Theme 1.2

Question 1

What is demand?

Answer 1

This is the quantity of a good or service purchased at a given price over a given time period. Demand is different a want, as it is backed by the ability to pay. This is known as effective demand.

Question 2

What does a demand curve show?

Answer 2

This shows the quantity of a good or a service which would be bought over a range of different price levels over time.

Question 3

Why does the demand curve slope downwards from left to right?

Answer 3

As the price falls, the good becomes cheaper in comparison to substitute goods, and more can be purchased with a given level of income.

Question 4

What is on the x and y-axis of a demand curve diagram?

Answer 4

Price is on the y-axis. Quantity is on the x-axis.

Question 5

What is the horizontal demand curve?

Answer 5

This is the horizontal summation of each individual demand curve for a particular good or service.

Question 6

What is a contraction in demand?

Answer 6

When price rises and quantity demanded falls.

Question 7

What is an extension in demand?

Answer 7

When price falls and quantity demanded increases.

Question 8

What is marginal utility?

Answer 8

This is the utility or satisfaction obtained from consuming one extra unit of a good or service.

Question 9

What is diminishing marginal utility?

Answer 9

As successive units of a good are consumed, the utility gained from each extra unit will fall. The total utility will still increase, but it occurs at a diminishing rate (it won’t increase as much as it did after the previous unit).

Question 10

What are the two shifts in demand curves?

Answer 10

Shift to the right (demand increases).
Shift to the left (decrease in demand).

Question 11

What may cause an shift in demand to the right (increase in demand)

Answer 11

• Fall in price of complementary goods
• Rise in price of substitute goods
• Change in fashion and taste which makes certain things more popular.
• Increased advertising
• Increase in real incomes
• Decrease in income tax
• Increase in population or change to the age structure
  -Increase in credit facilities.

Question 12

Could a demand curve ever slope upwards?

Answer 12

Yes, this is due to the ‘snob effect’. People gain from value from having other people notice that they are rich enough to consume these goods. Eg Rolex watches.
Sometime known as conspicuous consumption or the Veblen effect.

Question 13

What happens to demand for normal goods when income rises?

Answer 13

Demand increases. A normal good is something like a restaurant meal or holiday.

Question 14

What happens to demand for inferior goods when income rises?

Answer 14

These fall in demand. E.g using public transport or shop-branded food items.

Question 15

How is a increase in demand different to a increase in the quantity demanded?

Answer 15

Increase in demand is a shift in demand bought about by a condition of demand (e.g income). However, increase in quantity demanded refers to a change in price (movement along the curve)

Question 16

What is the equation for price elasticity of demand?

Answer 16

Price elasticity of demand = % change in quantity demanded of good A/percentage change in price of good A.

Question 17

What is Price elasticity demand?

Answer 17

This is the responsiveness of demand for a good or service to a change in its
price.

Question 18

What are the types of price elasticity demanded?

Answer 18

-Elastic
-Inelastic
-Unit elasticity
-Perfectly inelastic
- Infinite (perfectly elastic)

Question 19

What is elastic price demand?

Answer 19

This is if the PED is greater than 1. Quantity demanded changed by a larger percentage than
price.

Question 20

What is inelastic price demand?

Answer 20

When the PED is between 0 and 1. This means the percentage change of quantity demanded is smaller than the percentage change in price.

Question 21

What is unit elasticity of demand?

Answer 21

If the PED is equal to 1. Percentage change in demand is equal to the percentage change in
price when this occurs.

Question 22

What does it mean if the price elasticity of demand is perfectly inelastic?

Answer 22

PED is equal to zero. The change in price has absolutely no effect on the quantity demanded.

Question 23

What is perfectly price elastic in demand?

Answer 23

This is when any change in price would cause the demand to fall to zero.

Question 24

How does elasticity change along a straight-line demand curve?

Answer 24

Elasticity falls as you move along the curve from the top left to the bottom right. When you’re at the mid point, demand has unit elasticity.

Question 25

What is total revenue?

Answer 25

This is the price per unit of a good multiplied by the quantity sold.

Question 26

Why is it important for firms to know the PED of their product when making pricing decisions?

