A) The demand curveof a perfectly competitive market is derived from the relationship between theprice of a good or service and the quantity demanded for it. It is essentially the marginal benefit curvefor consumers. The curve can beinterpreted in 2 ways: horizontally and vertically. From a given pricehorizontally, the demand curve can be used to find the quantity of the goodsthe consumer is willing to purchase and vertically, an associated price can befound on the curve. This associated price is also the consumer reservationprice, which is the maximum price the consumer is willing to pay for themarginal unit of that good. Fora good at this price, the consumption decisions made by the consumer wouldinclude considering the opportunity cost of the item (the value of somethingthat must be given up in order to obtain another) – as they should weigh up thebenefits and loses of choosing another good, which is potentially cheaper overthis one. B) The demand curveis usually downward sloping (negative gradient) by the law of demand, i.e.
thereis an inverse relationship between price and quantity demanded. The incomeeffect shows a change in the quantity demanded of a good after a decrease inthe consumer’s purchasing power. This determines the shape of the curve; if theprice of a good decreases, the consumers purchasing power increases and so doestheir demand. Hence, at a lower price, there is an increase in demand and viceversa, causing the downward slope.
Another factor that determines the shape ofthe curve is the substitution effect which shows a change in the quantitydemanded of a good after a change in its relative price. If the price of a goodfalls, its substitutes by comparison are more expensive and thus will be inlower demand, allowing an increase in demand of the good that had a pricereduction. The substitution effect must dominate the income effect in order to createthe downward sloping relationship of the demand curve where, as priceincreases, quantity decreases. C) An increase inthe price of tea makes Sally relatively poorer in terms of her purchasingpower, as she now can no longer afford the same amount of tea she demandedbefore the increase. Since tea is a normal good, this would result in adecrease in her demand for tea due to the income effect, which dictates thechange in the quantity demanded of a good after a decrease in the consumer’spurchasing power.
The substitution effect furthers this as it dictates a changein the quantity demanded of a good after a change in its relative price. As theprice of tea increased, this makes coffee relatively less expensive and sincetea and coffee are substitute goods, this would result in an increase inSally’s demand for coffee by the substitution effect. This is because she isspending less money on tea and hence allowing more money for coffee andincreasing her purchasing power. Thus, by the income and substitution effect,Sally would increase her demand for coffee. D) Elasticity = P = 1 – 2Q,if P = 4, Q = – Priceelasticity of demand = E) Elasticity refersto the responsiveness of the demand in relation to price changes. A moreelastic curve has a price elasticity of demand greater than 1, and a smallchange in the price will result in a large change in the quantity demanded.Conversely, a less elastic curve will have a smaller change in quantitydemanded after a change in price.
Whencomparing 2 demand curves, assume that they are for the same product, there isno change in price of substitutes or complements, there is no change in theincome of the consumers and no change in the consumers preferences. Intuitively,consider a flat horizontal demand curve, no change in price still changes the quantitywhich is perfectly elastic. However, a demand curve which is a straightvertical line is perfectly inelastic as changes in price doesn’t affect thequantity demanded. Thus, the vertical line compared to the horizontal is lesselastic, showing that steeper demand curves are less elastic.
Mathematically,consider the point where both demand curves A: P = 1 – 2Q and B: P = 1 – Q meet– which is P = 1 and Q = 0. If we change the price of both goods to P = 0.5,curve A would suggest an increase of quantity to 0.25, whereas curve B’squantity increases to 0.5. This price change has caused curve A to change inprice less than curve B, making it less elastic.
Thus a steeper demand curve isless elastic.