Price Elasticity of Demand

The sign of the price elasticity of demand is always negative because of the law of demand. As you remember, the law of demand states that an increase in the price of a good causes the quantity demanded of the good to fall. In the example above, the sign of the elasticity is shown with plus sign due to the common practice of dropping the negative sign in economics.

Consumer must consider factors other than his or her own tastes or preferences or choices. These factors, such as prices of commodities and the level of the consumer’s income, can limit or constrain the nature and size of the market basket that he or she can buy. The correct answer is C.

Price elasticity of demand is also affected by how the consumers view a good or service a necessity or luxury for themselves. Necessities tend to have inelastic demand and luxuries tend to have elastic demand. Education and health services (doctor visits), heating in the winter, gasoline for car owners are considered necessities for consumers and these items have inelastic demand since the case of price increases in these items gets small reactions from consumers to cut their quantity demanded. On the other hand, for the items that is considered as luxury for the consumers, a price increase gets a substantial response from the consumers’ demand. The correct answer is C.

Consumer preferences or choices have changed from time to time and to understand what accounts for these changes, as well as consumer choice or preferences more generally, it is important to outline several fundamental principles underlying consumer behavior. We also mentioned that these changes find their reflection through an indifference curve that measures the satisfaction of consumers via utility. Moreover, we, as consumers, have a goal in life, which is to maximize our utility subject to our budget constraint. When we go to the store, we pick the basket that we like best and that stays within our budget. Therefore, this section underlies the basic assumptions that economists make about the nature of the consumer’s tastes or preferences.

Ceteris paribus, increase in input prices shifts supply curve to the left while demand stays the same. Therefore equilibrium price increases and equilibrium quantity decreases.

The conventional demand curve is that the lower the price, the higher the quantity demanded. This relationship follows the law of demand. It states that the quantity demanded will drop as the price rises, ceteris paribus, or  “all other things being equal.” The relationship between quantity and
price will follow the demand curve as long as the four determinants of demand don’t change. These determinants are:
1. Price of related goods or services. 
2. Income of the buyer.
3. Tastes or preferences of the buyer,
4. The expectation of the buyer, especially about future prices.

The true answer is A.

?P d = %?Qd/%?P = 15%/10% =1.5. Answer is D.

There are a number of non-price factors that determine supply and that lead to an actual shift of the supply curve to either the right or the left. Whenever we look at a change in one of the determinants, we always make the ceteris paribus assumption. Some of these determinants are: input prices, technology, expectations of producers and/or sellers and number of sellers. Income is a factor determining demand. The correct answer is B.

Properties of Indifference Curves

The valuation of a good declines as it is consumed more intensively—therefore, indifference curves are always convex. As we noted above, the slope of the indifference curve represents the willingness of the individual to substitute one good for the other. This is also defined as the marginal rate of substitution (MRS), which refers to the amount of good X that is just sufficient to compensate the consumer for the loss of a unit of the good Y. Reflecting the principle of diminishing marginal utility, MRS of a good Y will decline as the good X is consumed more intensively relative to other goods Y. This means that as his or her consumption of good X increases (and his or her consumption of good Y declines), his or her valuation of good X relative to good Y will decline, and vice versa. Therefore, since the valuation of each good declines as it is consumed more intensively, indifference curves must be convex to the origin.

Markets can be classified into two depending on the intensity of competitive forces: as perfect competition and imperfect competition. Markets for all goods and services are scattered on a continuum ranging from perfectly competitive markets at the one end to monopolistic markets, the least competitive example to imperfect competition, at the other end. In perfect competition, there are a large number of buyers and sellers, so no individual buyer or seller ca have the power to alter the market price. The prices are transparent. On the other hand, imperfect competition may be in the form of monopoly or monopsony. The true answer is E.

Properties of Indifference Curves

In consumer theory, economists assume that the preferences of consumers exhibit certain properties or characteristics. These properties enable us to make statements about the general pattern of indifference curves.

