7/25/2019 Micro Economics PME1A-1 http://slidepdf.com/reader/full/micro-economics-pme1a-1 1/19 Subject Code: PME1A Paper: Micro Economics Specific Instructions: Answer all the five questions. Marks allotted 100. Each uestion carries equal !arks. "ord li!it is #$0%&00 wordsGeneral Instructions: 'he Student should sub!it this assi(n!ent in the handwritten for! )not in the t*+ed for!at, 'he Student should sub!it this assi(n!ent within the ti!e s+ecified b* the e-a! de+t Each uestion !entioned in this assi(n!ent should be answered within the word li!it s+ecified 'he student should onl* use the ule sheet +a+ers for answerin( the questions. 'he student should attach this assi(n!ent +a+er with the answered +a+ers. /ailure to co!+l* with the above /ive instructions would lead to rejection of assi(n!ent. _____________________________________________________ Question No1 a,"hat do *ou understand b* the aw of Equi%Mar(inal tilit*2 Answer 'he funda!ental +roble! in an econo!* is that there are unli!ited hu!an wants. 3owever4 there are no adequate resources to satisf* all hu!an wants. 3ence4 a rational individual tries to o+ti!i5e the available scarce resources in order to attain !a-i!u! satisfaction. An individual6s atte!+t to o+ti!i5e the available scare resources is known as consu!er6s behavior. 'he law of equi%!ar(inal utilit* e-+lains such consu!er6s behavior when the consu!er has li!ited resources and unli!ited wants. 7ecause of this reason4 the law of equi%!ar(inal utilit* is further referred to as the law of !a-i!u! satisfaction4 the +rinci+le of inco!e allocation4 the law of econo!* in e-+enditure or the law of substitution. "hat does the law sa*2 Su++ose that a +erson +ossesses 8#00 )li!ited resources,. 3owever4 his wants are unli!ited. 'he law e-+lains how the +erson allocates the 8#00 a!on( his or her various wants in order to !a-i!i5e the satisfaction. 'he +oint at which the consu!er6s satisfaction is !a-i!u! with the (iven resources is known as consu!er6s equilibriu!. 3ence4 we can sa* that the law e-+lains how the consu!er6s equilibriu! is attained. 'he law is basicall* a cardinal utilit* a++roach. Conce+t of Equi%!ar(inal tilit* 9ow let us see how an individual !a-i!i5es his or her satisfaction with the hel+ of equi%!ar(inal utilit*. 'he law sa*s that in order to attain !a-i!u! satisfaction4 an individual allocates the resources in such a wa* that he or she derives equal !ar(inal utilit* fro! all thin(s on which the resources are s+ent. /or instance4 *ou have 8100 and *ou s+end the !one* to bu* 10 different thin(s. "hat the law sa*s is that *ou s+end !one* on each thin( in such a wa* that all the 10 thin(s +rovide *ou with the sa!e a!ount of !ar(inal utilit*. Accordin( to the law of equi% !ar(inal this is the wa* to attain !a-i!u! satisfaction. Assu!+tions of the aw of Equi%Mar(inal tilit*
a,"hat do *ou understand b* the aw of Equi%Mar(inal tilit*2
Answer
'he funda!ental +roble! in an econo!* is that there are unli!ited hu!an wants. 3owever4 thereare no adequate resources to satisf* all hu!an wants. 3ence4 a rational individual tries too+ti!i5e the available scarce resources in order to attain !a-i!u! satisfaction. An individual6satte!+t to o+ti!i5e the available scare resources is known as consu!er6s behavior. 'he law of equi%!ar(inal utilit* e-+lains such consu!er6s behavior when the consu!er has li!ited resourcesand unli!ited wants. 7ecause of this reason4 the law of equi%!ar(inal utilit* is further referred to
as the law of !a-i!u! satisfaction4 the +rinci+le of inco!e allocation4 the law of econo!* ine-+enditure or the law of substitution."hat does the law sa*2
Su++ose that a +erson +ossesses 8#00 )li!ited resources,. 3owever4 his wants are unli!ited. 'helaw e-+lains how the +erson allocates the 8#00 a!on( his or her various wants in order to!a-i!i5e the satisfaction. 'he +oint at which the consu!er6s satisfaction is !a-i!u! with the(iven resources is known as consu!er6s equilibriu!. 3ence4 we can sa* that the law e-+lainshow the consu!er6s equilibriu! is attained. 'he law is basicall* a cardinal utilit* a++roach.
