand curve

Answer 9

1. The demand curve D1 intersects the supply curve S1 at point A at a equilibrium price and quantity shown as P1 and Q1.
2. As a result of falling incomes/bad advertisement campaign etc. the demand curve will shift inwards. Shown as the shift from D1 to D2.
3. Given D2, at the initial market price of P1, there is a movement to point B. This represents excess supply, equal to the horizontal distance between points A and B.
4. Point B represents a disequilibrium, where quantity demand is less than the quantity supplied.
5. Because of this this there is a downward pressure on prices. There is now a movement along the demand curve to point C, this is because more people can afford to buy the good at a lower price. Furthermore there is a movement on the supply curve to point C. This is because firms are less incentivised to produce the same level of supply at a lower price.
6. At point C the equilibrium is restored at a lower equilibrium price of P2 and a higher lower quantity of Q2.
7. There is a fall in price and quantity, due to a fall demand.

Question 10

Consumer Surplus

Answer 10

This is defined as the highest price consumers are willing to pay for a good minus the price actually paid. The price consumers are willing to pay is represented by the demand curve.

Question 11

Producer surplus

Answer 11

This is defined as the price received by firms for selling the good minus the price they are willing to accept to produce the good.

Question 12

How to calculate consumer surplus

Answer 12

• Vertical distance between the price your willing to pay and the price you actually pay = consumers surplus.
• To calculate consumer surplus you must work out the area of the triangle.

Question 13

How to calculate producer surplus

Answer 13

• The vertical distance between the price received by firms and the price firms are willing to accept for the good.
• To calculate producer surplus you must work out the areas of the triangle.

Question 14

Price elasticity of demand

Answer 14

According to the Law of demand there is a negative relationship between price and quantity, the higher the price the lower demand. Price elasticity allows us to determine the extent to which quantity demand changes.

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

Question 15

PED formula

Answer 15

% change quantity demanded / % change price

Question 16

PED = 0

Answer 16

Perfectly inelastic, A % change in price has no impact on the quantity demanded.

Question 17

0>PED>1

Answer 17

Relatively inelastic, A % change in price results in a proportionally smaller change in demand.

Question 18

PED = 1

Answer 18

Unitary elastic, A % change in price results in a proportionate change in demand.

Question 19

PED = Infinite

Answer 19

A % change in price results in a infinite change in demand.

Question 20

PED > 1

Answer 20

Relatively elastic, A % change in price results in a proportionally higher change in demand.

Question 21

Determinants of PED

Answer 21

1. The number and closeness of substitutes, the more substitutes a good has, the more elastic its demand. If the price of a goods with many substitutes increase, consumers can switch to other substitute products. Therefore resulting in a relatively large fall in quantity demanded.
2. Length of time, the longer the time period in which a consumer makes a purchasing decision, the more elastic the demand. As this gives the consumer a opportunity to get any information available on alternatives.
3. Proportion of income spent on good, the larger the proportion of ones income needed to buy he goods, the more elastic the demand. An item such as a pen makes up a very small proportion of ones income, so a 10% rise in price will results in a proportionally smaller fall in quantity demanded.
4. Whether the good is luxury or a necessity, necessities are essential goods and the demand for these is likely to be relatively inelastic because there are limited substitutes. Luxury goods on the other hand are non-essential goods and the demand for these are likely to be relatively price elastic as if the price rises you become less willing to pay as they are not essential.
5. Addictive goods.

Question 22

Relationship between PED and total revenue

Answer 22

A price increase when demand is price inelastic will likely lead to a increase in total revenue, although a price increase when demand is elastic will likely cause a TR fall.

This happens because when the demand for the good is price elastic, the proportionate fall in quantity outweighs the rise in price, BUT when the demand for the good is inelastic the percentage rise in price is greater than the percentage fall in quantity.

Question 23

Inceom elasticity of demand

Answer 23

Income elasticity of demand measures the responsiveness of a change in demand due to a change in income.

Question 24

Forumla for YED

Answer 24

% change quantity demanded / % change income, the value of YED can be positive or negative.

Question 25

Normal goods

Answer 25

• If the value of YED is POSITIVE it means an increase in incomes leads to a increase in QD.
• These are NORMAL goods.
• Examples include… Cars, electronic devices, shoes, meat etc.

Question 26

Inferior goods

Answer 26

• If the value of YED is NEGATIVE, it means an increase in incomes leads to an fall in QD.
• These are INFERIOR goods.
• Examples include… Basic food, rice, instant noodles, frozen food, McDonald’s.

Question 27

Inelastic or elastic YED

Answer 27

FURTHERMORE if the absolute value of YED is positive and greater than q, it means a rise in income leads to a proportionally larger rise in quantity demanded of that good. This means that the good has income elastic demand.
If the value is positive but less than 1 than a rise a income will lead to a proportionally smaller rise in quantity demand of that goods. This means that the good has a income inelastic demand.

Question 28

Cross price elasticity

Answer 28

XED measures the responsiveness of a change in demand of one good, X, to a change in price of another good, Y.

Question 29

Formula for XED

Answer 29

% change in QD of good X / % change in price of good y

Question 30

Complementary goods

Answer 30

These have negative XED, if one good becomes more expensive than the quantity demand for both goods will fall.
Close complements, a small rise in the price of good X will lead to a large decrease in QD of good Y. Weak compliments is the opposite.

Question 31

Subsitutes

Answer 31

These can replace another good, so the XED is positive, for example if the price for a brand of TV increases consumers switch to the other brand and QD rises.
Close subsitutes, a small increase in the price of Good X will lead to a large increase in QD of Y.

Question 32

Price elasticity of supply

Answer 32

This measures the responsiveness of a change in supply to a change in price.

Question 33

Forumla for PES

Answer 33

% change in quantity supplied / % change in price

Question 34

Elastic supply

Answer 34

This means that firms can easily increase supply of the good in response to a rise in price

Question 35

Factors influencing PES

Answer 35

Time scale:
In the short run, supply is more price inelastic, because producers cannot quickly
increase supply. In the long run, supply becomes more price elastic.

Spare capacity:
If the firm is operating at full capacity, there is no space left to increase supply. If
there are spare resources, for example in a recession there are lots of spare and
unemployed resources, supply can be increased quickly.

Level of stocks:
If goods can be stored, such as CDs, firms can stock them and increase market supply
easily. If the goods are perishable, such as apples, firms cannot stock them for long
so supply is more inelastic.

How substitutable factors are:
If labour and capital are mobile, supply is more price elastic because resources can
be allocated to where extra supply is needed. For example, if workers have
transferable skills, they can be reallocated to produce a different good and increase
the supply of it.

Barriers to entry to the market:
Higher barriers to entry means supply is more price inelastic, because it is difficult
for new firms to enter and supply the marke