How Markets Work

Question 1

What is supply?

Answer 1

-quantity of a good/service that producers are willing and able to supply at a given price in each time period.

Question 2

What happens on a supply curve when price rises?

Answer 2

-when price rises, it becomes more profitable for producers to supply a product and so they have an incentive to increase production.
-RISE IN PRICE: expansion
-FALL IN PRICE: contraction

Question 3

What are shifts in supply curve caused by?

Answer 3

-Productivity, indirect taxes, number of firms, technology , subsidies, weather and costs of production

Question 4

Explain how productivity and indirect taxes cause a shift in the supply curve.

Answer 4

-productivity:labour productivity refers to the output per worker per hr worked. If there is a rise in productivity, then supply curve will shift to the right. (OUTWARD)
-indirect taxes:indirect tax raises cost of supply and so causes an inward shift in supply curve. A rise in VAT will cause the supply curve to become steeper as well as causing an inward shift.

Question 5

Explain how number of firms, tech and subsidies cause a shift in the supply curve.

Answer 5

-number of firms:when more firms enter the market, total quantity of goods/services available in the market increases, causing an outward shift.
-technology:new invention and new tech usually results in an increase in productivity, chasing supply curve to shift outwards.
-subsidies:grants to producers from the government which lead to a reduction in the costs of production, causing an outward shift in supply curve.

Question 6

How does weather, costs of production and discovery of new reserves of a raw material cause a shift in the supply curve?

Answer 6

-weather:droughts/flooding can cause a supply shock in agricultural markets. A drought will cause supply to decrease.
-costs of production: these include wages, raw materials, energy and rent which can cause whole curve to shift.

Question 7

What is price elasticity of supply (PES) and how is it measured?

Answer 7

-PES: measure of the responsiveness of quantity supplied for a product to a change in its price.
-PES: percentage change in quantity supplied/ percentage change in price

Question 8

What is the value of PES?

Answer 8

-PES will always have a positive value because price and quantity move in the same direction (since supply curve is upwards sloping)

Question 9

What do unitary elastic supply, perfectly inelastic supply and perfectly elastic supply curves look like?

Answer 9

-price elastic supply: when supply is price elastic, value of PES will be greater than 1.
unitary elastic supply:when supply is unit elastic, value of PES will be equal to 1. (STRAIGHT LINE THROUGH ORIGIN)
perfectly inelastic and perfectly elastic supply: when supply is perfectly price inelastic, value of PES will be 0. (VERTICAL LINE) When supply is perfectly priced elastic, value of PES would be infinity. (HORIZONTAL LINE)

Question 10

What are the four factors influencing price elasticity of supply?

Answer 10

-time
-stocks
-spare capacity
-availability and cost of switching resources from one use to another

Question 11

How does time and stocks affect price elasticity of supply?

Answer 11

-time:elasticity of supply is very likely to vary over time. It is often difficult to change supply quickly in response to a price change in the short run, making supply very inelastic. However, in the long run, supply is likely to be more elastic because all resources are variable.
-stocks:if stocks of finished goods are available, then supply will be relatively elastic because manufacturers will be able to respond quickly to a price change.

Question 12

How does spare capacity and availability and cost of switching resources from one use to another influence PES?

Answer 12

_spare capacity:if a firm has under utilised machinery and under employed workers or if it is possible to introduce a new shift or workers, then supply is likely to be elastic.
-availability and cost of switching resources from one use to another:if resources such as labour, have specific skills/machinery is highly specific, it will be expensive to reallocate resources from one use to another (supply will be inelastic)

Question 13

What does the equilibrium price mean?

Answer 13

-the equilibrium price and output are determined by the interaction of supply and demand.
-When quantity supply is equal to the quantity demanded of a particular product, equilibrium is said to exist.
-EQUILIBRIUM PRICE WILL NOT CHANGE UNLESS ONE OF THE CONDITIONS OF SUPPLY/DEMAND CHANGES.

Question 14

How does excess supply show on the demand/supply curve?

Answer 14

-if the price is above the equilibrium price of P, then there will be excess supply.
-market forces will cause price to fall to Pe, which will lead to an extension of demand and a contraction in supply, so eliminating the excess supply.

Question 15

How does excess demand show on the curve?