First, more goods are preferable to fewer goods—thus, bundles on indifference curves lying farthest to the northeast of a diagram are always preferred. Let’s assume, a consumer consumes only two commodities, X and Y, that are both desired, the individual will always prefer a bundle with more of one good (without loss of the other) to the original bundle.

An indifference curve can be derived when there are two elements in every choice: (1) preferences (the desirability of various goods) and (2) opportunities (the attainability of various goods). It is related to the former: preferences. It separates better (more preferred) bundles of goods from inferior (less preferred) bundles, providing a diagrammatic picture of how an individual ranks alternative consumption bundles.

Second, goods are substitutable—therefore, indifference curves slope downward to the right. Given the fact that every commodity is defined so that more of it is preferred to less, indifference curves slope downward to the right or it follows that indifference curves must have a negative slope.

This definition is about the slope of indifference curve, which also indicates the alternative or opportunity cost of consuming good X more in terms of good Y. Moving along the indifference curve does not change the utility.

Third, indifference curves cannot cross each other, if they did, the rational ordering among preferences would be violated.

Fourth, indifference curves are everywhere dense. We can draw an indifference curve trough any point on the diagram. This simply means that any two bundles of goods (commodity bundle) can be compared by the consumers.

Fifth, the valuation of a good declines as it is consumed more intensively—therefore, indifference curves are always convex. As we noted above, the slope of the indifference curve represents the willingness of the individual to substitute one good for the other. This is also defined as the marginal rate of substitution (MRS), which refers to the amount of good X that is just sufficient to compensate the consumer for the loss of a unit of the good Y. Reflecting the principle of diminishing marginal utility, MRS of a good Y will decline as the good X is consumed more intensively relative to other goods Y. This means that as his or her consumption of good X increases (and his or her consumption of good Y declines), his or her valuation of good X relative to good Y will decline, and vice versa. Therefore, since the valuation of each good declines as it is consumed more intensively, indifference curves must be convex to the origin.

There are a number of factors that lead to an actual change in the supply of a product. For example, when the input prices go up, the profits of the producers change in the opposite direction. That is the reason why baklava producers halt production in our example. Simply because their profit falls due to a rise in input prices, they are no more willing to sell it. The correct answer is B.

Consumer surplus is the difference between the maximum amount a person is willing to pay for a good and the market price. On the other hand, producer surplus can be defined as the difference between the price at which a firm sells its product and the cost of production. Total surplus from a market is the sum of consumer and producer surpluses, which can be formulized as Total Surplus = Consumer Surplus + Producer Surplus. The correct answer is E.

Most of the markets are imperfectly competitive. The extreme cases of imperfect competition are monopoly and monopsony. Monopoly is a market where there is only one seller. Monopsonist markets are the ones in which there exist only one buyer and many sellers.

Microeconomics is the branch of economics that examines the decision making behavior of the smallest decision-making units such as the individuals, or households and the business firms, so the correct answer is C.

If the demand is elastic, an increase in the price causes the total revenue to decrease. A decrease in price, in contrast, causes total revenue to increase. On the other side, when the demand is inelastic, an increase in price causes the total revenue to increase and vice versa. The correct answer is D.

In general, elasticity can be defined as a measure that shows how much one variable responds to changes in another variable. So, elasticity shows not only the direction of the relationship between two variables, but also the quantitative response of one variable to another. Thus, elasticity is a numerical measure of the responsiveness of quantity demanded (Qd) or quantity supplied (QS) to one of its determinants. The correct answer is D.

Recall from chapter 2 that the behavior of the buyers in the market place is represented by the market demand function. Under the assumption of ceteris-paribus, a market demand curve shows how the quantity demanded of a good varies as the price of that good varies. Also, each point on the market demand curve for a good represents the marginal valuation of each consumer. In other words, each point on the demand curve represents the valuation of consumers and at the same time the price that each consumer is willing to pay most for the good. Hence, the demand curve can also be called the willingness to pay curve. Willingness to pay tells us the maximum amount that a buyer will pay for a good or service. Also it measures how much the buyer values the good. In any market, there are many buyers of a good and the market demand curve then represents each buyer’s willingness to pay for that good from the higher prices to the lowest.