Price Elasticity in Economy - Assignment Example

ASSESSMENT II ECONOMICS – ONLINE CHAP 4 Why do necessities tend to have demand that is price inelastic, while luxuries tend to have demand that isprice elastic? Price elasticity of demand refers to degree of responsiveness of demand for any commodity to its price when other factors influencing demand remains unchanged. There are many factors that influence the price elasticity of demand. In the context of the aforesaid question we are concerned about the nature of the commodity. The nature of the commodity determines whether the consumption of the commodity can be postponed or not. We consider a necessary good which is indispensable in nature. We can take the example of medicine. If the price of medicine rises would the consumers change the level of consumption? Simply the answer is no. he has to consume the amount required. He can’t avoid the consumption of it as it is highly required. Hence even a high change in price would leave the demand for medicines unaltered. There is no responsive change in demand to a change in price. A vertical straight line represents the demand curve. P D P** P* O Q* Q In the above figure horizontal and vertical axes measure quantity and price respectively. D is the demand curve. When price is OP* the demand is OQ*. When price is higher i.e. OP**, the demand sticks to OQ*. Hence price change has no impact on the demand for medicine. If the commodity is a luxurious one there is the possibility of the postponement of demand. Without luxury the life can easily be spent. So a ceteris paribus rise in price causes a sharp decline in the demand for the good. Hence the demand for luxury goods is highly elastic. We consider the case of moisturizers. If price raises that would lead to a sharp decline in demand for it, as it is easily dispensable. The demand curve for such good can be represented graphically P P** P* D O Q** Q* Q In the above figure horizontal and vertical axes measure quantity and price respectively and D is the demand curve. When price is OP* then demand is OQ*. Now there is a rise in price from OP* to OP** and the demand declines from OQ* to OQ**. Here we find that a small price change causes a larger decline in demand. (Price rise=P**P* and demand fall=Q**Q*). Hence the demand for a luxury good is highly elastic. (Kutsoyiannis 38-39) 2. Under what circumstances might a government price ceiling lead to the development of a black market? Whenever the state uses a price ceiling some more operations should be adopted by the state. Always the price ceiling lies below the market price. In market the price determined by demand and supply enables the producers to maximize profit so a price restriction below the level of the equilibrium market price leads towards a fall in the profit level, which induces the producers to cut down the supply in the market. This can be shown diagrammatically. P D S P* E PC A B O Qs Q* QD Q In the above figure horizontal and vertical axes measure quantity and price respectively. D is the market demand curve and S is the market supply curve. Equilibrium is attained at point E by demand supply interaction. OP* is the equilibrium price and OQ* is the equilibrium quantity. Now we consider that the government introduces a price ceiling that is OPC. At this price supply is OQs and demand is OQD. Hence market will be subject to excess demand to the extent AB. (Stonier and Hauge, 232-233) This shortage in supply would cause a black marketing in the market. To protect black marketing the government has to adopt a policy. That is known as public distribution system. To fight against this excess demand problem that may unleash black marketing the government should make a buffer stock of the commodity and sell it through the public distribution shops at the price OPC. At the ceiling price the government has to sell AB amount of the commodity so that the problem of excess demand can be solved efficiently. But if the government is unable to maintain a proper buffer stock and efficient public distribution system the phenomenon of black marketing is inevitable in the time of ceiling price by the public authority. CHAP 5 1. Give some examples of opportunity cost. Opportunity cost may be defined in two ways. Opportunity cost can be defined as the value of next best alternative sacrificed to produce one additional unit of any commodity while there is efficiency in production and endowment of factor and state of technology are unchanged. According to this definition the opportunity cost can be measurable in nominal units. There is another concept of opportunity cost, which is relative in nature. If we consider a two-sector economy it is convenient for us to express it. We consider two commodities food and cloth. Under full employment with given technology the amount of food that is sacrificed to produce one additional unit of cloth is termed as the opportunity cost of cloth in terms of food. This is a relative term, which is measured in unit used to measure the amount of the commodities in real term. Let us consider an economy in which 100 labour hours are required to produce 1 unit of food and 150 labour hours are required to produce one unit of cloth. Under full employment situation if we want to produce one more unit of cloth we have to transfer 150 labour hours from food to cloth industry. So production of food is hampered by 150/100 units=1.5 units. So, we can say the opportunity cost of cloth in terms of food is 1.5. Now if we multiply 1.5 with the market price of food we can find the opportunity cost of cloth in nominal term. We can show opportunity cost graphically. In the following figure the horizontal axis measure amount of cloth and the vertical axis measure amount of food. TT is the production possibility frontier (PPF) representing all the possible combinations of two commodities that can be produced given factor endowment, technology and full employment. Now we consider that economy initially operates at point A. now the economy wants to increase the production of cloth by ∆C units. To do that the country has to sacrifice ∆F units of food. So ∆F/∆C is known as the opportunity cost. Hence the slope of PPF explains the opportunity cost at that level. Food(F) T A ∆F B ∆C O T Cloth (C) (Gravelle and Rees 186) 