Part 1. Topics in Demand and Supply Analysis

Question 1

Own price elasticity

Answer 1

The measure of responsiveness of the quantity demanded to change in price.

• with a downward sloping demand, an increase in price decreases quantity demanded, thus own quantity elasticity is negative.
• elastic - quantity demanded is very responsive to change in price (absolute value of elasticity > 1)
• inelastic - quantity demanded is not responsive to change in price (absolute value of elasticity < 1)
• perfectly elastic demand - at any higher price, quantity demanded decreases to zero.
• perfectly inelastic demand - a change in price has no effect on quantity demanded.

Question 2

Factors that affect demand elasticity:

Answer 2

1. The quality and availability of substitutes.
2. Portion of income spent on a good - the larger proportion of income spent on a good, the more elastic an individuals demand for good, i.e. housing costs.
3. Time - elasticity of demand tends to be greater the longer the time period since price change, e.g. if energy prices rise, adjustments are made quickly such as lowering thermostat, but over time better insulation, double glazing windows etc are more easily made, meaning effect of price change on consumption of energy is greater.

Question 3

Unitary elasticity

Answer 3

When price elasticity equals -1, the total revenue (price x quantity) is maximised at this price.

Question 4

Income elasticity

Answer 4

The sensitivity of quantity demanded to change income; this value is positive.

• rise in income, leads to increase in quantity demanded = normal goods
• rise in income, leads to decrease in quantity demanded = inferior goods

i.e. rise in Y - noodles to ground meat to preferred cuts of meat; or commercial airline to private jet.

Question 5

Cross price elasticity of demand

Answer 5

The ratio of percentage change in quantity demanded of a good, to percentage change in price of related good.

• substitutes (positive) = when an increase in the price of related good increases demand for a good, i.e. Bread A and B, an increase in price of one will lead consumers to purchase more of the other.
• complements - when an increase in price of related good decreases demand for good, i.e. an increase in price of automobiles, leads to decrease in demand for gasoline.
• the more positive the better substitutes the 2 goods are, the more negative the better complements the 2 goods are.

Question 6

Substitution effect

Answer 6

When the price of good X decreases, there is a shift of consumption towards more of Good X.

This will always act to increase the consumption of good that has fallen in price.

Question 7

Income effect

Answer 7

The total expenditure on consumers original bundle of goods falls when the price of Good X falls.

This effect can either increase or decrease consumption of a good that has fallen in price.

Question 8

Three possible outcomes of a decrease in price of Good X:

Answer 8

1. The substitution effect is positive, and income effect is also positive, the consumption of Good X will increase.
2. The substitution effect is positive, and income effect is negative but smaller than substitution effect - consumption of good X will increase.
3. The substitution effect is positive, and income effect is negative and larger than substitution effect - consumption of good X will decrease.

Question 9

Giffen good

Answer 9

• An inferior good for which negative income effect outweighs positive substitution effect when price falls.
• This has an upward sloping demand curve.
• at lower prices, a smaller quantity would be demanded as a result of dominance of income effect over substitution.

Question 10

Veblen good

Answer 10

A higher price makes the good more desirable, whereby the consumer gets utility from being seen to consume a good that has high status (e.g. Gucci bag).

Positive slop demand curve, over some range of prices otherwise there would be no price rise limit.

This does not violate the theory of consumer choice, but it is not an inferior good, so both substitution and income effect of price increase are to decrease consumption of the good.

Question 11

Factors of production

Answer 11

• Resources a firm uses to generate output.

These include:

1. Land - where business facilities are located.
2. Labour - includes all workers from unskilled labourers to top management.
3. Capital - manufacturing facilities, equipment and machinery.
4. Materials - inputs into productive process, including raw materials, such as iron ore or water, or manufactured inputs such as wire or microprocessors.

Question 12

Production function

Answer 12

The quantity of output that a firm can produce can be thought of as a function of the amounts of capital and labour employed.

Question 13

Long Run vs Short run

Answer 13

Short run = a time period over which some factors of production are fixed, i.e. capital, so firm cannot change scale of operations over the short run.

Long run = all FOP are variable, the firm can let its leases expire and sell its equipment, avoiding costs that are fixed in the short run.

Question 14

Short run shut down point

Answer 14

If AR is less than AVC in the short run, the firm should shut down.

Question 15

Long run shutdown point

Answer 15

if AR > AVC in the short run, the firm should continue to operate even if it has losses, but shutdown in LR if AR < ATC.

Question 16

Break even point

Answer 16

If AR = ATC, then TR = TC.

Question 17

Minimum efficient scale

Answer 17

The lowest point on the LRATC corresponds to the scale or plant size at which the average total cost of production is at its minimum.