Question

a- Itemize and briefly describe the determinants of price elasticity of demand.

b- What is consumer surplus? Do consumers always get to keep it? Might there ways for sellers to capture some of this consumer surplus for themselves?

c- If the coefficient of cross elasticity of demand is negative this means that the goods involved are substitutes. True or false? Explain.

Answer 1

1. Demand

The law of demand states that there is an inverse relationship between price and quantity demanded, other things remaining the same.

Change in quantity demanded is the movement along the demand curve, whereas, change in demand is the shift in the demand curve due to change in determinants of demand.

A movement along the demand curve occurs when a change in quantity demanded is caused only by a change in price, and vice versa. A shift in a demand curve occurs when a good's quantity demanded changes even though price remains the same.

Factors causing shift in the demand curve:

• Size of the market: Demand will change or shift if the number of consumers for the product increases. The demand curve will shift to the right.
• Income of the consumers: Changes in income shifts the demand curve. Increases in income increases the demand for normal goods and decreases in income increase the demand for inferior goods. The demand curve will shift to the right.
• Increase in the price of related goods. If the price of substitute goods falls, then there is a shift in the demand. If price of large cars increase, then the demand for small cars will increase. Demand curve will shift to the right for small cars. In case of complements, as an example, if the price of gasoline increases demand for cars will fall. The demand curve for cars will shift to the left
• Tastes and preferences of consumers. Demand will depend upon the tastes and preferences of consumers. If there is a preference for health foods, then the demand curve for health foods will shift to the right.
• Expectations: If the consumers expect the prices to fall in the future, then demand curve will shift to the left.

B.

Consumer surplus is the area below demand curve and above market price. It is the difference between what consumers are willing to pay and what they actually pay. Producer surplus is the area above supply curve and below market price. It is the difference between what producers get and what is the minimum price at which they are willing to sell.

               If the price of the good increases and quantity demanded decreases, a part of consumer surplus could be changed to producer surplus. This happens when demand is inelastic.

3. False.

Cross price elasticity is calculated by dividing the % change in quantity demanded of good A by the % change in price of good B. A negative cross elasticity denotes two products that are complements, while a positive cross elasticity denotes two substitute products.

If the price of good B increases, then the demand for good A, a substitute good, increases. If price of Pepsi increases then demand for Coke, a substitute good, increases.