Finding the Equilibrium Price - Essay Example

? Chapter 3 Considering the Demand and Supply curve, it can be interpreted that it is the price change that leads the change in demand which is not true other way round. Change in demand is a matter of individual’s preference, which itself depends on parameters such as one’s income and affordability. The demand curve that exists between Price (i.e. vertical axis) and Quantity (i.e. horizontal axis) axes certainly shifts upward or downward depending upon the change in marginal benefit due to parameters other than Price (Ashby 2011). Similarly Supply curve shifts upwards or downwards in accordance with the increase or decrease in the marginal cost respectively. It must be noted here that for the private firms, the altitude of the supply curve from the horizontal axis determines the minimum price (average) at which a specific quantity must be sold so that supplier would be able to cover the variable cost. He cannot afford to sell at any less value. It is vital to understand the meaning of demand and supply as it has been used in the micro economics models. It must be perceived as the flow of inventory, inwards for supply and outwards for demand. Demand and supply do not have a direct link between them but it is the market that decides their levels. Finding the equilibrium price A unique price exists in the market that would establish perfect equilibrium between demand and supply known as equilibrium price. This price is a great leveller for both buyers and suppliers and there is least scope for manipulation of prices driven by greed in a long run. In a perfect market, there is an equilibrium quantity that exists for the equilibrium price and either way shifts in the value of this equilibrium due to misallocation of resources (whether too few scarce resources are being used or too many scarce resources are being used) would result in dead- weight loss. There has to be equilibrium between consumer surplus and producer surplus. No matter what combination is exercised by the supplier, it would be normalized in the long run. Surprisingly, the producers are the one who ultimately decide the equilibrium price knowingly or unknowingly. In response to the ‘feedback’ from the market, they are compelled to either adjust the price of the inventory or the supply of the inventory thereby reaching the equilibrium. It is more or less automatic. Trouble in the public sector This is in complete contrast to what happens in the public sector. When it comes to public services which are run by governments, there is hardly any interaction of demand and supply curve as there is absence of ‘feedback’ factor. So there is no automatic adjustment of the prices as government rely on taxes for covering the cost that is incurred in rendering these services and consumers hardly have any choice. This is why misallocation of resources is a commonplace under government led enterprises and it would be better if governments restrain themselves from getting engaged into non vital activities. Whenever government tries to control the price either by deciding the floor price or the upper cap, it runs the risk of misallocation of resources. It would result in ‘dead - weight losses and could get worse. Analysing the effects of minimum wage law indicates that it fails to achieve the objectives which it was originally devised for. It increases the supply of the unskilled labour in the market and at the same time decreasing their demand. It fails to serve the poor, worsens the problem of unemployment in the long run and increases the burden over the taxpayer in an unjustified manner. Even the ‘earned income tax credit’ program has the similar consequences though it is not as bad as minimum wage law. Under both the schemes, government seems to address the symptoms and not the root causes of the problem. It is relevant to suggest here that instead of attempting to control the prices directly, it would be much better to influence the market. Policies must be such that they help the market to decide a price level that is sought by us. No one other than a real (near perfect) market could decide a better price for itself. Chapter 4 Profit maximization is the prime objective for any non – charitable organization. Profit maximization is always market dependent and it does not necessarily mean big numbers. Under certain circumstances, minimizing loss becomes the one point focus of the organizations. Profit can be expressed as a difference between total revenue and total cost (including both fixed and variable components). Maximization of profit depends on arriving at the optimum level of output (maximizing the difference between average revenue and average cost), however, inter- linkage of output level, average revenue and average cost complicates this job. Explaining the costs Average total cost is the per unit total cost which is a U shaped curve. Similarly Average variable cost curve lies vertically below the ATC curve. But the bottom of Average variable cost curve exists for the lower quantity as compared to ATC curve. Distance between these curves decreases with increasing level of output, but they never touch each other as fixed cost always contributes to the total cost. Marginal Cost is defined as increase in total cost for unit increase in output. There is steep rise in the marginal cost once it reaches the bottom and when plotted against the same axes, it cuts both ATC curve and AVC curve at their respective bottoms (Appendix 1). Analyzing the short run total cost curve, we can see that there is a certain point at output level beyond which the total cost rapidly shoots up. This output level provides a proper trade- off between firm’s resources and their utilization. The detailed analyses of marginal cost curve, average total cost curve and average variable cost curve reveals that any firm would find itself in one out of five