Microeconomics: Price determination in a competitive market

Question 1

What is demand?

Answer 1

The quantity of a good or service that consumers are able and willing to buy at a given price during a period of time.

This varies with price as the lower the price, the more affordable the good so consumer demand increases.

Question 2

What does the demand curve show?

Answer 2

Price and Quantity demanded

Expansion in demand shows that if prices go down, demand increases because more people are willing and able to buy the good.

Contraction in demand shows that if prices go up, demand decreases because less people are willing and able to buy the good.

Question 3

What are factors that shift the demand curve?

Answer 3

Population
Advertising
Substitutes- if the price of the substitute falls, the quantity demanded for the original good will fall because consumers will switch to the cheaper option.

Interest rates- If the price of borrowing money increases, demand for high priced items will fall.

Fashion trends- demand for clothing items depends on the fashions at the time.

Income- for normal goods, demand rises as income rises. For inferior goods, demand rises as income falls. e.g. bus travel.

Complementary goods- goods where the demand is linked e.g. if the price of iPhone falls , the demand for air pods will rise.

Question 4

What 4 factors cause the demand curve to slope downwards?

Answer 4

Substitution effect
Income effect
Diminishing marginal utility
Seasonal factors

Question 5

What is the substitution effect?

Answer 5

As the price of a product decreases, it becomes more desirable compared to similar products so consumers are more likely to switch to the cheaper option, leading to an increase in quantity demanded.

Question 6

What is the income effect?

Answer 6

When the price of a product falls, consumers effectively have more real purchasing power allowing them to buy more of the product, leading to an increase in quantity demanded.

Question 7

What is diminishing marginal utility?

Answer 7

As people consume more of a particular product, the additional satisfaction/utility they derive from each additional unit starts to diminish meaning they are willing to pay less for each successive unit.
e.g. after buying so many pairs of shoes, consumer satisfaction starts to fall.

Question 8

What is effective demand?

Answer 8

Demand for a good/service from consumers that is backed up with an ability to pay.

Question 9

What is potential (latent) demand?

Answer 9

Demand is not yet expressed in the market-place because consumers do not have the ability to pay.

Question 10

What is derived demand?

Answer 10

Demand for a factor of production that is used to produce another good/service. The demand depends on the demand for the good/service they are used to produce.
e.g. the demand for economic teachers depends on the demand for students studying economics.

Question 11

What is joint demand?

Answer 11

Demand for one product is directly and positively related to market demand for a related good/service.
e.g. pasta and sauces
2 complements= joint demand
cross-price elasticity of demand= negative

Question 12

What is composite demand?

Answer 12

Goods that have more than one use.
An increase in market demand for one product can lead to a fall in market supply of the other as resources are switched.
e.g. milk is used for cheese, yoghurt, cream

Question 13

What does the right shift in demand show?

Answer 13

More is demanded at every price level

Question 14

What does the left shift in demand show?

Answer 14

Less is demanded at every price level

Question 15

What is supply?

Answer 15

Quantity of a good or service a producer is willing and able to provide at a given price.

Question 16

What is the law of supply?

Answer 16

For most products, quantity supplied varies directly with its price

Question 17

Why are supply curves upward-sloping?

Answer 17

If price increases, it is more profitable for firms to supply the good so supply increases

Higher prices encourage new firms to enter the market - seems profitable so supply increases.

Larger outputs mean that the firm’s cost increases so they can charge a higher price to cover the costs.

Question 18

What is extension in supply?

Answer 18

As price increases, quantity supplied increases.

Question 19

What is contraction in supply?

Answer 19

As price decreases, quantity supplied decreases.

Question 20

What is indirect tax?

Answer 20

A tax on spending e.g. VAT (on all non-essential goods), excise (taxes on petrol, cigarettes etc)

Question 21

What is direct tax?

Answer 21

A tax on income e.g. income tax, corporation tax etc

Question 22

What are the factors that shift the supply curve?

Answer 22

Productivity - if productivity increases, the quantity of supply increases e.g. better technology, education, and training

Indirect taxes - if Governments increase tax on a product, suppliers would supply less.

number of firms- If firms increase, supply increases

subides- cause an outward shift in supply

weather- favourable conditions will increase supply

Cost of production - If production costs increase, firms will reduce the amount they produce.

