How markets work

Question 1

What are the underlying assumptions of rational economic decision making?

Answer 1

• Consumers aim to maximise utility

- Firms aid to maximise profits

Question 2

What are the conditions of demand?

Answer 2

• Income
• Price of other goods
• Changes in population
• Changes in fashion
• Changes in legislation
• Advertising

Question 3

What is diminishing marginal utility?

Answer 3

The value, or utility, attached to consuming the last product bought falls as more units are consumed over a given period of time.

Question 4

What is the paradox of value?

Answer 4

When the price of necessities are lower than the price of unnecessary goods. (when goods are plentiful, consumers are only prepared to pay a low price as the last one consumed has low marginal utility.)

Question 5

What is consumer surplus?

Answer 5

The difference between the value to buyers and what they actually pay.

Question 6

What is the formulae to calculate price elasticity of demand?

Answer 6

% change in price

Question 7

What is the formulae to calculate income elasticity of demand?

Answer 7

% change in income

Question 8

What is the formulae to calculate cross elasticity of demand?

Answer 8

% change in price of good B

Question 9

How price elastic is demand if:

• PED : 1
• PED < 1
• PED > 1

Answer 9

• PED : 1 means unit elasticity (% change in price will lead to an exact and opposite change in quantity demanded)
• PED < 1 means inelastic (% change in price will bring a smaller change in quantity demanded)
• PED > 1 means elastic (% change in price will bring about an even larger % change in quantity demanded)

Question 10

How income elastic is demand if:

• value is between +1 and -1
• value is greater than +1 and lower than -1

Answer 10

• Value between +1 and -1 is income inelastic

- Value is greater than +1 and lower than -1 is income elastic

Question 11

What type of food will experience demand falling as incomes increase?

Answer 11

Inferior goods (always has a negative elasticity)

Question 12

How cross elastic is demand if:

• XED is positive
• XED is negative
• XED is zero

Answer 12

• XED is profit = substitutes
• XED is negative = complements
• XED is zero = unrelated

Question 13

What are the determinants of price elasticity of demand?

Answer 13

• Availability of substitutes
• Width of market definition (more broad = fewer subs)
• Time (longer time = price elastic)

Question 14

What are the conditions of supply?

Answer 14

• Cost of production
• Technology
• Prices of other goods
• Government legislation
• producer cartels (band together to limit supply to raise prices)

Question 15

What is producer surplus?

Answer 15

The difference between the market price which firms receive and the price at which they are prepared to supply

Question 16

How do you calculate price elasticity of supply?

Answer 16

% change in price

Question 17

How price elastic is supply if:

• PES : 1
• PES < 1
• PES > 1

Answer 17

• PES : 1 means unit elasticity
• PES < 1 means inelastic
• PES > 1 means elastic

Question 18

What are the determinants of elasticity of supply?

Answer 18

• Availability of substitutes
• Time (shorter the time = more difficult producers to switch)
• Short run and long run

Question 19

What are the functions of price mechanism to allocate resources?

Answer 19

• Rationing ; efficiently allocate resources
• Incentive ; encourage firms to increase supply
• Signalling ; shows where new resources are needed

Question 20

What impact do indirect taxes have on:

• consumers
• producers
• governments

Answer 20

• consumers ; increased prices
• producers ; decreased quantity and lower profits
• government ; increased revenues

Question 21

What impact do subsidies have on:

• consumers
• producers
• governments

Answer 21

• Consumers ; lower prices
• Producers ; increased quantity supplied
• Governments ; increased spending costs

Question 22

Why would consumers may not behave rationally?

Answer 22

• Influence of other people’s actions (influenced by social norms)
• Habitual behaviour
• Consumer weakness at computation (not always willing to make comparisons between prices)