How Markets Work

Question 1

What two assumptions are made by Neo-classical analysis about the way firms and consumers behave?

Answer 1

1) Consumers act rationally by trying to maximise their utility.
2) Firms act rationally by aiming to maximise their profits.

Question 2

Define demand.

Answer 2

Demand refers to the quantity of a product demanded by consumers at a given price over a certain period of time.
Demand means that consumers are both willing and able to purchase a product.

Question 3

What does the shape of the demand curve reveal?

Answer 3

The demand curve is downwards sloping showing that a fall in price would lead to an extension of demand, whereas a rise in price would lead to an contraction of demand.

Question 4

What is the substitution effect?

Answer 4

The substitution effect explains that when there is a rise in price, a consumer who’s income has remained constant will choose to switch their spending to a similar product or substitute of a lower price to the original product.

Question 5

What is the income effect?

Answer 5

The income effect is where a rise in price leads to a fall in real incomes because consumer’s money can no longer buy as much, their purchasing power falls. With normal goods, the quantity demanded will fall when there is a fall in real incomes.

Question 6

What causes a movement along the demand curve?

Explain the two scenarios.

Answer 6

Movement along the demand curve are brought about by a change in the price of the product itself.
A rise in the price of the product would bring about a contraction of demand which is shown by a movement up the demand curve.
A fall in price would bring about an extension of demand which is shown by a movement down the demand curve.

Question 7

What factors may cause a change in the quantity of a product demanded other than price? (5)

Answer 7

1) Real incomes
2) Size or age of the population.
3) Tastes, fashions or preferences
4) Prices of substitutes or compliments
5) Interest rates

Question 8

Explain how real incomes may affect quantity demanded.

Answer 8

An increase in real incomes would lead to an increase in demand for a product, shown by a rightward shift of the demand curve.
A decrease in real incomes would lead to decrease in demand for a product, shown by a leftward shift of the demand curve.

Question 9

Explain how the size or age of the population may affect demand.

Answer 9

An increase in the size of the population would lead to an increase in the demand of most goods and services.
An ageing population would cause an increase in demand for certain goods and services, such as sheltered accommodation and a fall in demand for others, e.g. clothes for teenagers.

Question 10

Explain how tastes and fashions may affect demand.

Answer 10

The demand for goods and services can rise and fall as they come into and go out of fashion.

Question 11

Explain how the prices of substitutes and compliments can affect demand.

Answer 11

A change in the price of substitute good can affect the demand for other goods, for example a rise in the price of beef may cause an increase in demand for s substitute such as lamb.
A rise in the price of a compliment good, e,g. petrol made lead to a fall in demand for cars.

Question 12

Explain how interest rates may affect demand?

Answer 12

Interest rates affect the cost of borrowing money. For example, a rise in interest rates, would increase the cost of borrowing money for mortgages and may lead to a fall in demand for homes.

Question 13

What is total utility?

Answer 13

Total utility is the amount of satisfaction gained from the total amount of a product consumed.

Question 14

What is marginal utility?

Answer 14

Marginal utility is the change in utility from consuming an extra unit of the product.

Question 15

Explain the law of diminishing marginal utility.

Answer 15

The law of diminishing marginal utility states that, as a person consumes more and more of a product, the consumers’ total utility increases but marginal utility decreases.
People are prepared to pay less for each additional unit as their consumption increases, with the result that there will be an inverse relationship between the quantity demanded and the price.

Question 16

Define price elasticity of demand.

Answer 16

Price elasticity of demand is a measure of the responsiveness or sensitivity of the demand for a product to change in the products price.

Question 17

How can PED be calculated?

Answer 17

PED = % change in QD/ % change in price.

Question 18

Explain price inelastic demand.

What is the value of PED when demand is price inelastic?

Answer 18

Demand is price inelastic when a proportional or percentage change in price leads to a proportionally smaller change in the demand for the product.
When demand is price inelastic, the value of PED is between 0 and -1.

Question 19

Explain price elastic demand.

What is the value of PED when demand is price elastic?

Answer 19

Demand is price elastic when a proportional or percentage change in price leads to a proportionally larger change in demand for the product. When demand is price elastic, the value of PED will be greater than -1.

Question 20

Explain unitary elasticity.

What is the value of PED when demand is unit elastic.

Answer 20

Demand is unit elastic when a percentage or proportional change in the price of the product leads to the same proportional or percentage change in price.
When demand is unit elastic, the value of PED will be equal to 1 and the demand curve will be a rectangular hyperbola.

Question 21

Explain perfectly inelastic demand.

What is the value of PED when demand is perfectly inelastic?

Answer 21

Demand is perfectly inelastic when a proportional or percentage change in the price of the product does not bring about a change in the demand for the product.
When demand is perfectly price inelastic, the value of PED will be 0 and the demand curve will be a straight line vertically upwards.