Answer 15

-if the price is below the equilibrium price of Pe, then there will be excess demand.
-Market forces will cause the price to rise to Pe, which will lead to an extension of supply and a contraction in demand so eliminating the excess demand.

Question 16

What are changes in the equilibrium price caused by?

Answer 16

-a change in the conditions of demand (causing demand curve to shift)
-a change in the conditions of supply (causing supply curve to shift)

Question 17

What are the reasons for an upward sloping curve?

Answer 17

-production costs
-profit motive
-new entrants into the market

Question 18

How do consumers and firms act rationally?

Answer 18

-consumers act rationally by aiming to maximise their utility (satisfaction).
-firms also act rationally by aiming to maximise profits.

Question 19

What does demand mean?

Answer 19

-demand refers to the willingness and ability to purchase goods/services at a given price at a given period of time.

Question 20

What causes a contraction/expansion in demand?

Answer 20

-fall in price causes an increase in QD (extension).
-rise in price causes a decrease in QD (contraction)

Question 21

What is the idea of contractions/expansions in demand based on?

Answer 21

-substitution effect:when there is a rise in price, the consumer will tend to buy more of a relatively lower priced good and less of a higher priced one.
-income effect:when there is a rise in price, consumers will suffer a fall in their real incomes (purchasing power). With normal goods, the fall in real incomes will reduce the QD so income effect reduced the substitution effect.

Question 22

What causes a shift in the demand curve?

Answer 22

-population: increase in the size of population —> increase in demand for most goods/services. An ageing population would cause demand for some goods and services to rise (sheltered accom.) and demand for other to fall.
-advertising
-substitutes
-income tax (more IT,less demand as real incomes fall)
-fashion and taste
-income (disposable)
-complements

Question 23

What does diminishing marginal utility mean?

Answer 23

-consumers gain satisfaction/utility from the goods they consume. Total utility represents the total satisfaction gained from the total amount of a product consumed, whereas marginal utility represents the change in utility from consuming an additional unit of the product.
-the principle of diminishing marginal utility states that, as a person consumes more and more of a product, the marginal utility falls. Consequently, people are prepared to pay less as their consumption increases with the result that there will be an inverse relationship between the price and QD.

Question 24

What does PED mean?

Answer 24

-PED is a measure of the responsiveness of QD for a product to a change in its price.
-PED= percentage change in QD/ percentage change in price

Question 25

What will the value of PED always be?

Answer 25

-PED will always have a negative value because price and quantity move in opposite directions (since demand curve is downward sloping).

Question 26

What does unit elastic, perfectly inelastic, perfectly elastic mean?

Answer 26

unit elastic demand:PED= -1 {downward sloping curve from top left to bottom right}
perfectly inelastic demand:PED= 0 {vertical line}
perfectly elastic demand:PED= -infinity {horizontal line}

Question 27

What are the factors influencing PED (availability of substitutes, proportion of income spent on a product)?

Answer 27

-availability of substitutes:if substitutes are available, then there will be a strong incentive to shift consumption to them when the price of the product rises. The existence of substitutes will therefore tend to make demand for the product elastic.
-proportion of income spent on a product:if only a small % of income is spent on a product, then demand will tend to be inelastic.

Question 28

What are the factors influencing PED (nature of the product, durability of the product)?

Answer 28

-nature of the product:if the product is addictive, then demand will tend to be inelastic.
-durability of the product:if the product is long-lasting and hard-wearing, then demand will be fairly elastic since it is possible to postpone purchases.

Question 29

What are the factors influencing PED? (length of time under consideration, breadth of definition of a product)

Answer 29

-length of time under consideration:it usually takes time for consumers to adjust their expenditure patterns following a price change. Consequently, demand is usually more price elastic in the long run.
-breadth of definition of a product:if a product is broadly defined E.g. fruit, demand is likely to be price inelastic.

Question 30

What are the key relationships between PED and total revenue?

Answer 30

-when demand is inelastic,a price change causes total revenue to change in the same direction.
-when demand is elastic,a price change causes TR to change in the opposite direction.
-when demand is unit elastic,a price change causes total TR to remain unchanged.
-when demand is perfectly inelastic,a price change causes TR to change in the same direction,by the same proportion.
-when demand is perfectly elastic,a price rise causes TR to fall to 0.