Conce+t of Equi%!ar(inal tilit*
9ow let us see how an individual !a-i!i5es his or her satisfaction with the hel+ of equi%!ar(inalutilit*. 'he law sa*s that in order to attain !a-i!u! satisfaction4 an individual allocates theresources in such a wa* that he or she derives equal !ar(inal utilit* fro! all thin(s on which theresources are s+ent. /or instance4 *ou have 8100 and *ou s+end the !one* to bu* 10 differentthin(s. "hat the law sa*s is that *ou s+end !one* on each thin( in such a wa* that all the 10thin(s +rovide *ou with the sa!e a!ount of !ar(inal utilit*. Accordin( to the law of equi%!ar(inal this is the wa* to attain !a-i!u! satisfaction.Assu!+tions of the aw of Equi%Mar(inal tilit*
'he followin( e-+licit assu!+tions are necessar* for the law of equi%!ar(inal utilit* to hold(ood:
• Consu!er6s inco!e is (iven )li!ited resources,.
• 'he law o+erates based on the law of di!inishin( !ar(inal utilit*.
• 'he consu!er is a rational econo!ic individual. 'his !eans that the consu!er wants to
(ain !a-i!u! satisfaction with li!ited resources.
• 'he !ar(inal utilit* of !one* is constant.
• Another i!+ortant assu!+tion is that the utilit* of each co!!odit* is !easurable in
cardinal nu!bers )14 #4 & and so on,.
• 'he +rices of the co!!odities are constant.
• 'here +revails +erfect co!+etition in the !arket
b,Prove that the de!and curve slo+es downwards62 3ow would *ou deter!ine the on( runavera(e cost and the on( run Mar(inal cost fro! the short ter! cost curves2
c,"hat are indifference curves2 ist & +ro+erties and e-+lain with e-a!+le.
Answer
/i-ed costs are those that do not var* with out+ut and t*+icall* include rents4 insurance4
de+reciation4 set%u+ costs4 and nor!al +rofit. 'he* are also called overheads.
;ariable costs are costs that do var* with out+ut4 and the* are also called direct costs. E-a!+lesof t*+ical variable costs include fuel4 raw !aterials4 and so!e labour costs.An e-a!+leConsider the followin( h*+othetical e-a!+le of a boat buildin( fir!. 'he total fi-ed costs4 '/C4
include +re!ises4 !achiner* and equi+!ent needed to construct boats4 and are <10040004irres+ective of how !an* boats are +roduced. 'otal variable costs )';C, will increase as out+utincreases.
OUTPUT
TOTAL
FIXED
OST
TOTAL
!A"IA
#LE
OST
TOTAL
OST
1 100 $0 1$0
# 100 =0 1=0
& 100 100 #00
> 100 110 #10$ 100 1$0 #$0
? 100 ##0 �
@ 100 &$0 >$0
= 100 ?>0 @>0
Plottin( this (ives us 'otal Cost4 'otal ;ariable Cost4 and 'otal /i-ed Cost.
otal fi-ed costsiven that total fixed costs )'/C, are constant as out+ut increases4 the curve is a hori5ontal lineon the cost (ra+h.'otal variable costs'he total variable cost )';C, curve slo+es u+ at an acceleratin( rate4 reflectin( the law ofdi!inishin( !ar(inal returns.'otal costs'he total cost )'C, curve is found b* addin( total fi-ed and total variable costs. Bts +ositionreflects the a!ount of fi-ed costs4 and its (radient reflects variable costs.