Government regulations- If Governments implement health and safety requirements, consumer protection increases but this increases the cost of firms.

Question 23

What is equilibrium price and quantity?

Answer 23

Supply meets demand

Question 24

What is market clearing price?

Answer 24

Firms are willing and able to supply at the price and consumers are willing and able to buy it.

Question 25

What is a shortage?

Answer 25

Demand is greater than supply as a result of lower prices

Question 26

What is surplus?

Answer 26

There is too much supply and not enough demand as the price is too high.

Question 27

What is price elasticity of demand (PED)?

Answer 27

The responsiveness of quantity demanded to a change in the price of a product.

Question 28

How is PED calculated?

Answer 28

Percentage change in quantity demanded / percentage change in price

Question 29

What are the key factors affecting PED?

Answer 29

Number of close substitutes
Addictiveness/habitual consumption
Degree of necessity
Proportion of income spent on the good
Cost of switching between products
Time period allocated for consumers to respond following a price change
Peak and off-peak demand (peak=inelastic, off-peak=elastic)
Breadth of definition of a good/service (narrow=inelastic, wider=elastic)
Method of payment (cash=elastic, card=inelastic)

Question 30

What does elastic demand show?

Answer 30

A change in price leads to a proportionally greater change in quantity demanded.
greater than (>) 1

Question 31

What does inelastic demand show?

Answer 31

A change in price leads to a proportionally lesser change in quantity demanded.
less than (<) 1

Question 32

What does unitary elastic show?

Answer 32

The quantity demanded changes at exactly the same rates as price.
1

Question 33

What does perfectly inelastic show?

Answer 33

The quantity demanded remains the same as the price changes i.e. demand is completely unresponsive to changes in price.
0

Question 34

What does perfectly elastic show?

Answer 34

Any quantity is demanded at a given price.
INFINITY

Question 35

What should a firm do if demand for a firm’s good is inelastic?

Answer 35

Increase prices to maximise revenue as this will lead to a proportionally smaller decrease in demand which increases revenue.

Question 36

What should a firm do if demand for a firm’s good is elastic?

Answer 36

Decrease prices to maximise revenue which will lead to a proportionally greater increase in demand which increases revenue.

Question 37

How is revenue calculated?

Answer 37

Price x quantity

Question 38

What is income elasticity of demand?

Answer 38

The responsiveness of quantity demanded to a change in income.

Question 39

How is income elasticity of demand calculated?

Answer 39

Percentage change in quantity demanded / percentage change in income

Question 40

What YED do normal goods have?

Answer 40

Positive which means YED>0. When incomes are falling, demand decreases.

Question 41

What YED do inferior goods have?

Answer 41

Negative YED>0, fall in demand as income increases e.g. “value” options at supermarkets.

Question 42

What YED do normal necessary products have?

Answer 42

Income inelastic, YED>0<1. Low but positive income elasticity.

Question 43

What should firms do if demand for a firm’s good is inelastic?

Answer 43

Increase prices to maximise revenue. This will lead to a proportionally smaller decrease in demand which increases revenue.

Question 44

What should firms do if demand for a firm’s good is elastic?

Answer 44

Decrease prices to maximise revenue. This will lead to a proportionally greater decrease in demand which increases revenue.

Question 45

What is cross price elasticity of demand (XED)?

Answer 45

Measures the responsiveness of the quantity demanded of one good to a change in the price of another related good.

Question 46

How is XED calculated?

Answer 46

% change in QD of A/ % change in price of B

Question 47

What XED do substitutes have?

Answer 47

Positive as an increase in the price of one product will lead to a rise in demand for its substitutes.

Question 48

What are strong substitute relationships?

Answer 48

Very responsive to each other- consumers quick to switch e.g. coke and Pepsi.

Question 49

What are weak substitute relationships?

Answer 49

A big price rise doesn’t have that much impact on demand- goods aren’t related e.g. Coke and Lemonade.

Question 50

What happens if XED is negative?

Answer 50

Two goods are complements e.g. fish and chips