Question 31

What is the significance of PED for firms?

Answer 31

-if firms know that demand for their product is price inelastic, then they know that they can increase TR by raising price.
-However, if firms know that demand is elastic, then they can increase TR by reducing price.

Question 32

What is the significance of PED for government?

Answer 32

-if the government wishes to maximise its tax revenue, then it will place indirect taxes on those products whose demand is price inelastic E.g. petrol, tobacco. However, in this case, the consumer will bear most of the tax burden.
-the government may therefore also tax products/services whose demand is price elastic, in which case the producers will bear a higher proportion of the tax burden.

Question 33

What are the functions of price mechanisms (4
explained)?

Answer 33

-rationing device:market forces will ensure that the amount demanded is exactly equal to the amount supplied.
-incentive:the prospect of making a profit acts as an incentive to firms to produce goods/services.
-signalling device:for producers to increase/decrease the amount supplied.
-changes in wants:change in demand will be reflected in a change in price.

Question 34

What is the definition of market?

Answer 34

-a market refers to all those buyers and sellers of a product/service in making exchanges with each other and who help to determine its price. These markers may be local, national or global.

Question 35

What is consumer surplus?

Answer 35

-consumer surplus: refers to the difference between how much a person is willing to pay and how much they actually pay. Diagrammatically, the consumer surplus is the area under the demand curve and above the market price.

Question 36

What is producer surplus?

Answer 36

-producer surplus: refers to the difference between how much firms are willing to supply at each price and the market price. Diagrammatically, the producer surplus is the area between the supply curve and market price.

Question 37

What are the factors affecting consumer surplus?

Answer 37

-gradient of the demand curve (steeper it is, the greater the consumer surplus will be)
-changes in the condition of demand (increase in demand increases amount of consumer surplus)

Question 38

What are the factors affecting producer surplus?

Answer 38

-gradient of supply curve (steeper it is, greater the producer surplus).
-changes in conditions of supply (increase in supply increases producer surplus).

Question 39

What is the definition of cross elasticity of demand (XED)?

Answer 39

-Cross elasticity of demand is a measure of the responsiveness of quantity demanded for one product (Y) to a change in the price of another product (X).

Question 40

How is XED measured and what do the values mean?

Answer 40

-XED=percentage change in QD of product Y/ percentage change in price of product X
-a positive sign indicates that the products are substitutes. A rise in one will cause an increase in demand for another.
-a negative sign indicates that the products are complements. A rise in price of one product will cause a decrease in demand for another.

Question 41

What is the value of XED to businesses?

Answer 41

-a knowledge of XED is helpful for firms to set prices for their products. E.g. if the firm is selling a product with a close substitute then it would expect demand for its product to fall considerably if it decided to increase price.
-firms also know that complementary goods can command high prices.

Question 42

What is income elasticity of demand (YED)?

Answer 42

-income elasticity of demand is a measure of the responsiveness of QD for a product to a change in real income.

Question 43

How is YED measured and what do the values mean?

Answer 43

-YED=percentage change in QD/ percentage change in real income
-a positive sign indicates that the product is a normal good. E.g. a rise in real income will cause an increase in demand. UPWARD SLOPING CURVE FROM LEFT TO RIGHT.
-a negative signindicates that the product is an inferior good e.g. a rise in real income leads to a fall in demand for the product. DOWNWARD SLOPING DURVE FROM RIGHT TO LEFT.

Question 44

How do you differentiate between income elastic/income inelastic demand?

Answer 44

-whenever YED is greater than +1,demand is income elastic.
-whenever YED is **between 0 and +1, **demand is income inelastic.

Question 45

What is the significance of YED for firms?

Answer 45

-if firms know that demand for their product is income elastic, then they know that demand and total revenue will increase significantly during periods of economic growth and fall during recessions.
-consequently, knowledge of YED may be important when making investment decisions.

Question 46

What is the significance of YED for the government?

Answer 46

-if the government wishes to maximise its tax revenue during an economic boom, it will place indirect taxes on those products whose demand is income elastic.
-knowledge of YED might help the government in estimating tax revenues from indirect taxes of particular goods and services.