Effect of Own-Price Elasticity of Demand - Assignment Example

Economics Name Course Tutor’s Name Date Using a market defined by: QD = 50 ‒ P, and QS = ‒10 + 2P At equilibrium, quantity demanded equals quantity supplied, i.e. QD = QS Thus 50 – P = -10 + 2P 60 = 3P P = 20 With a price of 20, quantity demanded/supplied is 30 units Effects of a market transitioning from perfectly competitive to a monopoly The market structure determines the pricing and profits gained by firms. Similarly, higher prices and profits for firms result from a concentration of the market. Large numbers of firms compete on the finite market in a pure competition market structure and in the course of developing the market, profit-making possibilities diminish as the equilibrium state the firms’ profits equals to zero. Their profit being the ‘normal’ profit derived from the supply function computed from the firms’ opportunity costs. On the other side a monopolist in his market dominance gains greater positive profit by further increasing the price to relatively high levels. However, there are situations known as ‘industrial regimes’ which cause a monopolist to behave like firms competing in a pure market, and also prompt competitive firms to adopt monopolists’ strategies in pursuit of positive profit. Figure 1 How monopoly reduces economic welfare The effect of a market transitioning from perfectly competitive to a monopoly results in a loss of economic welfare; in form of consumer and producer surpluses. The difference between the maximum price a consumer is willing to pay and the actual price expected by the producer, is considered the consumer surplus. In a competitive market, all the consumers in the market enjoy the consumer surplus, as shown by the triangular area P1EA in the figure 1(a), above. A fall in the price (from P1 to Po) increases consumer surplus, despite decreasing producer surplus, in turn increasing consumer welfare. Conversely, increases in prices reduce consumer surplus, and consequently lowering consumer welfare1. On the other hand, producer surplus which refers to the difference between the minimum price a firms is willing to charge for a good and the actual price charged, measures the producer’s welfare. The triangular area FP1A in the figure 1(b) above represents the producer surplus enjoyed by all the firms in the market. Assuming there are no economies of scale, the reduction in economic welfare occurs when a monopoly replaces perfect competition, as depicted in the figure 1(b), above. In a perfect competition, market equilibrium occurs at point A; price P1 and output Q1. For a monopoly, however, the equilibrium point where MR = MC exists at point B (where the marginal cost curve reflects the perfect competition market supply curve)2. The diagrammatic comparison between perfect competition and monopoly portrays the monopoly as restricting output (to Q2) and raising price (to P2). Furthermore, an investigation into how the consumer surplus and producer surplus (thus economic welfare) are affected reveals that the increase in price from P1 to P2 generates a rectangular consumer surplus P1P2CD to the monopolist. Consequently, the producer surplus (considered monopoly profit) increases at the expense of consumer surplus. In spite of this transfer, a net loss is experienced in the net loss occasioned by fall in the quantity sold from Q1 to Q2. Thus the deadweight loss, represented by triangle CBA in the Figure 1 (b), combines the loss of consumer surplus and loss of producer surplus; loss of economic welfare. Although the welfare analysis above has outlined the disadvantages of transforming a market from perfect competition to monopoly, perfect competition has been discovered to foster consumer sovereignty; whereby the goods and services are produced according to what the consumers have voted for. ‘Consumer is considered as king’ when consumer sovereignty exists although the extent of their sovereignty is limited. The ruling price would be adopted in the sales of goods by all the firms. However, industries and firms that produce goods different from what the consumers demand are forced to exit the industry due to the competition3. On the contrary, a monopoly enjoys producer sovereignty, as unlike in perfect competition, the goods and services available for consumers are determined by the monopolist instead of consumer preferences in the market place. Through the marketing devices as persuasive advertising, a monopolist can manipulate the consumer wants; and hence the ‘the producer is king’. On the basis of the largest incentive to innovate both perfect competition and monopoly participate in varying degrees. For a perfect competition, whose long-run equilibrium are zero profits, innovation will increase profits4. But the long run innovation will be copied by the entrants into the industry by competitors, hence forcing prices back to zero. Hence without a potential for a long-run increases in profits perfectly competitive markets lack motivation for motivation5. For a monopoly, innovation increases profits. Because of barriers to entry, monopolists do not fear the competition from competitors and will retain profits from innovation in the long run as a result of the incentive to innovate6. Similarly, although perfect competition is more desirable than monopoly, especially due to welfare maximization, economic efficiency and consumer sovereignty, these desirable traits that do not result from any assumption that businessmen or entrepreneurs in competitive industries are relatively highly motivated by personal ambition or highly elated than monopolists. Effect of own-price elasticity of demand The own-price elasticity of demand is a measure for the responsiveness of demand for changes in a factor that affects demand, such as income, price, advertising expenses, and process of related products. Being a negative figure, the own-price elasticity is a ratio of percentage change in the quantity demanded, to the percentage change in price. Price elastic demand exists if a 1% increase in price results to a more than 1% drop n the quantity demanded; and it is considered inelastic if it results in a less than 1% drop in quantity demanded. Once computed, the own-price elasticity is an appropriate forecasting tool for the effects of price changes on quantity demanded and expenses for buyers. Additionally, elasticities can be used to determine the effects of simultaneous changes in multiple factors on demand. With adjustment time, elasticities vary, as the long-run demand is considered more elastic than the short-run demand especially for non-durable goods; but not so for durable goods. Bibliography Kwasnicki W., Kwasnicka H. Market, Innovation, Competition. An Evolutionary Model of Industrial Dynamics, Journal of Economic Behavior and Organization, vol. 19, 1992, pp. 343-68. Nelson Richard R., Winter Sidney, An Evolutionary Theory of Economic Change, Harvard University Press, Cambridge, MA, p. 1982. Trajtenberg, M., Economic Analysis of Product Innovation: The Case of CT Scanners, Harvard University Press, Cambridge, MA, 1990. Waterson, M., Economic Theory of tke Industry, Cambridge University Press, 1984. Winter, S, Schumpeterian competition in alternative technological regimes, Journal of Economic Behavior and Organization, vol. 5, 1984, pp. 287-320. Read More