Avera(e fi-ed costsAvera(e fi-ed costs are found b* dividin( total fi-ed costs b* out+ut. As fi-ed cost is divided b*an increasin( out+ut4 avera(e fi-ed costs will continue to fall.
'he average fixed cost )A/C, curve will slo+e down continuousl*4 fro! left to ri(ht.Avera(e variable costsAvera(e variable costs are found b* dividin( total fi-ed variable costs b* out+ut.
'he average variable cost )A;C, curve will at first slo+e down fro! left to ri(ht4 then reach a!ini!u! +oint4 and rise a(ain.A;C is 6 sha+ed because of the +rinci+le of variable Pro+ortions4 which e-+lains the three +hases of the curve:
1. Bncreasin( returns to the variable factors4 which cause avera(e costs to fall4 followed b*:#. Constant returns4 followed b*:&. i!inishin( returns4 which cause costs to rise.
Avera(e total costAvera(e total cost )A'C, is also called avera(e cost or unit cost . Avera(e total costs are a ke* costin the theor* of the fir! because the* indicate how efficientl* scarce resources are bein( used.
Avera(e variable costs are found b* dividin( total fi-ed variable costs b* out+ut.
Question No2
a, 3ow would *ou e-+lain the ia!ond water +arado-62
Answer
'he dia!ond%water +arado- +oses the +er+le-in( observations: Even thou(h water is obviousl*i!+ortant to hu!an activit* )life cannot e-ist without water,4 the +rice of water is relativel* low.Alternativel*4 dia!onds are clearl* !uch less i!+ortant to hu!an e-istence4 but the +rice of dia!onds is substantiall* hi(her. Bn other words4 the utilit* obtained fro! water is obviousl* ver*
(reat4 while the utilit* obtained fro! dia!onds is substantiall* less.
Bnsi(ht into4 and clarification of4 the dia!ond%water +arado- results b* differentiatin( betweentotal utilit* and !ar(inal utilit*.
• 'otal tilit*: 'his is the overall satisfaction of wants and needs obtained fro! consu!in(
a (ood. 'hat is4 total utilit* is the accu!ulated a!ount of satisfaction4 or the total value4(enerated b* several units of a (ood.
• Mar(inal tilit*: 'his is the e-tra satisfaction of wants and needs obtained fro!
consu!in( one additional unit of (ood. 'hat is4 !ar(inal utilit* is the incre!entalsatisfaction (enerated b*4 and the value of4 a sin(le unit of a (ood.
"ater +rovides hu!ans with an enor!ous a!ount of total utilit*. "ater satisfies A D' of wants
and needs for A D' of +eo+le. "ater +rovides a hi(h level of total utilit* because it is +lentiful%%water4 water ever*where 3owever4 because it is so +lentiful4 the !ar(inal utilit* of water isrelativel* low. An e-tra ounce of water +rovides ver* little additional satisfaction.
b, "hen !ar(inal cost falls4 it alwa*s +ulls the Avera(e cost downFF6do *ou a(ree2Elaborate
Answer
Bn the short run )which is what this question is about,4 as out+ut increases4 the avera(e total cost
decreases where the !ar(inal cost is below it. /irst *ou have to realise that increasin( and
decreasin( out+ut will affect avera(e fi-ed costs and avera(e variable costs. Consider the
followin( )e-+lanation to these s+ecific +oints is at the botto! of the +a(e,: Avera(e fi-ed costs
)A/C, decrease as out+ut increases. A fall in avera(e fi-ed costs leads to a fall in !ar(inal costs.
etGs call the decrease in A/C4 and therefore a decrease in !ar(inal costs4 HIHAvera(e variable
costs. )A;C, increase as out+ut increases. BtGs the one !ost associated with !ar(inal cost. A rise
in avera(e variable costs leads to a rise in !ar(inal costs.etGs call the increase in A;C4 and
therefore an increase in !ar(inal costs4 HJH Bt is +ossible to deduce that: "hen I is (reater
than J4 the decrease is (reater than the increase in !ar(inal costs.
