Theme 1.3 - Introducing the market: the price mechanism

Question 1

What is a market?

Answer 1

Any medium in which buyers and sellers interact and agree to trade at a price.

Question 2

Define demand.

Answer 2

The quantity of a good or service that people are willing and able to buy at a given price.

Question 3

Define market demand.

Answer 3

The sum of all individual demands for a particular good or service.

Question 4

What are private benefits? Give 2 consumer objectives.

Answer 4

Benefits that accrue to an individual or firm through economic activity.
- Maximisation of private benefit from consumption.
- Maximisation of private benefit from working.

Question 5

Describe a typical demand curve.

Answer 5

As price increases, the quantity demanded decreases (price is on the y-axis).

Question 6

What is a normal good?

Answer 6

Where price rises, demand falls and vice versa.

Question 7

What is a Veblen good?

Answer 7

Where price rises but demand still rises (luxury products).

Question 8

What is the rational choice theory?

Answer 8

The assumption that all individuals make logical decisions that maximises their private benefits.

Question 9

What are the determinants (factors) of demand?

Answer 9

• Price of a good
• Consumer income
• Price of other goods
• Consumer tastes/fashion
• Others e.g. advertising

Question 10

What is the equation for quantity demanded?

Answer 10

qd = f (p, y, p of other goods…)

qd = quantity demanded
f = a function of
p = price
y= consumer income

Question 11

Define ceteris paribus.

Answer 11

The idea that all other factors remain the same

Question 12

What is a substitute product? How do these affect the demand curve?

Answer 12

A product that acts as an alternative, creating competition.
E.g. if the price of Coca Cola goes up, the demand curve shifts to the left but the demand curve for Pepsi will shift to the right.

Question 13

What is a complementary product? How do these affect the demand curve?

Answer 13

A product bought alongside a good/service.
E.g if the price of fish goes up, the demand for chips will decrease, causing the demand curve to shift left.

Question 14

If real incomes increase, how does this affect demand and demand for inferior goods?

Answer 14

• Demand will generally increase.
• Demand for inferior goods decrease as people can afford branded products.

Question 15

What is a Giffen good?

Answer 15

• As the price increases, demand still increases regardless of consumer income.
• Giffen goods are rare forms of inferior goods that have no ready substitute or alternative, such as bread, rice, and potatoes.

Question 16

How does changes in tastes and fashion affect the demand curve?

Answer 16

More fashionable products will experience an increase in demand.

Question 17

How does changes in size and age distribution of the population affect the demand curve?

Answer 17

• Demand for goods will change with population size.
• Different demographics will see a change in demand.

Question 18

How does advertising and branding affect the demand curve?

Answer 18

The demand curve will shift to the right through brand awareness and loyalty.

Question 19

What is supply?

Answer 19

The amount of a good or service that producers are willing and able to provide, at a given price, at a given time.

Question 20

What is market supply?

Answer 20

The total output of all individual suppliers of a particular good or service.

Question 21

What is the supply curve?

Answer 21

It shows the relationship between price and quantity supplied. As price increases, the quantity supplied increases.

Question 22

What causes a movement along the supply curve and what causes a shift in the supply curve?

Answer 22

• A change in price causes movement along a supply curve.
• A shift can be caused by several factors and can alter the level of supply.

Question 23

What are the determinants of supply in a market?

Answer 23

• Price of a good
• Impact of changing costs of production
• Technology
• Prices of other goods and services
• Government policies e.g. tax and subsidies
• Others e.g. the expectations among producers of future prices.

Question 24

How do production costs affect the supply curve?

Answer 24

If production costs increase, the supply curve shifts upwards and left as it decreases the quantity suppliers will offer at any price.

Question 25

How does technology affect the supply curve?

Answer 25

The supply curve will shift to the right as technology helps to reduce unit costs

Question 26

What are indirect taxes and how do these affect the supply curve?

Answer 26

Indirect taxes increase the cost of production, so the quantity supplied of that product will decrease. Supply curve will shift to the left.

Question 27

What are subsidies and how do these affect the supply curve?

Answer 27

A subsidy is a direct/indirect payment to an individual/ firm, usually cash from the government or targeted tax cut. Supply curve will shift to the right.

Question 28

How does the amount of firms in an industry affect the supply curve?

Answer 28

As more firms enter the market, the supply curve will shift to the right.

Question 29

What are external shocks and how does this affect the supply curve?

Answer 29

These are unexpected events outside of a firm’s control but have a direct impact on supply, causing the curve to shift to the left.

Question 30

Define specific tax. How does it affect the supply curve?

Answer 30

Specific tax is charged as a fixed amount per unit.
E.g. 50p/ can of drink.
The supply curve will shift upwards.

Question 31

Define ad valorem tax.How does it affect the supply curve?

Answer 31

Ad valorem tax (% tax) is charged as a percentage of the price of a good. So the more expensive the product, the greater the tax levied on it.
E.g. VAT (20%) is a type of ad valorem tax.
The supply curve will shift upwards but will be tilted to have a larger gradient.

Question 32

What is the equilibrium point?

Answer 32

The point where the demand and supply curve meet.

Question 33

What is the equilibrium/ market clearing price?

Answer 33

The price where there will be no unsold stocks and customers will be able to buy all they demand at that price. By definition, the market clears.

Question 34

In market economies, what do prices guide?

Answer 34

The allocation of resources. They indicate clearly to suppliers when consumers want more or less of their product.

Question 35

What is excess supply and what does this look like on the graph?

Answer 35

• Where there is a surplus of a good or a service and suppliers are unable to clear the market as prices are too high.
• Draw lines where the equilibrium price is. Draw lines where the price is higher. The distance between the 2 lines on the x-axis represents excess supply.

Question 36

What is excess demand and what does this look like on the graph?

Answer 36

• Where there is a shortage of a good/service and the market is failing to clear as the prices are below the equilibrium level.
• Draw lines where the equilibrium price is. Draw lines where the price is lower. The distance between the 2 lines on the x-axis represents excess demand.

Question 37

What is the only factor that causes a movement, not a shift on the supply and demand curves?

Answer 37

Price

Question 38

What is the fallacy of composition?

Answer 38

When an economist infers something is true for the whole from information derived from one part.

Question 39

Describe the operation of market forces to eliminate excess demand and supply. Use the example of cars and petrol.

Answer 39

• Income rise
• Car sales go up (excess demand)
• More petrol demanded
• Petrol price goes up (movement up the demand curve)
• Oil companies increase supply to earn more profit (movement up the supply curve, equilibrium restored)
• Oil companies open new wells and access more expensive oil (excess supply)
• Supply increases as prices are high.
• Prices go back down to restore equilibrium.

Question 40

What are the limitations of the supply and demand model?

Answer 40

• It’s only a model that is a simplified demonstration of a set of complex events.
• It looks only at competitive markets when in real life, competition in the market varies.
• Ceteris paribus - other variables change in a dynamic economy.
• It assumes businesses and individuals have full information when making economic decisions.