Markets and competition Flashcards
Suppose a consumer has a budget of £20 and partakes in a market where only Apples and Bananas are sold for £1 and £2 respectively.
Describe the “budget set” and “budget line”.
Let Apples be the X-axis and Bananas the Y-axis of an X/Y plane.
Budget set: The budget set captures all possible bundles of Apples and Bananas the consumer can purchase with their £20.
Budget line: All bundles of Apples and Bananas where the consumer spends all their £20.
Briefly define the slope of the budget line, what factors influence this and how, and the name of this slope.
The slope of the budget line is defined by the ratio of prices between the two goods on the X and Y axis.
If the price of the X axis good increases (Y axis good decreases), the slope steepens as less (more) can be bought for the given price, shifting the point where the budget line intercepts the axis left (up). Vice versa.
The name of this slope is the “market rate of exchange” between the two goods.
Explain the concept of an “indifference curve” and how they interact with the idea of utility maximisation. Also, name the slope of this curve.
An indifference curve is normally a concave curve (well-behaved preferences) describing all bundles of goods X and Y that provide a consumer with equal utility - hence their indifference between the options.
Utility maximisation dictates that an individual will choose the cheapest of these options in accordance to continuity, completeness, and transitivity.
The indifference curve’s slope is called the marginal rate of substitution (or colloquially, the personal rate of exchange).
Imagine the indifference curve of an individual with well-behaved preferences between two goods X and Y.
Describe how the nature of well-behaved preferences influence the trade of X for one unit of Y when the individual has:
A lot of X and few Y,
Few X and a lot of Y.
Well-behaved preferences are concave to the origin of the X/Y plane.
Such an individual would be willing to trade a lot of X for one more Y when they have plenty X, but the amount of X they’d be willing to trade for one more Y decreases as their stock of X decreases.
Describe how an individual with well-behaved preferences maximises utility for any given budget set?
They choose a bundle where the indifference curves rests on the budget line.
More technically: The point where the slopes of the budget line and indifference curves are equal; where the marginal rate of substitution equals the marginal rate of transformation (MRC = MRT).
Describe how an increase in income impacts the purchase of normal and inferior goods. What technical phrases are used to describe these outcomes?
For normal (inferior) goods, and increase in income leads to more (less) being purchased. This is described as a positive (negative) income elasticity of demand.
You have two goods, A and B. Suppose the price of A decreases while B stays fixed. What two effects on the budget set will this have?
Slope change: As the price of A falls, the slope of the budget set changes to reflect the changed market rate of exchange between the goods. This is the “substitution effect” - as the rate at which one good can be substituted for another changes.
Purchasing power: As the price of A falls, the maximum amount of A the consumer can buy with a fixed income increases. This is the “income effect”, as the purchasing power of money has changed.
Given two goods, A and B, and considering just the substitution effect, what would the impact of A’s price decreasing do to demand for A at the margin?
With A’s fall in price, the opportunities for trading B for A are better (as you can get more A for one unit of B). This would lead the individual to demand more of A and less of B.
This effect is consistent no matter the good type. In general - the change in demand due to the substitution effect is always opposite the change in price.
Given two goods, A and B, and considering just the income effect, what would the impact of A’s price decreasing do to demand for A a the margin? Does anything impact this effect?
A decrease in A’s price increases the purchasing power of the consumer’s money - this is analogous to an increase in their income. Therefore, what happens to demand depends on whether good A is normal or inferior.
If A is a normal good, a decrease in A’s price (analogous to income increase) will increase demand.
If A is an inferior good, then a decrease in price will decrease demand.
Suppose the price of A decreases. Describe, in terms of substitution and income effects, what happens to overall demand is A is normal or inferior. Also, highlight the conditions for A to be classed as a Giffen good.
Normal: - Price = + Sub. and + In. = + Demand.
Inferior: - Price = + Sub. and - In. = ? Demand.
Giffen: A Giffen good is so inferior the negative income effect of a decrease in price outweighs the positive substitution effect and price decreases overall.
Examples of Giffen goods are basic foodstuffs like rice. A fall in price has a small substitution effect (they are essential staples) but the increase in purchasing power leads consumers to replace rice with fancier alternatives.
Suppose A and B are substitutes and the price of A increases. Describe what happens to demand for B when B is a normal good?
Normal: + Price = + Sub. and - In. = ? Demand
Technically, the outcome of A’s price changing determines on whether B is normal or inferior.
However, as A and B are substitutes it is assumed a change in the market exchange rate (slope of the budget line therefore substitution effect) will outweigh any income effect impacts.
Suppose A and B are compliment and the price of A increases. Describe what happens to demand for B when B is a normal good?
Normal: + Price = + Sub. and - In. = ? Demand
Technically, the outcome of A’s price changing determines on whether B is normal or inferior.
However, as A and B are compliments it is assumed a change in the buying power of money (income effect) exceeds the change in market rate of exchange thus demand for B falls.
Define the “price elasticity of demand”. What does the PED influence about the demand curve?
PED = % change in demand / % change in price.
PED influences the slope of the demand curve. PED of 1 (unit elasticity) gives a 45 degree line. PED > 1 (elastic demand) gives a shallow curve. PED < 1 (inelastic demand) gives a steep curve.
What two factors mainly influence the price elasticity of demand for a good?
The number of alternatives to the good and what proportion of income the good usually takes up.
A good with more alternatives will have more elastic demand. A good taking up a large proportion of your income will also have elastic demand, as people will be quick to seek alternatives if prices increase.
Price elasticity of demand depends on the time period you observe. What key differences in PED are there between the short and long term?
In the short term PED can be any form of elasticity based on initial market reactions. In the long term, it is assumed alternatives will be sought after ensure PED is elastic in the long run.