c, e+ict the followin( on a sin(le short ter! costs (ra+hKA/C 4 MC 4 AC L A;C."here do the AC and MC curve alwa*s intersect2Also discuss how the cost function is a !irror i!a(e of the +roduction function curves.Answer
otal pro(uct is si!+l* the out+ut that is +roduced b* all of the e!+lo*ed workers. Mar)inal
pro(uct is the additional out+ut that is (enerated b* an additional worker. "ith a second worker4 +roduction increases b* $ and with the third worker it increases b* ?. "hen these workers areadded4 the !ar(inal +roduct increases. "hat factors would cause this2 As !ore workers areadded4 the* are able to (i*i(e the res+ective tasks and speciali+e. "hen the !ar(inal +roduct isincreasin(4 the total +roduct increases at an increasin( rate. Bf a business is (oin( to +roduce4 the*would not want to +roduce when !ar(inal +roduct is increasin(4 since b* addin( an additionalworker the cost +er unit of out+ut would be declinin(.Bn The Wealth of Nations4 Ada! S!ith wrote about the advanta(es of the division of labor usin(the e-a!+le of a +in !aker. 3e +ointed out that an individual not educated to the business couldscarce !ake one +in a da* and certainl* not !ore than twent*. 7ut the business of +in !akin( isdivided u+ into a nu!ber of +eculiar trades and each worker s+eciali5es in that trade. Dne !an
draws out the wire4 another strai(hts it4 a third cuts it4 a fourth +oints it4 a fifth (rinds it at the to+for receivin( the headK to !ake the head requires two or three distinct o+erationsK to +ut it on4 is a +eculiar business4 to whiten the +ins is anotherK it is even a trade b* itself to +ut the! into the +a+erK and the i!+ortant business of !akin( a +in is4 in this !anner4 divided into about ei(hteendistinct o+erations4 which4 in so!e !anufactories4 are all +erfor!ed b* distinct hands4 thou(h inothers the sa!e !an will so!eti!es +erfor! two or three of the!.N As a result4 these ten +eo+le
are able to +roduce u+wards of fort*%ei(ht thousand +ins in a da*.eference: htt+:OOwww.econlib.or(Olibrar*OS!ithOs!"91.ht!l7.B4Q#0Ch.14Q#0DfQ#0theQ#0ivisionQ#0ofQ#0abor
Diminis,in) "eturns
At so!e +oint4 di!inishin( !ar(inal returns sets in and the !ar(inal +roduct of another workerdeclines. As !ore workers are added4 the ca+ital4 i.e.4 factor* si5e4 sta+ler and +en beco!e !orescarce. 'he law of (iminis,in) mar)inal returns states that as successive a!ounts of thevariable in+ut4 i.e.4 labor4 are added to a fi-ed a!ount of other resources4 i.e.4 ca+ital4 in the +roduction +rocess the !ar(inal contribution of the additional variable resource will eventuall*decline. As the !ar(inal +roduct be(ins to fall but re!ains +ositive4 total +roduct continues toincrease but at a decreasin( rate. As lon( as the !ar(inal +roduct of a worker is (reater than thea*era)e pro(uct4 co!+uted b* takin( the total +roduct divided b* the nu!ber of workers4 theavera(e +roduct will rise. /or students4 it is often easiest to re!e!ber when *ou think about *our(rade +oint avera(e. Bf *our (.+.a. for this se!ester4 i.e.4 *our !ar(inal (.+.a.4 is (reater than *our cu!ulative (.+.a.4 i.e.4 *our avera(e (.+.a.4 then *our avera(e (.+.a. will rise. 7ut if *our (.+.a.
this se!ester is lower than *our cu!ulative (.+.a.4 then *our cu!ulative (.+.a. will fall. 'hus the!ar(inal +roduct will alwa*s intersect the avera(e +roduct at the !a-i!u! avera(e +roduct.
