Price Elasticity of Demand - Essay Example

Introduction to Economics SECTION A (5 marks per question) Answer all questions in this section The price elasticity of demand of Ivory brand soap would generally be greater than the price elasticity of demand of all soaps, taken as a category”. UNCERTAIN: Price elasticity of demand refers to the measure of a responsiveness of the quantity demanded to changes in price. In most cases, as the price increases the demand decreases. In a situation where there are substitutes, it is obvious that when the price of Ivory brand shop increases, its demand will decrease and demand for other soaps will definitely increase (Lipsey & Chrystal, 2007). Therefore, the overall price elasticity of all soaps will depend on the changes in prices of all soaps. It is uncertain to compare the price elasticity of ivory brand soap and the price elasticity of all soaps given that there will be differential changes in prices. 2. “It is bad economic policy for a country to import a good that it can produce more cheaply itself”. TRUE: If a country has the competitive advantage of producing a good, then it should use the same advantage to produce the same and export (Lipsey & Chrystal, 2007). Importing commodities that a country can produce more cheaply will only lead to trade deficits, hence a bad economic policy. 3. “The demand for an inferior good must be upwards-sloping.” TRUE: Demand curve for an inferior good must be upwards-sloping due to the fact that the income and substitution effects work in different directions. Whereas a decrease in price of an inferior good causes more consumption via the substitution effect, the same is likely to cause less consumption given the income effect (Lipsey & Chrystal, 2007). In the below figure, X is a inferior good while Y is a normal good given the reduction and increase in demand respectively due to increases in income (income substitution). 4. “Rising marginal cost tends to raise average costs. Hence, if we graph average and marginal cost, we find that marginal cost crosses average cost at a point where average cost is increasing”. TRUE: Marginal cost (MC) is the additional cost incurred in producing one more unit hence; it changes with changes in the quantity produced. In a scenario where the marginal cost is increasing, the average total cost (ATC) curve is likely to be U-shaped (Lipsey & Chrystal, 2007). MC is factored within ATC and as quantity increases; the ATC and MC will decrease and increase respectively. MC will continue to increase thereby pulling up the ATC hence the marginal cost crosses average cost at a point where average cost is increasing as illustrated below. 5. “Diseconomies of scale occur whenever a production function exhibits diminishing marginal returns”. FALSE: Diseconomies of scale occur in an organization when expansion of all available inputs such as labour and capital causes an increase in the long-run average cost (Lipsey & Chrystal, 2007). On the other hand, diminishing marginal return refers to an economic scenario where marginal product continues to diminish despite addition of one input and holding the other inputs constant (Lipsey & Chrystal, 2007). Therefore, diseconomies of scale is not related to diminishing marginal returns since the latter only involves one input and the former all available inputs. 6. “When all input prices double, marginal cost is unaffected and so remains the same. Similarly, a doubling of all input prices results in no shift in supply for a perfectly competitive market”. FALSE: Marginal cost is the change in cost or the additional cost incurred from producing one more additional unit of output. Therefore, as the cost increases without an increase in quantity produced the marginal cost is likely to increase (Lipsey & Chrystal, 2007). For example, in the below table, doubling the prices of inputs would lead to an increase in variable costs hence total costs. Increase total costs without an increase in bottles per day will affect MC. For instance, increasing doubling price of employee wages from 12 to 24 will increase the VC and TC for 1 employee to 24 and 64 hence MC will be 0.3 from 0.15. On the other hand, doubling of all the inputs will affect the production of individual firms within perfectly competitive market given the fact that no individual firm has control over the market price of the product as in the case of monopoly where. In a monopoly market, a firm would increase the market prices of the output hence making it easier to maintain their supply (Lipsey & Chrystal, 2007). This is illustrated in the following graph where changes in prices cause a shift in supply of the individual firm hence the whole market. 7. “A perfectly competitive firm earns zero profits, so there must be no incentive to enter a perfectly competitive market”. TRUE: Given the fact that there are many buyers and sellers within perfectly competitive market, there is no need for incentives for entrance into the market (Lipsey & Chrystal, 2007). The zero profits will definitely cause firms to automatically enter or leave the market. 8. “Monopoly is not favoured by consumer groups because monopoly price is set so as to leave no surplus to consumers. On the other hand, since perfect competition results in no producer’s surplus, firms do not favour it. From the point of view of how markets generate surplus, then, monopolist and consumer interests are completely opposed.” TRUE: Monopoly will always sent prices that favour them and therefore would not require any surplus to consumers (Lipsey & Chrystal, 2007). On the other hand, in a perfect competition, there is no producer surplus as it is favoured by the consumer. Perfect competition firms are known as price takers hence will favour the consumers. It is therefore true that from the point of view of how markets generate surplus, then, monopolist and consumer interests are completely opposed 9. “David had the choice between taking a job that paid £30,000 a year or a job that paid £5,000 as a base wage, but had the potential to earn an additional £45,000 per year if it turned out that David performed well. David thinks that there is a 50% chance that he is a good performer. If David accepts the second job, he is a risk lover. FALSE: An individual who is ready and willing to accept a project, investment, or job that has a relatively lower expected return is referred to as a risk lover (Lipsey & Chrystal, 2007). The expected return for the job is $5,000 and David is accepting it on the basis that there is an opportunity to increase the earning to $50,000. Without such higher expectations in the earnings, David would not have accepted the job hence; David is not a risk lover but a risk averse individual. 