Answer 26

The total revenue of certain goods will be higher or lower at certain prices depending on its PED. Total revenue will be higher for an inelastic good when the price is higher, however for an elastic good total revenue will be higher at a lower price, where the quantity demanded is higher.

Question 27

What is marginal revenue?

Answer 27

This is the revenue gained by a firm from selling one extra unit of output.

Question 28

What does it mean when unit elasticity has been reached in terms of total revenue?

Answer 28

When at unit elasticity, total revenue has been maximised. When the marginal revenue is positive, demand is price elastic. When the margin revenue is negative, the demand is price inelastic.

Question 29

What does it mean when marginal revenue is zero?

Answer 29

This means that the demand is unit elasticity.

Question 30

What are the determinants of PED?

Answer 30

-Availability of substitutes. If there are many substitutes for the product it will likely have a demand that is price elastic. There will be more substitutes the more a good is defined. E.g Heinz ketchup has more substitutes than ketchup on a whole would.
-Luxury and necessity goods. Luxury goods will be price elastic, where as necessity goods will be price inelastic.
- % of income spent on good. If a high % of income is spent on the good, it’s demand will be price elastic. A small part of your income and the goods demand will be price inelastic.
-Addictive/habit forming. Alcohol, tobacco etc will most likely have a demand that is price inelastic.
-Time period. Most goods will be less elastic in demand in the short term than the long term. This is because in the long term people have more time to make changes meaning they no longer need to use the good which has gone up in price, so it’s demand falls.
Brand image - Goods with a strong brand image are more likely to have goods which have a demand that is price inelastic.

Question 31

What is income elasticity of demand? (YED)

Answer 31

This is the responsiveness of demand for a good or service to a change in real income. Real income is the spending power of money income - and amount of goods and services that can be purchased with the income.

Question 32

What is the equation of YED?

Answer 32

Percentage change in demand for a good / percentage change in real income

Question 33

What is the YED of normal goods?

Answer 33

In most cases the YED is positive. The two variables of income and demand move in the same direction. A rise in income causes a rise in the normal good demanded. Some economists say if the YED is >1, it is a luxury good. This is still a type of normal good.

A good with a YED <1 is income inelastic of demand.

A good with a YED = 1 means it has unit elasticity.

Question 34

What is the YED of inferior goods?

Answer 34

Usually, for inferior goods the YED would be negative, as the values move in opposite directions. This is because as incomes rise, people tend to demand higher-quality goods and substituting them in for the lower quality (inferior) goods. An example of an inferior good is public transport, as people will buy a car when they can afford the quality of a car.

Question 35

What is cross elasticity of demand? (XED)

Answer 35

The responsiveness of demand for good B to a change in price of good A. This is used to determine if goods are compliments or substitutes of each other.

Question 36

What is the equation for XED?

Answer 36

% change in demand for good B/ % change in price for good A.

Question 37

What is the XED of a substitute good?

Answer 37

XED is positive for substitute goods, this is because the two variables for price and demand will move in the same direction. There is a positive gradient. An example is a rise in the price of coffee will cause a rise in the demand of tea.

Question 38

What is the XED of a complimentary good?

Answer 38

XED is negative, as the two examples move in opposite directions. For example, as the cost of tennis rackets increases, the demand for tennis balls will decrease.

Question 39

What is the XED of unrelated goods?

Answer 39

Zero. If they’re unrelated, a price increase in good A will have absolutely no affect on the demand of good B. For example, if microwaves increased in price, the demand for cigarettes would not change.

Question 40

What is supply?

Answer 40

This is the quantity of a good or a service that firms are willing to sell at a given price and over a given time period.

Question 41

What does a supply curve show?

Answer 41

This shows the quantity of a good or service that firms are willing to sell to a market over a range of different price levels in a given period of time. The supply curve shifts upwards from left to right, as when a firm raises output in the short run, they then face rising production costs and pass them onto consumers by charging higher prices. As well as this, as price rises, it encourages firms to supply more of a good to increase profits.

Question 42

What may higher prices cause a firm to do?

Answer 42

Higher prices may encourage firms to enter a market and so raise supply.

Question 43

What does the movement along a supply curve show?

Answer 43

This movement along a supply curve is ONLY when there is a change in price. A rise in price causes an extension in supply, and a fall in price causes a contraction in supply.