'here !a* even co!e a +oint where addin( an additional worker !akes thin(s so crowded thattotal +roduct be(ins to fall. Bn this case the !ar(inal +roduct is ne(ative. Bn our e-a!+le4 addin(the ninth and tenth worker *ields lower out+ut than what was +roduced with onl* ei(ht workers.So how !an* workers should be e!+lo*ed2 "e know that we would not sto+ in the re(ionwhere !ar(inal +roduct is increasin( and we would not +roduce in the re(ion where !ar(inal +roduct is ne(ative. 'hus we will +roduce where !ar(inal +roduct is decreasin( but +ositive4 butwithout lookin( at the costs and the +rice that the out+ut sells for4 we are unable to deter!ine how!an* workers to e!+lo*.
A +roduction function shows the out+ut or total +roduct as !ore of the variable in+ut4 in our caselabor is added.
Question No3
ifferentiate between !ono+ol* and !ono+olistic co!+etition 4(ivin( current e-a!+les fro!the industr*.
Answer Mono+ol* and Mono+olistic co!+etition describe !arket situations4 which are quite distinct toeach other in ter!s of the level of co!+etition4 level of !arket +ower4 t*+es of +roducts sold4 and +ricin( structure. Mono+ol* and Mono+olistic co!+etition are si!ilar to each other in that a lar(enu!ber of bu*ers have onl* a few nu!bers of sellers who have better control over !arketd*na!ics. 'he article will clearl* outline the d*na!ics of each !arket structure re+resentin(si!ilarities and differences between the two.
Mono+ol* is when a sin(le co!+an* owns all or the !ajorit* of the !arket for a +roduct orservice sold. "hen a !ono+ol* situation e-ists in the !arket4 this !eans that there is one lar(eseller who has the (reatest !arket +ower4 which results in ver* low levels of co!+etition. Sinceco!+etition is low4 such lar(e !ono+olistic !arket +la*ers are able to char(e hi(h +rices and sellinferior +roducts. An e-a!+le would be +ublic !ono+olies for!ed b* (overn!ents for the
+rovision of +ublic (oods such as water and electricit*.
Another e-a!+le of a !arket with !ono+ol* would be a +har!aceuticals co!+an* whichdiscovered a cure for a disease. 'his innovation will allow the fir! to +atent the dru( so that itcannot be +roduced b* another co!+etitor durin( the +eriod for which the +atent lasts. 'his will(ive the +har!aceutical co!+an* a !ono+ol* effect in the !arket.
"hat is Mono+olistic Co!+etition2
A !ono+olistic !arket is one where there are a lar(e nu!ber of bu*ers but a ver* few nu!ber ofsellers. 'he +la*ers in these t*+es of !arkets sell (oods which are different to each other and4therefore4 are able to char(e different +rices de+endin( on the value of the +roduct that is offered
to the !arket. Bn a !ono+olistic co!+etition situation4 since there are onl* a few nu!ber ofsellers4 one lar(er seller controls the !arketK therefore4 has control over +rices4 qualit*4 and +roduct features. 3owever4 such a !ono+ol* is said to last onl* within the short run4 as such!arket +ower tends to disa++ear in the lon( run as new fir!s enter the !arket creatin( a need forchea+er +roducts.
"hat is the difference between Mono+olistic Co!+etition and Mono+ol*2
Mono+ol* and Mono+olistic co!+etition are si!ilar because each !arket structure has a lar(enu!ber of bu*ers and one or a ver* few nu!ber of sellers. 3owever4 !ono+olistic !arkets havefew barriers to entr* for new fir!s4 whereas !ono+ol* !arkets have hi(h entr* barriers becausethe !arket is controlled b* one lar(e co!+an*.
Mono+ol* !arkets are re(ulated b* co!+etitive co!!issions4 to ensure that !ono+ol* +la*ersdo not full* control !arket d*na!ics.
Su!!ar*
Mono+olistic Co!+etition vs Mono+ol*
R Mono+ol* and Mono+olistic co!+etition describe !arket situations4 which are quite distinct toeach other in ter!s of the level of co!+etition4 level of !arket +ower4 t*+es of +roducts sold4 and +ricin( structure.
