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Short Answer Questions: Chapter 2
Q1. Explain the difference between substitutes and complement goods
Q2. Can you think of an example of a good such that when income rises, its demand
decreases?
Q3. Explain how price elasticity of demand changes across the phases of the product life
cycle.
Q4. Discuss the concept of consumer surplus.
Q5. Explain why first degree price discrimination is the best strategy to extract consumer
surplus.
Essay questions
E1. Explain why allowing Ferrari cars to be sold at discounted prices is likely to decrease
the demand for them.
E2. Explain how second degree price discrimination may solve, in practice, the problem of
extracting consumer surplus.
ANSWERS:
Short Answer Questions
Q1. Explain the difference between substitutes and complement goods
A: Substitutes are rival products; for example, an EasyJet flight is a substitute for a
British Airways one on the same route, or a Sony notebook is a substitute for a
Toshiba one. Complements are products that are demanded together. For example,
if you buy a razor, then you will have to buy blades. This, therefore, means that the
demand for the two products is related.
Q2. Can you think of an example of a good such that when income rises, its demand
decreases?
A. Goods that are demanded less when income rises are inferior goods. Inexpensive
food - for example canned meat - is typically considered an example of inferior
good.
Q3. Explain how price elasticity of demand changes across the phases of the product life
cycle.
A. In the launch phase the product is innovative and hence is likely to be unique,
facing few if any competitors. Demand will then be price inelastic. In the growth
phase, other companies join the market. This increases competition and
substitutability and increases the elasticity of demand. During the mature phase of
the cycle, sales are at a peak and the market can be supplied by the largest number
of competitors. Elasticity reaches its peak. In the decline phase of the market
consumers will begin to leave the market. In response some firms will also exit,
seeking better commercial opportunities elsewhere. Competition will fall and the
degree of price sensitivity among consumers will diminish. Hence demand begins
to become more inelastic.
Q4. Discuss the concept of consumer surplus.
A. Consumer surplus is the difference between the price you are charged for a
product and the maximum price that you would have been willing to pay. It is
measured by the area between the demand curve and the market price.
Q5. Explain why first degree price discrimination is the best strategy to extract consumer
surplus.
A. Only under first-degree price discrimination are consumers charged exactly what
they are willing to pay for the good or service. However, it may be difficult to
implement such a strategy in practice.
Essay questions
E1. Explain why allowing Ferrari cars to be sold at discounted prices is likely to decrease
the demand for them.
Answer guidelines. You need to highlight that expensive goods like Ferrari cars are
mainly directed to consumers with a taste for expensive and exclusive goods.
Hence, they are willing to buy a Ferrari if not many other consumers can afford it.
Goods that are demanded more when the price rises are defined Giffen goods, a
case similar to that of inferior goods for which the law of demand – price and
quantity demanded are negatively related – is violated.
E2. Explain how second degree price discrimination may solve, in practice, the problem of
extracting consumer surplus.
Answer guidelines. Second degree price discrimination means that consumers are
charged according to the number of units they buy. Implementation of second
degree price discrimination pricing strategy can be done by dividing the price paid
by consumers into two parts. An example is that of the gym, where the cost is
formed by a fixed cost which aims to cover the cost of the infrastructure., whereas
the second part is variable and covers the cost of using the gym more often. The
fixed price element is set to extract the consumer surplus. Because the consumer
surplus is not constant across all consumers, the fixed element can also be varied
across consumers through the provision of pricing menus. High users with a
presumably high willingness to pay are offered a high fixed access price, but a low
cost per unit. Low users with a presumably low willingness to pay select a low fixed
access price but a high cost per unit.