Question

a) Explain in words what characterizes goods that are substitutes and give examples of such goods.

b) Define what we understand by the own price elasticity of demand for a good and explain in words the connection between the own price elasticity and the supply of substitutes.

c) Explain and illustrate graphically how price and quantity sold are determined in a perfect free competition market. Explain and illustrate graphically what we mean by consumer surplus, producer surplus and socio-economic surplus.

d) Why is the perfect free competition market the theoretical market form that maximizes socio-economic profits?

Answer 1

a) When two goods are substitutes of each other then increase in the price of one good increases the demand of other good and decrease in the price of one good decreases the demand of other good.

For Ex- Tea and coffee are substitute goods of each other. Increase in price of tea will increase the demand of coffe while decrease in its price will cause decrease in demand of coffee.

b) Own price elasticity of demand is defined as the percent change in demand of one good due to change in prices of given good. For ex- suppose we have pen which has a demand of 100 units at a price of $2 and its demand becomes 70 if its price is increased to $2.5. It is called elasticity of demand.

It is given by the formaula E= % change in demand/ % change in price

Own price elasticity affects the supply of substitutes. If price of given goods decrease then supply of substitutes increases and if price of given good increases then supply of substitutes decreases.

c) Prices in perfectly free competition market is determined with the help of market demand curve and market supply curve intersection and the firms present in competition free market are price takers rather than price deciders. In this way prices and quanity are determined.

Consumer surplus is defined as the difference between what consumer pays and his willingness to pay.

Producer surplus is defines as the difference between what producer receives and their willingness to sell at a particular price.

Socio economic surplus is defined as the sum of consumer and producer surplus of the given economy.

d) Conditions required for perfect free competition:

• products sold should be identical
• firms are price takers
• buyers has knowledge of market
• free entry and exit
• firms has small market share

This all conditions may not met in any given market so it is quite theoretical market form to have perfect free competition where all firms are price takers and works for the socia-economic factors. There is always a firm in the market which somewhat affects the price of the given market