A) and so does their demand. Hence, at a

The demand curve
of a perfectly competitive market is derived from the relationship between the
price of a good or service and the quantity demanded for it. It is essentially the marginal benefit curve
for consumers. The curve can be
interpreted in 2 ways: horizontally and vertically. From a given price
horizontally, the demand curve can be used to find the quantity of the goods
the consumer is willing to purchase and vertically, an associated price can be
found on the curve. This associated price is also the consumer reservation
price, which is the maximum price the consumer is willing to pay for the
marginal unit of that good. For
a good at this price, the consumption decisions made by the consumer would
include considering the opportunity cost of the item (the value of something
that must be given up in order to obtain another) – as they should weigh up the
benefits and loses of choosing another good, which is potentially cheaper over
this one.


The demand curve
is usually downward sloping (negative gradient) by the law of demand, i.e. there
is an inverse relationship between price and quantity demanded. The income
effect shows a change in the quantity demanded of a good after a decrease in
the consumer’s purchasing power. This determines the shape of the curve; if the
price of a good decreases, the consumers purchasing power increases and so does
their demand. Hence, at a lower price, there is an increase in demand and vice
versa, causing the downward slope. Another factor that determines the shape of
the curve is the substitution effect which shows a change in the quantity
demanded of a good after a change in its relative price. If the price of a good
falls, its substitutes by comparison are more expensive and thus will be in
lower demand, allowing an increase in demand of the good that had a price
reduction. The substitution effect must dominate the income effect in order to create
the downward sloping relationship of the demand curve where, as price
increases, quantity decreases.

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An increase in
the price of tea makes Sally relatively poorer in terms of her purchasing
power, as she now can no longer afford the same amount of tea she demanded
before the increase. Since tea is a normal good, this would result in a
decrease in her demand for tea due to the income effect, which dictates the
change in the quantity demanded of a good after a decrease in the consumer’s
purchasing power. The substitution effect furthers this as it dictates a change
in the quantity demanded of a good after a change in its relative price. As the
price of tea increased, this makes coffee relatively less expensive and since
tea and coffee are substitute goods, this would result in an increase in
Sally’s demand for coffee by the substitution effect. This is because she is
spending less money on tea and hence allowing more money for coffee and
increasing her purchasing power. Thus, by the income and substitution effect,
Sally would increase her demand for coffee.


Elasticity =


P = 1 – 2Q,
if P = 4, Q = –  


elasticity of demand =


Elasticity refers
to the responsiveness of the demand in relation to price changes. A more
elastic curve has a price elasticity of demand greater than 1, and a small
change in the price will result in a large change in the quantity demanded.

Conversely, a less elastic curve will have a smaller change in quantity
demanded after a change in price. When
comparing 2 demand curves, assume that they are for the same product, there is
no change in price of substitutes or complements, there is no change in the
income of the consumers and no change in the consumers preferences. Intuitively,
consider a flat horizontal demand curve, no change in price still changes the quantity
which is perfectly elastic. However, a demand curve which is a straight
vertical line is perfectly inelastic as changes in price doesn’t affect the
quantity demanded. Thus, the vertical line compared to the horizontal is less
elastic, 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’s
quantity increases to 0.5. This price change has caused curve A to change in
price less than curve B, making it less elastic. Thus a steeper demand curve is
less elastic. 


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