Question 22

Explain perfectly elastic demand.

What will be the value of PED when demand is perfectly elastic?

Answer 22

When the demand for a product is perfectly elastic a percentage or proportional change in the price of the product will lead to demand falling to zero or rising to infinity.
When demand is perfectly elastic the value of PED is infinity and the demand curve will be a straight, horizontal line.

Question 23

What are the determinants of the price elasticity of demand? (6)

Answer 23

1) Availability of substitutes
2) Proportion of income spent on the product
3) Nature of the product
4) Durability of the product
5) Length of time under consideration
6) Width of market definition

Question 24

Explain how availability of substitutes can affect PED.

Answer 24

The more substitutes a product has, the greater the incentive will be to switch spending when the price of that product increases and the more elastic the demand will tend to be.

Question 25

Explain how the proportion of income spent on the product can affect PED.

Answer 25

If only a small percentage of income is spent on the product, the demand for that product tends to be more price inelastic.

Question 26

Explain how the nature of the product can affect PED.

Answer 26

If the product is addictive, e.g. alcohol and tobacco, then the demand for the product will be more price inelastic.

Question 27

Explain how durability of the product effects PED.

Answer 27

If the product is long-lasting and hard wearing such as furniture, then the demand for the product will tend to be more price elastic because it is easier for consumers to postpone the purchase.
However demand for non-durable goods such as petrol and mil tends to be price inelastic because these must be regularly replaced.

Question 28

Explain how length of time under consideration effects PED.

Answer 28

It usually takes time for consumers to change their spending patterns as a result of a price change. Consequently demand tends to be more price inelastic in the short run than in the long run.

Question 29

Explain how the width of market definition effects PED.

Answer 29

If a product is broadly defined, for example fruit, demand is likely to be inelastic. However the demand for a particular type of fruit will tend to be more price elastic.

Question 30

What is total revenue and how is it calculated?

Answer 30

Total revenue is the value of goods and services sold by a firm and is calculated by multiplying the price of the product by the quantity of the product sold.

Question 31

What are the five key relationships between PED and total revenue?

Answer 31

1) When demand is price inelastic, a price change causes total revenue to change in the same direction.
2) When demand is price elastic, a price change causes total revue to change in the opposite direction.
3) When demand is unit elastic, a price change causes total revenue to remain unchanged.
4) When demand is perfectly inelastic, a price change causes total revenue to change in the same direction by the same proportion.
5) When demand is perfectly elastic, a price rise causes total revenue to fall to zero.

Question 32

What is the significance of PED to firms?

Answer 32

If firms are aware that the demand for their product is price inelastic, then to increase total revenue, they can increase the price.

If they know that the demand for their product is price elastic then they can increase total revenue by reducing the price.

Question 33

What is the significance of PED to the government?

Answer 33

If the government wishes to raise tax revenue, then it will place indirect taxes on products which have price inelastic demand, such as alcohol or tobacco.

The government may therefore also tax products, the demand for which is price elastic, in the knowledge that producers will bear the greatest burden of the tax.

Question 34

What is cross price elasticity of demand (XED)?

Answer 34

Cross price elasticity of demand is a measure of the responsiveness of the demand for product X to a change in the price of product Y.

Question 35

How can XED be measured?

Answer 35

XED = % change in QD of product Y / %c change in price of product X

Question 36

For XED, what does a positive sign indicated?

What does a negative sign indicate?

Answer 36

A positive sign indicates that the products are substitutes, e.g. arise in the price of one product will cause an increase in demand for the other product.

A negative sign indicates that the products are compliments, e.g. a rise in the price of one product will lead to a fall in demand of the other product.

Question 37

Why is XED valuable to businesses?

3

Answer 37

1) Knowledge of XED is helpful to businesses in setting the price of their products.
2) If the firm is selling a product with a close substitute, then it would know that demand for this product would fall if they were to increase it’s price.
3) Firms also know that complimentary goods command high prices, e.g. ink cartridges command high prices compared to the actual printer because a certain type of cartridge is required for each particular printer.

Question 38

Define income elasticity of demand.

Answer 38

Income elasticity of demand is a measure of the responsiveness or sensitivity of the demand for a product to a change in real income.

Question 39

How can YED be measured?

Answer 39

YED = percentage change in quantity demanded/percentage change in real income.

Question 40

Why is the sign very significant for YED?

Answer 40

For YED the sign is very significant because a positive sign indicates that the product is a normal good, i.e a rise in real income will lead to a rise in demand for the product.

Question 41

What is income inelastic demand?

What is the value of YED?

Answer 41

Demand is said to be income inelastic when a percentage or proportional change in real income leads to a proportionally smaller change in the demand for the product.
When the value of YED is between 0 and +1, demand is income inelastic.

Question 42

What is income elastic demand?

What is the value of YED?