Question 44

What factors could cause a shift in supply?

Answer 44

-Improvement in technology
- Change of labour costs
- Change in capital costs
- Change in transport costs
- Discovery of new resources
- Change in the number of firms in an industry
- Change in laws surrounding the industry
- Weather conditions (for for agricultural industries)
- Change in taxation on the industry/land
- Change in government subsidies.

Question 45

What is price elasticity of supply? (PES)

Answer 45

This is the responsiveness of the supply of a good to a change in its price.

Question 46

What is the equation for PES?

Answer 46

% change in supply of a good/ % change in price of a good.

Question 47

What do different PES values mean?

Answer 47

> 1, good is relatively price elastic
= 1, unit elasticity
<1, the good in price inelastic.

Question 48

What factors determine the PES?

Answer 48

-Level of spare capacity. A large amount of spare capacity means that a firm can raise its production quickly.
- State of the economy. In a recession there’s many unemployed resources and therefore a high level of spare capacity.
- Level of stock of finished goods. A high level of stocks means a firm can quickly increases supply, so the supply is price elastic. An example of this is car companies, who stock cars.
-Perishability of the product. Some goods cannot be stockpiled, e.g fruit, as it will go off.
- Ease of entry to an industry
- Time period in consideration. Many products will be supply inelastic in the short term, but will become more price elastic in the long term.

Question 49

Why may minerals be price inelastic in the short term but price elastic in the long run?

Answer 49

The time taken to explore and find as well as extracting certain minerals may take time to do. However, once they have started extracting them, they can be done efficiently and the supply will then become price elastic.

Question 50

How is price determined?

Answer 50

Price is determined through the interaction of demand and supply in a competitive market. An equilibrium price and quantity occurs when there’s a balance in the market. There’s no tendency for price or quantity to change. This point occurs at the point of intersection between the demand and supply curves.

Question 51

What is the equilibrium price?

Answer 51

This is the price where the quantity demanded equals the quantity supplied for a good or service in a market.

Question 52

What is excess supply?

Answer 52

This is where the quantity supplied exceeds the quantity demanded for a good at the current market price.

Question 53

What is excess demand?

Answer 53

This is where the quantity demanded exceeds the quantity supplied for a good at the current market price.

Question 54

What is the ‘invisible hand’?

Answer 54

This was suggested by Adam Smith. It says the the price mechanism automatically eliminates surpluses and shortages of a good.

Question 55

What is price?

Answer 55

This is the exchange value for a good or a service.

Question 56

What is price mechanism?

Answer 56

This is the use of market forces to allocate resources in order to solve the economic problem of what, how and for whom to produce.

Question 57

What does the price mechanism refer to?

Answer 57

This is the way that price responds to the changes in demand and supply for a product or factor input, so that a new point of equilibrium can be reached. It is the principle method of allocating resources in a market economy.

Question 58

What are the functions of the price mechanism?

Answer 58

• A rationing device. Resources are scarce, and their supply is limited. The price mechanism allocates these goods and services to those prepared to pay the most for them. In effect, price will rise or fall until equilibrium reached between
• An incentive device. Rising prices tend to act as an incentive to firms to produce more of a good or service, since higher profits can be earned. These rising prices all allow firms to be able to cover the cost of increasing the output.
• A signalling device. The price mechanism indicates changes in the conditions of demand and supply. Eg, an increase is demand for a good or service raises its price and encourages firms to expand their supply, where as a decrease in demand will cause firms to decrease their supply. As a result, fewer resources are are allocated to the production of a particular good or service.

Question 59

What is consumer surplus?

Answer 59

This is the extra amount of money that consumers are prepared to pay for a good or service above what they actually pay. The utility of satisfaction gained from a good or service in excess of the amount payed for it.

Question 60

What is producer surplus?

Answer 60

This is the extra amount of money paid to producers above what they’re willing to accept to supply a good or service. It’s the extra earnings obtained by a producer above the minimum required for them to supply a good or a service.

Question 61

How does an increase in demand change producer and consumer surplus?

Answer 61

An increase in demand for a good is likely to raise producer and consumer surplus.

Question 62

How would a decrease in supply effect consumer and producer surplus?