R "hen a !ono+ol* situation e-ists in the !arket4 this !eans that there is one lar(e seller whohas the (reatest !arket +ower4 which results in ver* low levels of co!+etition.
R A !ono+olistic !arket is one where there are a lar(e nu!ber of bu*ers but a ver* few nu!berof sellers. 'he +la*ers in these t*+es of !arkets sell (oods which are different to each otherKtherefore4 are able to char(e different +rices.
R Mono+olistic !arkets have few barriers to entr* for new fir!s4 whereas !ono+ol* !arkets havehi(h entr* barriers because the !arket is controlled b* one lar(e co!+an*.
"hat do *ou understand b* consu!er equilibriu!62 3ow does +rice chan(e in a +articularco!!odit* affect the consu!er behavior2
Answer
Bn the consu!er6s equilibriu! anal*sis4 it is +ri!aril* assu!ed that the +rice of the (oods I andJ and the inco!e of the consu!er re!ains constant. "e now e-a!ine as to how the consu!er reacts as re(ards to his +urchases of (ood when his inco!e chan(es within the indifference curve
fra!eworks. Bnco!e is one of the !ost i!+ortant factors affectin( the +urchase of co!!odities.
Bf the +rices of (oods4 tastes and +references of the consu!er re!ains constant and there a chan(ein his inco!e4 it will directl* affect consu!er6s de!and. 'his effect on the +urchase due tochan(e in inco!e is called the inco!e effect. A rise in consu!er6s inco!e will shift the +rice lineor bud(et line u+ward to the ri(ht and he (oes on to hi(her +oint of equilibriu!. A fall in theinco!e4 will shift the +rice line downward to the left and the consu!er attains lower )tan(enc*, +oints of equilibriu!. 'he shift of the +rice line is +arallel as the +rices of the (oods are assu!edto re!ain the sa!e. 'he inco!e effect is e-+lained with the hel+ of followin( dia(ra!. Bn thedia(ra! )&.1#, wheat is !easured alon( DI and rise alon( DJ. "hen the +rice line or bud(etline is 77O 4 the consu!er (ets !a-i!u! satisfaction or is in equilibriu! +osition at +oint where it touches the indifference curve BC1. 'he consu!er bu*s DS quantit* of wheat and D9
quantit* of rice. "e su++ose now that the inco!e of the consu!er has increased and the +rice lineis now CC1. "hich shifts in a +arallel fashion to the ri(ht. 'he consu!er is in equilibriu! at a level at +oint which is its equilibriu! +oint. Bf there isfurther increase in inco!e: shift of the +rice line now will be 14 and the consu!er is inequilibriu! at +oint ' and will be +urchasin( DT quantit* of wheat and DE quantit* of rice. Bf these4 equilibriu! +oints 4 4 ' are joined to(ether b* a dotted line +assin( throu(h the ori(in4we (et inco!e consu!+tion curve BCC. 'his shows that with the rise in inco!e4 the consu!er (enerall* bu*s !ore quantities of the twoco!!odities rice and wheat. 'he inco!e consu!er is now better off at ' on indifference curveBC& as co!+ared to at a lower indifference curve BC # . 'he inco!e effect is +ositive in case of
both the (oods rice and wheat as these are nor!al (oods. 'he inco!e consu!+tion curve BCCwhich is derived b* joinin( the successive equilibriu! +ositions has a +ositive slo+e. Chan(es in Consu!er6s Equilibriu! )Price Effect,:
"e now discuss the reaction of the consu!er to the chan(es in the +rice of a (ood while his!one* inco!e4 tastes4 +references and +rices of other (oods re!ain unchan(ed. "hen there ischan(e in the +rice of a (ood shown on the two a-es of an indifference !a+4 there takes +lace achan(e in de!and in res+onse to a chan(e in +rice of a co!!odit*4 other thin(s re!ainin( the
sa!e4 is called +rice effect.