2. Why is the relationship between marginal product and marginal cost an inverse one? The classical theory of production function is given as Y=f(L) while Y= amount of output. And L= employment of labour. The term f defines the functional relationship. Marginal productivity refers to the change in total product due to employment of one additional unit of labour. MPL=dY/dL… the slope of total product curve gives the MPL at corresponding level of employment. Now we consider the cost function. As in short run we consider labour is the only variable factor of production then the total cost is given as: C=W.L, C= total variable cost of production W= money wage of labour which is fixed. And L= amount of labour required. L=f-1(Y) Now marginal cost is defined as the change in cost to produce one additional unit of output. So MC=d(WL)/dY Or MC=W* dL/dY On the other hand we can say that dL/dY=1/dY/dL=1/MPL So we can say MC=W*1/MPL We know that the money wage rate is fixed hence the marginal cost is inversely related to the marginal productivity. Logically we can also explain it. Higher marginal productivity implies that lower amount of labour would be required to produce one additional unit of the output. As the money wage rate is constant the marginal cost is inversely related to marginal productivity. CHAP 6. 1. Why should anyone bother to study perfect competition, since it seldom or never exists in reality? We are aware of the fact that economics considers both positive approach and normative approach as well. The positive approach is considered as what really is and the normative approach is concerned with what ought to be or what should be the ideal situation. So the main objective of the subject and content of economics is the welfare of the people. We are aware of the fact that perfect competition is a theoretical form of the market, which is assumed to be the most ideal situation. That’s why we should study the perfect competition. Study of perfect competition is useful for us to know that what actually the market structure should be so that both parties can enjoy the maximum level of welfare. Why perfect competition is known as an idealistic situation? To answer this we need to find the basic assumptions. Numerous buyers and seller exists and the product is homogeneous. That means none of the parties enjoy any type of market power, as each constitutes a very negligible share of total market. On the other hand perfect flow of information and free entry and exit of firms and sellers enable the sellers to enjoy normal profit. There is no concept of supernormal profit in long run and the existing capacities are fully utilized. As the price is determined by the demand supply interaction the competitive situation maximizes the consumer and producer’s surplus. That can be shown graphically. P C S P* E D D O Q* Q (Salvatore, 33) Perfectly Competitive Equilibrium In this figure horizontal and vertical axes measure quantity and price respectively. D is the demand curve and S is the supply curve. E is the equilibrium point. Equilibrium price=OP*, equilibrium quantity=OQ*, Revenue of firms=expenditure of consumers=OP*EQ* Now consider the consumers, to purchase OQ* amount they are willing to pay OCEQ* amount. But they have to pay OP*EQ* amount. Hence the consumers’ surplus is CEP*. Now we consider the producers, they were willing to accept ODEQ* amount but actually the total revenue is OP*EQ*. Hence they get DEP* amount excess. This is the producers’ surplus. Hence the perfect competitive situation is a yardstick to which every real market should be considered to be judged how they are close to the ideal situation. 2. If all firms in perfect competition have the same average revenue and pay the same price for inputs such as labor and materials, why do they not all have the same profit? It is true that in a perfectly competitive market all the agents have to play the role of price takers. On the other hand the factors are perfectly mobile too. So the factor prices should be same for each firm. The profit is known as the total difference between total revenue and total cost. Profit=Total Revenue – Total Cost, In other words we can say TR=PQ, P= Price/Unit, Q= quantity sold In a simple form C=W.L W=money wage, , L= Labour Required So ∏=P.Q-W.L ∏/Q=P-W.L/Q So Profit per unit is the difference of P and W.L/Q L/Q can be represented as 1/Q/L, here Q is total output and L is total employment. So APL=Q/L, so Profit per unit=price-money wage/average productivity The price of the commodity is same for all firms. The money wage is same all over the market. But the average productivity of labour in the firms differs as they use different state of technology, different machineries, different capital goods and different styles of training of workers. So even if the price and wage are same for the entire market the difference in productivity causes difference in profit per unit and also difference in equilibrium level of output of different firms make the difference in total profit. CHAP 7 1. Why can a monopoly not sell all that it desires at any given price? The monopolist is the single producer in a market who owns the absolute market power. The monopolist is not a price taker rather he is a price maker as he alone faces the entire demand in the market for his product. In one hand the monopolist enjoys the market power to set the price and on the other hand for maximization of profit he can change the price level to sell more in the market. But on the other hand monopolist has to face some restrictions such as he should never produce the output beyond the level where price elasticity of demand equals one. The marginal revenue function of the monopolist is given as MR=P(1-1/e), so when e=1 then MR=0 There is another restriction for the monopolist who is selling in only one market in which there is perfect flow of information among the consumers. In such a case we can consider the profit maximization objective. ∏(q)=P.q-C(q) P=price level which he can change according to selling of output q=level of output, C(q)=cost function, ∏(q)= the profit function we have to maximize ∏(q) with respect to q d∏(q)/dq=o => P+q.dP/dq-dC/dq=0 MR-MC=0 MR=MC…..This is the first order condition The second order condition is ..d2∏(q)/dq2 dMR/dq-dMC/dq Read More