Answer 42

Income elastic demand is when a percentage or proportional rise in real income leads to a proportionally larger rise in demand for the product.
When the value of YED is greater than +1, demand is income inelastic.

Question 43

What does a negative value of YED indicated?

Answer 43

A negative sign indicates that the good is an inferior good, i.e. a rise in real incomes will lead to a fall in demand for the product. This is sometimes because consumers are now able to afford a more expensive and high quality item.

Question 44

What is the significance of YED for firms?

Answer 44

Knowledge of YED can help with investment decisions. For example, if firms know that the demand for their product is income inelastic, then they know that demand for their product will increase significantly during times of rapid growth but fall significantly during recession.

Question 45

What is the significance of YED for the government?

Answer 45

If the government wishes to maximise its tax revenue during an economic boom, then it will place indirect taxes on products it knows the demand for which is income elastic.

Question 46

What is supply?

Answer 46

Supply refers to the amount supplied by producers at a given price over a certain period of time.

Question 47

What can be said about the shape of the supply curve?

Explain why this is the case.

Answer 47

The supply curve is upward sloping from left to right, meaning that as price rises, the quantity supplied will increase.

When the price rises, it become more profitable for producers to supply a product and so they have an incentive to increase production.
When there is a fall in price, it becomes less profitable for producers to supply a product and so they make the decision to cut production and or exit the market.

Question 48

What are movement along the supply curve caused by?

Answer 48

Movements along the supply curve are caused by price changes, a rise in price will cause an extension of supply and a movement up the supply curve. A fall in price will cause a contraction of supply and a movement down the supply curve.

Question 49

What factors may cause a shift in the supply curve? (6)

Answer 49

1) Costs of production
2) Productivity of the workforce
3) Indirect taxes
4) Technology
5) Subsidies
6) Discoveries of new technology

Question 50

Explain how costs of production and productivity of the workforce may affect supply?

Answer 50

An increase in the costs of production, such as increase in electricity costs, will lead to a decrease in supply and a leftward shift of the supply curve.

If there is a rise in productivity there will be an increase in supply shown by a rightward shift of the supply curve.

Question 51

Explain how indirect taxes and technology may affect supply?

Answer 51

In indirect tax raises the cost of supply leading to a decrease in in supply, shown by a leftward shift of the supply curve.

New innovation and technology will usually lead to a rise in productivity bringing about an increase in supply shown by a rightward shift of the supply curve.

Question 52

Explain how subsidies and discoveries of new resources may affect supply.

Answer 52

Subsidies are grants made to producers from the government which effectively lead to a reduction in the costs of production bringing about an increase in supply.
If, for example a country discovers new oil reserves, there will be a rise in the supply of oil.

Question 53

Define PES.

Answer 53

Price elasticity of supply is a measure of the sensitivity or responsiveness of the supply for a product to a change in the price of the product.

Question 54

How is PES measured?

What is significant about the value of PES and why is this the case?

Answer 54

PES = Percentage change in quantity supplied / percentage change in price
PES will always have a positive value because price and quantity always move in the same direction, as the supply curve is upwards sloping.

Question 55

What is price inelastic supply?

What is the value of PES when supply is price inelastic?

Answer 55

Supply is said to be price inelastic when a percentage or proportional change in price of the product leads to a proportionally smaller change in the supply of the product.
When supply is price inelastic, the value of PES will be between 0 and 1.

Question 56

What is price elastic supply?

What is the value of PES when supply is price elastic?

Answer 56

Supply is said to be price elastic, when a percentage or proportional change in price leads to a proportionally greater change in the supply of the product.
When supply is price inelastic, the value of PES will be greater than 1.

Question 57

What is unit elastic supply?

What is the value of PES when supply is unit elastic?

Answer 57

Supply is said to be unit elastic when a percentage or proportional change in the price of the product leads to a change in supply which is proportionally equal.
When supply is unit elastic, the value of PES will be equal to 1 and the supply curve will be a straight line drawn through the origin.

Question 58

What is perfectly inelastic supply?

What is the value of PES when supply is perfectly price inelastic?

Answer 58

Supply is said to be perfectly price inelastic when a percentage or proportional change in the price of the product has no affect on the quantity supplied.
When supply is perfectly price inelastic, the value of PES will be 0 and the supply curve will be a straight line vertically upwards.

Question 59

What is perfectly elastic supply?

Answer 59

Supply is said to be perfectly elastic when an infinite amount could be supplied at a given price.
When supply is perfectly elastic the value of PES would be infinity and the supply curve would be horizontal.

Question 60

What factors may affect PES? (5)

Answer 60

1) Time
2) Stocks
3) Spare Capacity
4) Availability and cost of switching resources from one use to another.
5) Perishability of a product

Question 61

Explain how time may affect PES.