/or e-a!+le in fi(. &.1$4 A7 is the initial bud(et line. Bt is assu!ed that the +rice of wheat hasfallen and the +rice of rice and the inco!e of the consu!er re!ains unchan(ed. 'he +rice linetakes a new +osition AC and the equilibriu! +oint shifts fro! P to .
'he consu!er bu*s now D' quantit* of wheat )the a!ount de!anded rises fro! DE to D' andDT quantit* of rice. "ith further fall in the +rice of wheat4 the consu!er is in equilibriu! at +ointS4 where the bud(et line A is tan(ent to a hi(her indifference curve AC&. 3e bu*s now D/quantit* of wheat and D quantit* of rice.
'he rise in a!ount +urchased of wheat )DE to D/, as a result of a fall in its +rice is called +riceeffect. 'he +rice effect on the consu!+tion of a nor!al (ood is ne(ative. Bf we join theequilibriu! +oints PS4 we (et +rice consu!+tion curve )PCC, of the consu!er for theco!!odit* wheat.
Price Effect "hen Co!!odit* I is a iffen ood:
iffen (ood is a +articular t*+e of inferior (ood. "hen there is a decrease in the quantit*de!anded of a (ood with a fall in its +rice4 the (ood is called iffen (ood after the na!e of obert iffen.
A 7ritish Econo!ist obert iffen )1=&@%1U10,4 observed that so!eti!es it so ha++ens that adecrease in the +rice of a +articular (ood causes its quantit* de!anded to fall. 'he consu!er s+ends the !one* he saves )b* curtailin( the de!and, on the +urchase of increased quantit* of the other (ood. 'he decease in the +rice of iffen (ood has an effect si!ilar to an an increase inthe inco!e of a bu*er. 'his +articular t*+e of behavior of the consu!er to decrease de!anded of (ood when its +rice falls is called iffen Parado-.
E-+lain the conce+t of elasticit* 4M and ' and the relationshi+ a!on( the three2Bllustrate it
with the hel+ of an e-a!+le.
Answer
Answer
"hether +rice cuttin( or an increase in advertisin( dollars is desirable or not de+endslar(el* on the elasticit* of de!and for the +roduct. Dne of the !ost i!+ortant conce+ts inde!and is elasticit* which tells *ou how sensitive quantit* de!anded is to the chan(e ina factor in the de!and function. 'he +rinci+al factors involved with de!and elasticit*are:
1. 'he +rice of the (ood )in the case of +rice elasticit*,.#. 'he +rice of a substitute +roduct )in the case of cross elasticit*,.&. Bnco!e )in the case of inco!e elasticit*,.>. Advertisin( )in the case of advertisin( elasticit*,.
PBCE EAS'BCB'JPrice elasticit*4 denoted with e +4 is the ratio of a +ercenta(e chan(e in quantit* de!anded), to a +ercenta(e chan(e in +rice )+,4 as stated as a positive ter!. "e classif* the +riceelasticit* of de!and into three cate(ories:
Price elasticit of de!and "egree of elasticit
e +V1 Elastic
e +W1 nitar*
e +X1 Bnelastic
'here are two t*+es of +rice elasticit*: )1, arc elasticit* and )#, +oint elasticit*.1. Arc Elasticit*Arc elasticit* of de!and is the avera(e res+onsiveness of quantit* de!anded to a chan(ein +rice between two different values:
where P14 and 1 are the ori(inal +rice and quantit*4 and P # and # are the new +rice andquantit*.Bn other words4 chan(es in and P are calculated as +ercenta(es of the avera(e of their res+ective ori(inal and final values. 'his a++roach eli!inates the +roble! of the elasticit*!easure bein( de+endent on which end of the ran(e is viewed as the initial +oint andresults in a !ore accurate !easure of the avera(e relative relationshi+ between the twovariables over the ran(e indicated b* the data.
A ne(ative si(n is e-+ected4 so the absolute value e-+ression Ye +Y is widel* ado+ted inte-ts.
