Demand/Supply & Price setting in a market

Question 1

Define Demand

Answer 1

Demand is the willingness and ability of consumers to buy a product at a given price

Question 2

Why does the demand curve slope downwards? (3)

Answer 2

1. The Law of Diminishing Marginal Utility: consumers are willing to pay a price equal to the utility (benefit/happiness) of the last unit they purchase (marginal utility). However the utility of each unit we buy is always less than the one before, so the price we will pay also falls.
2. The Income Effect: if the price of a good rises then my real income (what I can buy with my income) falls, therefore I buy less.
3. The Substitution Effect: if the price of a good rises consumers will switch to alternative, now relatively cheaper products and buy less of the good.

Question 3

What are the possible causes of a shift in demand? (9)

Answer 3

If anything rather than the price of the good changes then a new demand curve needs to be drawn.

1. Fashion/Trends
2. Income (real disposable income)
3. Weather/Seasons
4. Changes in quality
5. Population
6. Change in the price of substitutes (similar products)
7. Change in the price of complimentary goods (2 goods you buy together)
8. Derived demand - the demand for labour depends on the demand for the product
9. Speculation

Question 4

Define Consumer Surplus

Answer 4

Consumer Surplus is the difference between the price consumers would be willing to pay and the actual market price

Question 5

Define Supply

Answer 5

Supply is the willingness and ability of firms to sell a product at a given price (we assume the firms are price takers - they do not set the price)

Question 6

Explain Willingness and Ability in terms of Supply

Answer 6

Willingness: if the price rises, the profit rises, which should encourage new firms to enter the market and existing ones to expand, so the market supply would increase (firms supply in order to make profit)
Ability: supply can be affected by natural/unforeseen factors

Question 7

Describe the possible causes of a shift in supply

Answer 7

If a factor rather than price changes then the supply curve will shift. If more profit is possible at the same price the curve will shift outwards.
Causes of a fall in costs:
1. Increase in productivity/efficiency (new technology)
2. Cheaper resources/FoPs (lower wages)

Question 8

Define Producer Surplus

Answer 8

Producer Surplus is the difference between the price a producer is willing to sell at and the market price

Question 9

Define The Price Mechanism

Answer 9

The Price Mechanism is the interaction of supply and demand to allocate resources in a free market economy

Question 10

Explain the 3 key roles of price

Answer 10

1. A rationing device (it helps to decide who gets what)
2. An incentive (for firms to enter the market, disincentive for consumers)
3. A signalling device (lets firms/consumers know if there is a surplus/shortage, so signals if they should leave/enter the market)

Question 11

Explain rational behaviour

Answer 11

Traditional (new-classical) economics is based on the idea that economic agents (consumers, firms, governments, labour) act rationally is. can rank a series of options according to their own net gain and always choose the best one, or maximise their utility.
However, behaviour economics suggests that agents may not be so rational. They point to things such as: habitual behaviour, lack of knowledge, poor at computation, emotional actions.

Question 12

Define Price Elasticity of Demand

Answer 12

PED = %∆QD/%∆P or (∆QD/∆P)*(P/QD)original
It measures the proportionate response of QD to a proportionate change in P
Elastic: |PED|>1
Inelastic: |PED|

Question 13

Explain the factors determining PED (4)

Answer 13

1. Number of substitutes: few substitutes -> inelastic
2. Definition of the market: the wider the definition the more inelastic (Petrol - inelastic, BP - elastic)
3. Time: consumers take time to react to a change in P. So in short term PED is inelastic
4. Actual price: cheap products tend to be inelastic

Question 14

Define Income Elasticity of Demand

Answer 14

YED = %∆QD/%∆Y
It measures the proportionate response of QD to a proportionate change in income
Normal good: positive
Inferior good: negative
Elastic: |YED|>1
Inelastic: |YED|

Question 15

Define Cross Elasticity of Demand

Answer 15

XED = %∆QD of A/%∆P of B
It measures the proportionate response of QD for good A to a proportionate change in the price of good B
Substitutes: positive
Complimentary: negative
The closer the greater the magnitude

Question 16

Define Price Elasticity of Supply

Answer 16

PES = %∆QS/%∆P
It measures the proportionate response of QS to a proportionate change in price
Inelastic: PES1
Unitary: PES=1

Question 17

Explain Short Run and Long Run

Answer 17

Short Run (SR) is the period of time where one factor of production is fixed in quantity.
In Long Run (LR) all FoPs can vary.
If there is an increase in price then firms would like to increase quantity supplied but may not be able to in the SR. In the SR PES is relatively inelastic. In the LR PES will be relatively elastic.

Question 18

Describe the factors to consider for PES (6)

Answer 18

1. How long does it take to produce the good?
2. Are there stocks available? If so PES may be elastic even in SR
3. How much spare capacity is there? A lot implies easy to increase quantity supplied - elastic
4. Are resources easily available? (especially labour)
5. Do prices fluctuate? If so firms may not react to a change in price
6. Some commodities are finite so over the very LR PES becomes perfectly inelastic

Question 19

Explain Indirect Tax

Answer 19

Indirect Tax is a tax on the production/sale of a good/service. It shifts the supply curve vertically up by the amount the tax goes up. It is paid by the producer. It is effectively a cost of production, so increase in tax leads to a decrease in supply. The tax revenue raised is the value of tax * quantity (incidence on consumer + incidence on producer). Incidence on the consumer (always closer to S2) is the burden of tax of tax on the consumers. Incidence on the producer is the burden of tax on the producer, or the tax cost absorbed by the firm.
If the PED is perfectly inelastic consumer pays all the tax
If the PED is perfectly elastic, producer pays all the tax

Question 20

Define Specific/Unit tax and Ad Valorem tax

Answer 20

Specific or Unit tax - a set amount

Ad Valorem - a percentage of the selling price (VAT, IVA)

Question 21

Define Subsidy

Answer 21

Subsidy is a payment by the government to a firm to encourage the production/sale of a product. It reduces the costs of production and is like a negative tax.