10. “If the income elasticity of demand of a good is less than one, then increasing income with all prices held constant will result in consumers’ devoting a lower share of income to that good”. TRUE: Income elasticity of demand is the responsiveness of changes in demand due to changes in income. Positive income elasticity is for normal goods and if the elasticity is less than one then the normal good is a necessity, indicating that a percentage change in demand is less than the percentage change in income (Lipsey & Chrystal, 2007). Therefore, as the income increases a lower value is devoted to such products. Section B. (25 marks per question) Answer both questions in this section. 1. Mr. Butler is elderly, and receives only a state pension of £100 per month as income. He spends the entire pension on food and heating, where food is approximately £20 per unit (in this case, per shopping trip) while heating is £1 per unit. a. Illustrate Mr. Butler’s budget constraint in a careful diagram. If Mr. Butler wishes to remain comfortable during the winter, he must use 40 units of heating. How many shopping trips worth of food can he purchase each month and still remain comfortable? Budget constraint refers to a graph representing combination of goods and services that a consumer is willing and able to purchase within his income that meet his or her utility. Taking x to represent the quantity of food and y the quantity of heating that Mr. Butler may purchase based on his income: The total product consumed by Mr. Butler is 20x + y; hence the budget constraint is given by 20x + y = 100 If Mr, Butler consumes food only without heating, then x = 5; and when Mr. Butler buys only heating with no food then y = 100; The two coordinate points that form the budget constraint curve therefore are (5, 0) and (0, 100) Drawing the budget constraint curve will use the two coordinates as the x and y intercepts. The following is Mr. Butler’s budget constraint line depending on the consumption possibilities of food and heating based on the $100 income. If Mr. Butler has to use 40 units of heating, therefore the amount shopping trips of food for Mr, Butler will be 3 shopping trips according to the graph. Meaning that the amount will be $40+$60 obtained by multiplying 3*$20) = $100. b. The price of heating is likely to rise due to political unrest in the countries that produce fossil fuels. This year, the predicted price of heating is £1.50 per unit. The government is considering adding a supplement to the pension. How much must the government add to the pension in order to allow Mr. Butler to afford the amount of heating and food that he chose in (a)? Since the amount of heating units is 40, the total Price that Mr. Butler will have to pay given the increase in price = 40 * $1.50 = $ 60. Added to the total cost of shopping trips for food, $60, Mr. Butler will have to part with $120. Therefore, the government should add $120 - $100 = $20 in order to make sure that Mr. Butler affords 40 units of heating and 3 shopping trips of food without any inconveniences caused to his budget constraint. c. The government implements the increase in (b. Will Mr. Butler choose to consume the amount of heating and food he chose in (a)? Has his utility increased, decreased or stayed the same compared to (a)? Mr, Butler’s budget constraint will change given the increased supplement. Therefore, the new budget constraint line will be represented by the following graph: No, Mr. Butler will continue to consume 40 units of heating and 3.4 shopping trips of food as illustrated by the new budget constraint line. Therefore, the utility of Mr. Butler will definitely increase given the additional shopping trip of food. d. Consider an alternative policy whereby the government adds a heating allowance to the pension instead of the supplement of (b). This heating allowance must be spent on heating: it cannot be spent on food. How much must the allowance be in order for Mr. Butler to consume the heating and food he purchased in (a)? If the government implements this programme, will Mr. Butler choose to consume the amount of heating and food in (a)? Has his utility increased, decreased, or stayed the same compared to (a)? Given that there has been an increase in prices of units of heating, the needed amount to help Mr. Butler continue to consume choices that make him comfortable should be an additional $20. The new budget line for Mr. Butler will be 20x + 1.5y = $120. The following represents a new budget constraint line for Mr. Butler given that the increase in heating allowance only allows him to consume heating units that make him comfortable. From the above graph, Mr, Butler will continue to consume 40 units of heating and 3 shopping trips of food without any discomfort or making him worse off. Therefore, with such policy, Mr. Butler will be forced to continue consuming the normal 40 units of heating and 3 shopping trips of food hence utility has remained the same. e. If you were Mr. Butler, which programme – the supplement to the pension or the heating allowance – would you support and why? The supplement to the pension since it increases the utility of Mr, Butler. 2. Perfect Competition a. The recession has hit a number of industries very hard because consumers have reduced their demand for goods. Take the market for raw milk in the UK as approximately perfectly competitive. Hence, for the market for raw milk, produced on farms and sold to milk processors, use diagrams to analyse the effect of the recession on the equilibrium price, farm output, industry output, and the number of farms in the short and long run. In a perfect competition, no individual firm can affect the market price and the demand curve facing each firm is usually perfectly elastic as described by the following graphs: Due to the recession, consumers’ demand has reduced causing the prices and profitability of the milk producing firms to reduce considerably. As a result, existing firms will be forced to reduce the output thus causing more firms to exit the market hence decreasing the output even further. With decreased output, the demand will start to increase until the normal profitability levels are attained within the existing firms. The following graph illustrates how a change in demand for milk products (within the short run) causes a change in prices, supply, and consequently the number of firms within the industry. b. The unusual summer weather has reduced cow milk yields. How does this reduction in yields modify the market analysis that you conducted in (a)? Should farmers welcome the unusual weather or not? c. The government is concerned with the effect of the recession on dairy farmers and so proposes that price floors be raised for milk. Show how this affects your answer in (a). What other policy tools does the government have at its disposal to help farmers? Would you favour the use of price floors in this case? Explain your reasoning. Bibliography Lipsey, R. & Chrystal, A., 2007, Economics, Oxford University Press, Oxford. Read More