Session 2

Question 1

What does the Demand and Supply model explain?

Answer 1

The demand and supply model explains how price and output are determined and how they adjust demand or supply conditions change

Question 2

If demand contracts, what happens to the demand curve?

Answer 2

It shifts to the left and if other things equal, we expect price and output to fall

Question 3

What happens if supply expands?

Answer 3

If supply expands, the supply curve shifts to the right and, other things equal, we expect price to fall and output to rise

Question 4

If supply expands, what happens to the supply curve?

Answer 4

If supply expands, the supply curve shifts to the right and, other things equal, we expect price to fall and output to rise

Question 5

What do we need to know in order to get a proper understanding of market behaviour?

Answer 5

To get a proper understanding of market behaviour, we need to know by how much demand and supply change when there are changes in market conditions

Question 6

What is the definition of price elasticity of demand?

Answer 6

For any product, price elasticity of demand is a quantitative measure of the change in demand that occurs when there is a change in the products own price

Price elasticity (εp) is measured as the percentage change in quantity demanded divided by the percentage change in price

εp=ΔQ/Q÷ΔP/P
suppose p falls from £10 to £8 and q rises from 100 to 140
ΔP/P = ‒ £2/£10 = ‒ 0.20 = ‒ 20% and ΔQ/Q = +40/100 = 0.4 = + 40%
εp = 40% ÷ ‒ 20% = ‒ 2.0, indicating that the percentage increase in Q is twice the percentage reduction in Q

Question 7

What is the definition of elastic and inelastic demand?

Answer 7

Elastic demand: demand that goes up or down according to depending on price of product

Inelastic demand: demand that doesn’t change

Question 8

Why is price elasticity a negative number?

Answer 8

Price elasticity is a negative number, because a change in price leads to a change in demand in the opposite direction

In practice the negative sign is often omitted, because it is assumed that everyone knows that a fall in price causes demand to rise

Question 9

In mathematical terminology for small changes, price elasticity is:

Answer 9

εp = (dQ/Q) / (dP/P)

This can alternatively be written as εp = (dQ/dP) × (P/Q)

Question 10

Draw a diagram of P vs Q and indicate age elastic and inelastic regions

Answer 10

Slide 37

Question 11

What is the elasticity at the mid point of a linear demand curve?

Answer 11

Elasticity is equal to unity (− 1) at the mid-point on a linear demand curve

Question 12

Draw a diagram to illustrate the relationship between price elasticity and slope

Answer 12

Slide 40

Although price elasticity and slope are not the same thing, over a given price range, the more shallowly sloped D1 is more elastic than D2.

Question 13

What is perfectly inelastic demand? Draw a diagram to illustrate it.

Answer 13

Perfectly Inelastic. A rise or fall in price has no impact on demand and price elasticity is zero

slide 41

(vertical demand line)

Question 14

What is perfectly elastic demand? Draw a diagram to illustrate it.

Answer 14

Perfectly elastic. At £10 consumers will buy any quantity. A rise in price causes demand to fall to zero and price elasticity is infinite

slide 41

(horizontal demand line)

Question 15

Tracing the Impact of an Increase in Supply DIAGRAM! and explain

Answer 15

Slide 42

1. Initial market equilibrium at p1/q1
2. supply rises from s1 to s2
3. With demand shown by d1, a new equilibrium is established at p2/q2
4. With demand more elastic at d2, a new equilibrium is established at p3/q3

Question 16

What are the determinants of price elasticity?

Answer 16

1. Availability of substitute goods…………demand is more likely to be elastic when there are lots of close substitutes available
2. Luxuries and necessities………….demand for necessities is likely to be price inelastic than the demand for luxury goods
3. Market definition………..the more widely narrowly we define a market, the greater the price elasticity is likely to be. For example, the demand for food is more inelastic than the demand for a particular type of food
4. Time………demand is likely to be more elastic in the long run than the short run, because buyers have more time to find substitutes and alter behaviour

Question 17

Explain the relationship between price elasticity and business revenues

DRAW DIAGRAMS TO EXPLAIN

Answer 17

slide 44-45

1. Price Elastic: if price falls (from £10 to £8) buyers spend more and the total revenue earned from the sale of the product rises from £1000 to £1120 (from £10 × 100 to £8 × 140). Demand is responsive to the price change and the revenue lost by selling units more cheaply is more than offset by the revenue gained from selling more units. The reverse is true for a price rise…..total business revenue falls
2. Price Inelastic: if price falls, total revenue falls from £1000 to £880. Because demand is not responsive to price, the revenue gained from the sale of extra units does not offset the revenue lost by selling units more cheaply. The reverse is true for a rise in price…..total business revenue rises.

Question 18

Changes in income lead to changes in _____

Answer 18

demand

Question 19

Income elasticity measures the responsiveness of demand to_______

Answer 19

Income elasticity measures the responsiveness of demand to income changes, measured as the percentage change in quantity demanded divided by the percentage change in income

Question 20

What is the definition of income elasticity?

