Gillespie: Business Economics 2e

Chapter 07

1. Discuss the factors that influence the impact of a new indirect tax on the market price.

Answers may include:

An indirect tax is placed on producers. It increases costs and leads to an inward shift of
supply. This leads to a higher market price and lower equilibrium quantity.
The relative impact on price compared to quantity depends on the price elasticity of
demand. The more price inelastic demand is the more that price increases relative to the
fall in the equilibrium quantity i.e. the more the incidence of the tax is shifted on to the
consumer.
Demand is more likely to price inelastic if:
There are few substitutes
In the short run when it is difficult to switch to alternatives
The product is heavily branded

2. Discuss the case for and against the free market system as a way of analysing
resources.

Answers may include:

The free market relies on market forces to allocate resources. The price mechanism acts
as a signal and rationing device to bring about equilibrium.
The free market has advantages:
It relies on the “invisible hand” of the price mechanism. Individuals and businesses pursue
their own objectives (e.g. to maximize utility or profit) and the price will adjust to find the
equilibrium. Millions of individual decisions are effectively coordinated by the price.
It can maximize the community surplus (i.e. the combination of consumer surplus and
producer surplus) maximizing society’s welfare.
It encourages innovation and customer services as businesses seek high returns.
However there are many potential failures and imperfections such as monopolies,
externalities, merit goods, public goods, price instability and asymmetric information.
These move markets away from the optimal price and quantity.

3. Discuss the factors that would determine how effectively the price mechanism could
adjust to bring equilibrium if there was a change in supply or demand conditions.

Answers may include:

The free market relies on market forces to allocate resources. The price mechanism acts
as a signal and rationing device to bring about equilibrium. If there is excess demand, for
example, the price increases reducing the quantity demanded and increasing the quantity
supplied until equilibrium is restored
However there may be barriers to the price mechanism working such as:
Monopoly power dominating a market and setting the price
Contracts negotiated fixing prices for a set time

© Oxford University Press, 2013. All rights reserved.

 Gillespie: Business Economics 2e
Chapter 07

Information problems so difficult to identify the extent of excess demand or supply

Costs of changing prices meaning prices are left at a given level for a while
Intervention by governments to fix prices

© Oxford University Press, 2013. All rights reserved.