Answer 62

A decrease in supply is likely to reduce consumer and producer surplus.

Question 63

What is an indirect tax?

Answer 63

This is a tax imposed on goods or services supplied by businesses. This includes both specific and ad valorem taxes. The purpose of taxes is to raise funds in order to pay for government spending programmes.

Question 64

What is a direct tax?

Answer 64

This is levied directly on an individual or organisation. Direct taxes are generally paid on incomes, e.g income tax and corporation tax.

Question 65

What is a specific tax?

Answer 65

This is a fixed amount per unit of a good, e.g a litre of wine or packet of cigarettes.

Question 66

What is an Ad Valorem Tax?

Answer 66

This is charged as a percentage of the price of a good. E.g VAT is 20%.

Question 67

What do taxes do to a supply curve?

Answer 67

They shift the supply curve to the left, this is because the price rises per unit in order to pay for the tax.

Question 68

What is the incidence of tax?

Answer 68

This is the distribution of tax paid between producers and consumers. It usually falls partly on consumers and party on the producers. This ratio will change depending on how elastic the demand and supply of the product is. For an inelastic demand product such as cigarettes, the firm can pass most the of the tax cost onto the consumers.

Question 69

What is the negatives of high amount of indirect tax on elastic demand and elastic supply products?

Answer 69

As most of the tax burden is placed on producers, it may also lead to a significant reduction in output and therefore also production. As a result, the government may be reluctant to place high indirect taxes on these goods and services.

Question 70

What is a subsidy?

Answer 70

This is a government grant to firms, which reduced the production costs and encourages an increase in output. These are often given to public transport companies in order to increase the amount of services. These directly benefit the producer, but also indirectly benefit the consumers who get reduced prices.

Question 71

Is a subsidy more effective for elastic or inelastic price demand?

Answer 71

If the demand is price inelastic, then the market price falls by a relatively large amount, increasing the benefit to consumers. If the demand is price elastic, then there is less gain to consumers, but the quantity demanded increases, giving the producer a greater gain.

Question 72

What is the alternative views of consumer behaviour?

Answer 72

Economists often assume that consumers behave in a rational manner and would therefore allocate their income to buy goods and services which maximise their utility. Rational economic decision making comes from a deductive approach to the subject, where models are made based on how consumers are expected to behave and that their aim should be to maximise total utility.

However, an inductive approach to economics starts by investigating how consumers ACTUALLY behave, and how consumers don’t always act in a rational way. They often aim to reach a satisfactory level of utility rather than maximising utility.

Question 73

How does other peoples behaviour influence your own decisions….

Answer 73

Consumers are influenced by the behaviour of others. For example, if some people start buying a share in a particular company, others may follow even if this causes it to become less of a bargain due to the price rising. This is due to a ‘herd’ mentality which is often displayed that consumers who arrive too late gain a little benefit. An example is the property market, where you will lose out if you buy at the peak of an economic cycle.

Question 74

What is the importance of habitual behaviour on consumer behaviour?

Answer 74

-Consumers are creatures of habit and prefer what they know and have, rather than risking something new with uncertainty. An example of this would be switching bank accounts to get lower charges, or energy supplier for lower prices.
- This consumer inertia could also be explained through the difficulties involved in change, like mistakes in final bills and switchover as well as lots of time spent filling out forms. Many consumers prefer doing nothing.
- Consumers also prefer thinking in the short term - they’re often unrealistic about their future behaviour. An example is overweight adults. They expect to change their habits and eat less in the near future, but they often don’t and remain overweight, which leads to long-term health issues. This is because the short term benefit is overvalued and the long term cost is under-estimated, as well as undervaluing the long term benefit received if you don’t get the short term benefit.

Question 75

How does consumer weakness at computation affect consumer behaviour?

Answer 75

-Humans have limited processing skills - this means that they can struggle to work out what is actually the best buy for them. For example, bulk buying isn’t always the cheapest option but many people don’t realise and will buy the biggest packet anyway rather than multiple smaller packets.
-Imperfect market knowledge - This often underlies the weakness that some consumers display in computation. Consumers may buy a good at a higher price than necessary or a good of lower quality since they do not have full market knowledge on which they base their decisions. As a result, some markets will operate inefficiently.