Question

1. Briefly explain the difference between production efficiency and allocative efficiency. Define production possibilities frontier in your answer.

2. Define the law of demand and discuss the different factors/rationales that drive the relationship between price and quantity demanded. Also discuss the difference between quantity demanded and demand.

3. Define the law of supply. Interpret what a single point on the supply curve means. Explain why the supply function has quantity on the left hand side and why the when you plot the supply curve price is on the y-axis.

Answer 1

Ans) The production possibilities frontier is a graph that shows the various production possibilities of two commodities when resources are fixed. The PPF can illustrate two kinds of efficiency: productive efficiency and allocative efficiency.

Productive efficiency means that, given the available inputs and technology, it's impossible to produce more of one good without decreasing the quantity of another good that's produced. All choices along the PPF display productive efficiency whereas any point inside the PPF is productively inefficient. Productive efficiency is concerned with the optimal method of producing goods; producing goods at the lowest cost.

Allocative Efficiency means that the particular mix of goods a society produces represents the combination that society most desires.  Allocative Efficiency is concerned with the optimal distribution of goods and services.

The law of demand states that, other things equal, when the price of a good rises, the quantity demanded of the good falls.

The different factors that drive the relationship between price and quantity demanded are:

• Price of the good or service- Changes in price lead to a movement along the demand curve.
• Income - When income rises , so will the quantity demanded and there is a rightward shift in the demand curve.
• Price of substitutes and complementary goods - When the price of complementary goods rise, the demand falls and the demand curve shifts leftward. When the price of substitutes rise, people demand more of the good and the demand curve will shift righward.
• Tastes - When the pubic's tastes change in favour of a good, then the demand for the good increases leading to a rightward shift in the demand curve.
• Expectations - When people expect that the value of something will rise, they demand more of it leading to a rightward shift in the demand curve.
• Number of buyers - As more buyers enter the market, demand rises leading to a rightward shift in the demand curve.

The quantity demanded of a good is the amount of the good that buyers are willing and able to purchase. The demand curve shows what happens to the quantity demanded of a good when its price varies, holding constant all other determinants of quantity demanded. When one of these other determinants changes, the demand curve shifts.

The law of supply states that, other things equal, the quantity supplied of a good rises when the price of the good rises.

Price is measured on the vertical axis and quantity is measured on the horizontal axis because we plot the curves from Marshal's point of view. Changes in production capacity shift the supply curve and changes in tastes shift the demand curve. These are effectively quantity changes that subsequently affect prices. This makes quantity the independent variable and price the dependent variable. From this perspective, price should be on the y-axis.