possible conditions that arise for a given value of output. Implications of relationship equation between these variables are time specific. ATC >AVC> MC ATC >AVC = MC ATC >MC> AVC ATC = MC > AVC MC > ATC > AVC Long Run Average Costs At a given point of time every firm has variety of options that lead to different average total cost curves and a firm could decide on one as per their output level requirement. With continuous increase in level of output, a firm approaches economies of scale where a lower average total cost is incurred. But as the operations are scaled up and economies of scales are touched, certain expenses such as administrative expenses begin to dominate. As all the possible economies of scale are already in operation and the firm is still growing thick and fast, increasing costs are hard to cut down. The zone of diseconomies of scale begins. The long run average total cost curve (LRATC) is a map of bottom points of all possible average cost curves that lies above the level of output. As the number of available options for operating at lower average costs increases, it brings more smoothness to the LRATC curve. Least cost combination is the lowest point on the curve. Productive Efficiency Every firm is in a continuous search of efficient processes to bring down average total cost. There are various ways in which a firm could achieve that objective. First it tries to look into existing operations and possible improvements without disturbing the number of existing facilities or output level. Secondly, it could look to achieve the optimum output level which does not stress a given facility and the third approach could be upgrading the facility with latest technology, making it more efficient. Out of the three approaches, the first one is somewhat most preferred because in a real market because neither a firm would like to operate at high output level without demand (overproduction) nor it would prefer to use the facility with lowest average total cost (rather using least cost combination). Chapter 5 Logic of Demand Indifference curve depicts the importance of perceived benefit by the consumer. It suggests that consumers are more concerned about total benefit that a combination of goods (bundle) offer instead of a particular combination (Appendix 2). The underpinned reason behind such a curve is the budget constraint for the consumer. In order to arrive at the maximum benefit, a consumer would happily substitute a particular kind of good as long as he could associate it with increased benefit. If we take the absolute value of the slope of the indifference curve, it gives marginal rate of substitution which itself is an indicator of the willingness of a customer to substitute a given good with another for maximizing benefits. Subsequent change in prices of either product would only lead to change in the desired combination and indifference curve would remain the same. It is the budget constraint that will show movement along the indifference curve. Whenever there is increase in a price of substitute product, there are general two effects that are observed namely, the income effect and the substitution effect. Income effect prevents a consumer from buying the substitute because now he cannot afford the same quantity of it and substitution effect is reflected in increased liking of the other product in the bundle. However the income effect has a completely reverse implications in case of inferior or Giffen goods. Price Elasticity of Demand In order to maximize profits, a firm might require trimming down the existing price for its products in order to increase the sales considerably. Therefore it is essential to determine the extent of this price cut that would remain favourable for the firm. Price elasticity of demand determines the responsiveness of such price cuts on the overall sales of the firm. It is the ratio of percentage change in sales to the percentage change in price. If the ratio is greater than 1, the demand is termed as price elastic and if it’s less than 1, demand is inelastic. It is generally observed in the real market that larger the availability of substitutes for a given product more would be the price elasticity. This is the reason why daily need items have least price elasticity (almost inelastic) where luxury goods have very high price elasticity of demand. If the period for which price elasticity is being assessed be increased, we will observe an obvious increase. It is also obvious that larger the price elasticity, flatter would be the demand curve as there would be considerable change in flow of inventory in response to smaller price change. A demand curve having unit price elasticity throughout would be a rectangular hyperbola, and the curve that is convex to the origin will have high elasticity at its bottom and lower elasticity at its top. For determining the middle of a demand curve, there has to be adequate extension on its either sides. It is directly related to the total revenue of the firm and helps it in determining what combination of products needs to be touched to move the revenue level. For highly elastic goods, a slight decrease in price would boost total revenue and vice – versa. The case is in complete contrast when the demand is inelastic. Marginal Revenue The definition of Marginal Revenue suggests that it is the increase in total revenue that comes with one unit additional sale. As with the marginal cost concept, the marginal revenue curve too has certain relationship with the average revenue. It is equally important from the profit maximization point of view. The marginal revenue lies below the average revenue curve and its slope is two times the slope of average revenue curve. The sales level at which demand curve has unit price elasticity, marginal revenue approaches zero. Appendices Appendix 1 Appendix 2 Work Cited Ashby, D.B. Winter 2011. 31 January 2011 . Read More