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The Cross Elasticity of Demand and Indifference Curve - Assignment Example

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The author explains what the cross elasticity of demand measures and what the application and how it is calculated. The author also comments on the following statement: “The more inelastic the demand, the greater is the deadweight loss caused by any given tax rate".    …
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The Cross Elasticity of Demand and Indifference Curve
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1. What does the cross elasti of demand measure What is the application and how it calculated Ans: The cross elasti of demand measures the change in the quantity of one good in response to a change in price of another good, indicating how much more or less of a product. Since cross elasticity of demand help predicting changes in quantity demanded, it can be used to predict how price hike will affect the total revenue earning of a firm or organisation. Cross elasticity of demand is calculated by measuring the percentage of change in the quantity demanded divided by the percentage change in the price of a substitute or complement. For example, if in response to a 10% increase in the price of fuel, the quantity of new cars (which are fuel inefficient) demanded decreased by 20%, the cross elasticity of demand would be -20%/10%= -2.
2. What is indifference curve What is the application of the curve Why indifference curves are convex to the origin.
Ans: Indifference curve depicts equal levels of utility (satisfaction) for a consumer faced with various combinations of goods. There is no preference for one combination versus another as they render same amount of satisfaction for the consumer. Consumer theory uses indifference curves and budget constraints to produce consumer demand curves. The curves are convex to the origin as a result of diminishing marginal utility.
3. Comment on the following statement: "The more inelastic the demand, the greater is the deadweight loss caused by any given tax rate". Explain briefly.
Ans: When the price elasticity of demand is less than one, the demand is inelastic. When the demand is inelastic, a given change in price causes a smaller proportionate change in the quantity demanded. Inelastic demand is for things which do not have close substitute. When a tax is imposed on the product, the consumer bears the burden of the tax. The more inelastic the demand, the greater financial burden of a tax is placed on the consumer. When the demand is perfectly inelastic, the entire burden of a given tax will be borne by the consumer.
4. How does a system of marketable pollution permits affect the total cost of pollution abatement Explain briefly.
Ans: In order to maximize profit, a firm would always try to sell more and more pollution permits and avoid buying permits for own, if possible. At the same time, there will be an effort to improve efficiency of production to reduce pollution by less waste generation and yet keeping production cost low. Thus, the total cost of pollution abatement would be influenced by the degree of transaction of pollution permits. For example, if a firm earns high revenue from trading permits, it would not mind spending a part of the profit in reducing waste generation or carrying out better pollution abatement. Since eventually it is the environmental groups who would be buying more and more number of permits from most of the firms, the firms would be forced to generate less and less waste and the overall cost of pollution abatement will go down till an optimal level of pollution abatement is reached.
5. Give few examples of public goods and explain why are public goods are called sources of market failure.
Ans: Important examples of public goods are defence and law enforcement, basic research, program to fight poverty, public fireworks, lighthouses, information goods, software development and invention. The main reason for market failure with public goods is that private sector producers do not supply public goods to people because they cannot be sure of making an economic profit. Due to non-rivalry and non excludability, private firms cannot profitably produce a public good. Public goods suffer from free riders problem. As such public goods are not profitable to provide by private firm. In such a situation, government have the responsibility to provide the goods and the market to fail to create maximum efficiency.
6. What is the long run average cost curve And how the long-run average cost curves are different from the short run average cost curve, and explain how they are related.
Ans: The long run average cost curve of a firm shows the minimum or lowest average total cost at which a firm can produce any given level of output in the long run (when all inputs are variable). The key difference between short run and long average cost curve is that in a short run a firm can neither increase its size nor adjust its labour and capital according to fluctuating demand which remain more or less fixed whereas in the long run capital is variable and can be adjusted according to an increase in demand. The long run average cost curve is the lower envelope of the efficient short run average cost curves for all different scales of operations for a firm. The LARC is made up of the minimum points on all the short run average cost curves that would be efficient for various possible output levels. Read More
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