Answer 61

Elasticity of supply is likely to vary over time;. In the short run it is difficult to change supply in response to a price change, making supply price inelastic.
However, in the long run supply is likely to be more elastic because all factors of production are variable in quantity.

Question 62

Explain how stocks and spare capacity may affect PES.

Answer 62

If stocks of finished goods are available, supply will be relatively price elastic because manufacturers will be able to respond quickly to a price change.
If there is spare capacity in a firm such as under-utilised machinery then supply is likely to be more elastic.

Question 63

Explain how availability and cost of switching resources from one use to another may affect supply.

Answer 63

If resources such as labour, have specific skills or machines are highly specific, or it is expensive to re-allocate resources from one use to another, then supply will be relatively price inelastic.

Question 64

Explain how the perishability of a product may affect supply.

Answer 64

Some products cannot be stockpiled, e.g. fruit and vegetables due to their perishability. These products are typically inelastic in their supply.

Question 65

How is the equilibrium price and output of a product determined?

Answer 65

The equilibrium price and output of a product is determined by the interaction of the forces of supply and demand in the market. When the quantity supplied is equal to the quantity demanded, equilibrium is said to exist. The equilibrium price and quantity will not change unless there is a change in one for the conditions of demand or supply.

Question 66

What may cause a change in the equilibrium price?

Answer 66

A change in equilibrium price can be caused either by a change in one or more of the conditions of demand, causing the demand curve to shift. Or by a change in one or more of the conditions of supply causing the supply curve to shift.

Question 67

What would be the effect of an increase or decrease in demand on equilibrium price and quantity?

Answer 67

An increase in demand would cause a rightward shift in the demand curve, a rise in price and an increase in the quantity.
A decrease in demand would cause a leftward shift if the demand curve, a fall in price and a decrease in the quantity.

Question 68

What would be the effect of an increase or decrease in supply on equilibrium price and quantity?

Answer 68

An increase in supply would cause a rightward shift of the supply curve, a fall in price and an increase in quantity.
A decrease in supply would cause a leftward shift of the supply curve, a rise in price and a decrease in quantity.

Question 69

What are the key functions of the price mechanism? (4)

Answer 69

1) As a rationing device - market forces will ensure that the amount demanded is exactly equal to the amount supplied.
2) As an incentive - the prospect of making a profit acts as an incentive to firms to produce goods and sevrices.
3) As a signalling device - to producers to increase or decrease the quantity supplied.
4) To determine changes in wants - a change in demand will be reflected by a change in price.

Question 70

What is a market?

Answer 70

A market refers to all those buyers and sellers involved in the buying and selling of goods and services and making exchanges with each other to determine price. Markets may be local, national or global.

Question 71

What is consumer surplus?

Answer 71

Consumer surplus is the difference between how much someone is willing to pay and how much they actually pay, i.e. the market price. The consumer surplus is the area under the demand curve and above the market price.

Question 72

What is producer surplus?

Answer 72

Producer surplus is the difference between how much firms are willing to supply at each price and the market price. Producer surplus is the area between the supply curve and the market price.

Question 73

What factors may affect consumer surplus? (2)

Answer 73

1) The gradient of the demand curve, the steeper it is, the greater the consumer surplus will be.
2) Changes in the conditions of demand, an increase in demand will increase consumer surplus.

Question 74

What factors may affect producer surplus?

Answer 74

1) The gradient of the supply curve, the steeper it is, the greater the producer surplus will be.
2) Changes in the conditions of supply, an increase in supply will lead to an increase in producer surplus.

Question 75

What are indirect taxes?

What are the two types of indirect tax?

Answer 75

Indirect taxes are taxes on expenditure and include taxes such as VAT, excise duties and taxes on gambling. These taxes cause an increase in the costs of supply and so shift the supply curve to the left.

1) Specific tax
2) Ad valorem tax

Question 76

What is an Ad valorem tax?

What is a specific tax?

Answer 76

Ad valorem taxes are a percentage of the price of a good or service and will cause the supply curve to shift to the left.
Specific taxes is a set amount of tax on each unit consumed, the effect of a specific tax is to shift the supply curve to the left, parallel to the original curve.

Question 77

What is a subsidy>

Answer 77

A subsidy is money granted by the government to producers, in order to make production costs cheaper. This results in an increase in supply, shown by a rightward shift of the supply curve.

Question 78

Give five reasons why consumers may not behave rationally. (5)

Answer 78

1) Influence of other people’s behaviour
2) Habitual behaviour
3) Inertia - consumers may not make the effort to change because of an information overload, the complexity of the information available or the amount of choice available.
4) Consumer weakness at computation - people are easily influenced by recent events.

Question 79

What is behavioural economics and what are its implications?

Answer 79

Behavioural economics applies psychological insights into human behaviour to explain economic decision making.
Policy makers must focus more on the psychology of behaviour when devising policy.