Answer 20

Income elasticity measures the responsiveness of demand to income changes, measured as the percentage change in quantity demanded divided by the percentage change in income

εi=ΔQ/Q÷ΔI/I

If incomes rise by say 5% and the demand for product x rises by 10%, income elasticity is 5%/10% = 2

Question 21

What is the definition of normal goods?

Answer 21

Normal Goods…..the usual case, in which an increase in household incomes generates an increase in demand….income elasticity is positive

Question 22

What is the definition of inferior goods?

Answer 22

Inferior Goods……cases in which demand falls when incomes rise….and income elasticity is negative.

Question 23

What special characteristics do luxury goods possess over necessities?

Answer 23

Luxuries and necessities……as incomes rise and increasing proportion of the increase tends to be devoted to luxuries rather than necessities…..luxury goods tend to have a higher income elasticity than necessities

Question 24

What is the definition of cross-price elasticity?

Answer 24

The impact on demand arising from changes in the prices of other goods can also be expressed in elasticity terms

For 2 goods, x and y, the cross-price elasticity of demand for X is measured as the percentage change in the quantity of X demanded divided by the percentage change in the price of Y

εcp=ΔQx/Qx ÷ΔPy/Py

For substitute goods, cross-price elasticity is positive because a rise in the
price of Y leads consumers to switch to X

For complementary goods, such as tea and sugar, cross-price elasticity is negative, because a rise in the price of Y leads to a fall in the demand for Y and hence also a fall in the demand for the complementary good X

Question 25

When is cross-price elasticity negative and when positive?

Answer 25

Positive for substitute goods

Negative for complementary goods

Question 26

Can we calculate a preference elasticity of demand?

Answer 26

εPREF= ΔQ / Q ÷ ΔPREF /PREF

Tricky, hard to quantify!

Question 27

What is the definition of price elasticity of supply?

Answer 27

Price elasticity of supply is a measure of the responsive of supply to changes in price

Market supply is the total quantity supplied by all of the firms operating in the market

It is usual to suppose that an increase in price leads to an increase in quantity supplied

Price elasticity of supply is a measure of the responsive of supply to changes in price

It is measured as the percentage increase in quantity supplied divided by the percentage increase in price

We can think of supply as being elastic or inelastic, according to whether quantity supplied changes by a larger or smaller percentage than price

Question 28

What happens to supply quantities if there is an increase in price?

Answer 28

It is usual to suppose that an increase in price leads to an increase in quantity supplied

Question 29

What is inelastic and elastic supply? Draw diagram and explain!

Answer 29

Slide 51

Elasticity < 1
Inelastic Supply. Elasticity is less than 1 and any given percentage change in price rise leads to a smaller percentage change in quantity supplied

Elasticity > 1
Elastic Supply. Elasticity is greater than 1 and any given percentage change in price leads to a larger percentage change in quantity supplied

Question 30

Perfectly Elastic and Perfectly Inelastic Supply

diagrams and explain!

Answer 30

Slide 52

Perfectly Inelastic Supply. Elasticity is zero and any given percentage change in price leaves the quantity supplied unchanged

Perfectly Elastic Supply. Elasticity is infinite and firms will supply as much as people want to buy at the given price. At a lower price nothing is supplied.

Question 31

The longer the period of time considered, the greater the potential _________ of _______ and ________

Answer 31

Market adjustments take place over time and the longer the period of time considered, the greater the potential responsiveness of demand and supply

Question 32

What is the definition of short run?

Answer 32

The short run is a period during which the number of firms operating in the market is fixed and each firm operates with fixed capital capacity and a given technology

In the short run, firms can alter production by employing more or fewer people. Supply can therefore change, but only within the constraints of existing capacity and technology

Question 33

In the short run, firms can alter production by _____. What happens to supply?

Answer 33

….employing more or fewer people. Supply can therefore change, but only within the constraints of existing capacity and technology

Question 34

What is the definition of long run? What is supply in the long run?

Answer 34

The long run is a period during which existing firms can alter capacity, technology may change and new firms can enter the industry

In the long run, larger adjustments in production can occur and supply is more elastic than in the short run

Question 35

Explain how a technological innovation in farming increases supply DIAGRAM

Answer 35

Slide 56

1. Initial equilibrium at p1/q1
2. A technological innovation in farming increases supply. How are farm incomes affected?
3. With demand at d1, a new equilibrium is established at p2/q2 and farm revenues fall from (p1 ×q1) to (p3×q3)
4. With demand more elastic at d2, a new equilibrium is established at p3/q3 and farm revenues rise from (p1×q1) to (p2×q2)
5. How would farm incomes be affected by adverse weather conditions that caused a reduction in supply?

Question 36

Explain the impact of a tax on cigarettes DIAGRAM

Answer 36

SLIDE 57

Inelastic Demand
Price rises substantially but demand falls by a much smaller percentage
Smokers spend more of their income on cigarettes (p2×q2) > (p1×q1)

Elastic Demand
Priceriseislimited,anddemandfallsby a much larger percentage
Smokers spend less of their income on cigarettes (p3×q3) < (p1×q1)