Test 2 - Suggested Solution icap prepaation PDF

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CAF 02: Introduction to Economics and Finance Suggested Solution – Test # 2 (Chapter 3, LO 1 – LO 4)

A.1 Sr. # (i) (ii) (iii) (iv) (v) (vi) (vii) (viii) (ix) (x)

Correct Option d a d a d b b c b d

A.2 Arc Method of Elasticity Elasticity between two different and distinct points on a demand curve is called Arc Elasticity. It is calculated for large changes in price and demand.

Point Method of Elasticity Elasticity on a single point (or very close points) on a demand curve is called Point Elasticity. It is calculated for small changes in price and demand.

(01 mark for describing each method, and 01 mark for diagram of each method)

A.3 Price Elasticity of Demand (using Arc Method): PED = Percentage change in Demand / Percentage change in Price

A.4 (a) If price increases and total revenue decreases, then demand is elastic. (02 marks) (b) Availability of substitutes: If more substitutes are available (e.g. soft-drinks, soaps, tooth-pastes, edible oils), demand will be elastic because consumers can easily switch from one good to another. If substitutes are not available, demand will be inelastic.

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CAF 02: Introduction to Economics and Finance Suggested Solution – Test # 2 (Chapter 3, LO 1 – LO 4) Nature of the commodity: If product is necessity of life (e.g. wheat, sugar, rice, medicines), demand will be inelastic because people cannot live without them. If product is luxury/comfort (e.g. Cars, Air-conditions, Jewellery), demand will be elastic. Consumer loyalty: If there is strong consumer loyalty (e.g. in brand goods like i-phone), demand will inelastic because loyal customers don’t move to other products. Time Period: In short-run, dema nd is inelastic, because people cannot find substitutes or cannot change their habits quickly. In long-run, demand is elastic. Portion of income used on item: If significant portion of consumer’s income is spent on a good (e.g. car), demand will be elastic because consumers will be carefule in purchasing the good. If small portion of consumer’s income is spent on a good (e.g. salt, matchbox), demand will be inelastic. Degree of addiction: If there is an addiction of the good (e.g. cigarette, drugs), demand will be inelastic.

Income level of consumers: For rich, elasticity of demand for commodities is usually inelastic because increase in price does not affect their overall expenditure. For poor, elasticity of demand for commodities is usually elastic. Goods having several uses: Some goods have several uses e.g. electricity may be used as necessity as well as a luxury. If use is more important, demand will be inelastic. Durable Goods and Perishable Goods: Generally demand for durable goods (e.g. car, freezer, air conditioner) is elastic because it can be postponed. However, demand for perishable goods (e.g. vegetables, fruits) is inelastic because it cannot be postponed. (0.5 mark for identifying factor, 0.5 mark for explanation of factor, subject to maximum of 06 marks) (c) In pricing decision: Firms use PED in determining price of its products. If demand is inelastic, firm increases price to increase total revenue. If demand is elastic, firm decreases price to increase total revenue. In Price Discrimination by firms: If different consumers have different elasticity, higher price can be charged by firm to consumers with inelastic demand. In Shifting Tax Burden to Consumers: Producers can shift the burden of tax to consumers, if demand is inelastic. If demand is elastic, then more burden of tax will be on producers. (01 mark for each role)

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