#. Point Elasticit*Point elasticit* is the elasticit* !easured at a (iven +oint.
where dOdP is the slo+e of the de!and function W )P,.EIAMPE #'he de!and function is (iven as W #00 % ?P. 'he +rice elasticit* at PW> is co!+uted asfollows:/irst4 W #00 %?)>, W 1@?Since d Od P W %?4 the e + at P W > is:e +W %? - )>O1@?, W %0.1&?
which !eans that a 1 +ercent chan(e in +rice will brin( about a 0.1>Q chan(e in de!and.'he +roduct under stud* is considered +rice inelastic4 since the e + is less than 1 inabsolute value.'"D EI'EME CASES D/ PBCE EAS'BCB'J'here are two e-tre!e cases: )1, e + W 0 and )#, e + W Z. Bf e + W 04 then the +rice elasticit* of de!and is co!+letel* inelastic and the quantit* de!anded will not chan(e in res+onse tochan(e in +rice. 'he de!and curve in this case is a vertical line4 as in /i(ure &4 +anel )a,.Bf e + W Z4 then the +rice elasticit* of de!and is infinitel* elastic and a fir! can sell as!an* units of its +roduct as it wants to at the (oin( !arket +rice4 but it will lose all of itssales at a hi(her +rice. Bn this case the de!and curve is a hori5ontal line as seen in /i(ure&4 +anel )b,. 'hese cases4 however4 are ver* rare in realit*. 'he de!and for so!e
+roducts4 such as table salt4 over at least so!e +rice ran(es !a* be hi(hl* inelastic./urther4 we !a* relate the hori5ontal de!and curve with the +urel* co!+etitive fir!.B9EA EMA9 C;E A9 9D9%CD9S'A9' PBCE EAS'BCB'J'he infor!ation on +rice elasticit* is useful to see the effect of a chan(e in +rice on sales.3owever4 *ou should be careful to know the +rice elasticit* in each +rice ran(e4 sinceelasticit* is not constant alon( the de!and curve.EIAMPE &"e are (iven the followin( de!and function: P W 10 % # or W $ % .$P
Bn the case of a linear de!and function )See /i(ure >,4 while the slo+e of a strai(ht linede!and curve is the sa!e at all +oints4 the elasticit* for such a curve varies fro! one +oint to the ne-t. 'he reason for this is that in the e + for!ula
1. d O d P would be constant4 but#. PO would fall in the case of a !ove down and to the ri(ht.
'D'A E;E9E A9 PBCE EAS'BCB'JEcono!ists have established the followin( relationshi+s between +rice elasticit* )e +, andtotal revenue )',4 which can aid a fir! in settin( its +rice.
Price e p # 1 e p $ 1 e p % 1
Price rises ' falls 9o chan(e ' rises
Price falls ' rises 9o chan(e ' falls
EIAMPE >Bn E-a!+le &4 we note that
' W P W )10 % #, W 10 % ##
and hence M W 10 %>. /i(ure $ shows therelationshi+ between '4 +rice elasticit*4 and !ar(inal revenue.1. Price elasticities can be used to answer the followin( t*+es of questions:)a, "hat will be the i!+act on sales of a $Q +rice increase2)b, 3ow (reat a +rice reduction is necessar* to increase sales b* #0Q2#. /ir!s need to be aware of the elasticit* of their own de!and curves when the* set +roduct +rices. /or e-a!+le4 a +rofit !a-i!i5in( fir! would never choose to lower its +rice in the inelastic ran(e of its de!and curve such a +rice decrease would onl* decreasetotal sales and at the sa!e ti!e increase costs4 since out+ut would be risin(. 'he resultwould be a drastic decrease in +rofits. Bn fact4 when costs are risin( and the +roduct isinelastic4 the fir! would have no difficult* +assin( on the increases b* raisin( the +rice to
the custo!er.&. "hen there are !an* substitutes and de!and is quite elastic4 increasin( +rices !a*lead to a reduction in total revenue rather than an increase. 'he result !a* be lower +rofits rather than hi(her +rofits.>. Si!ilarl*4 !ana(ers are so!eti!es sur+rised b* a lack of success of +rice reductions4this !erel* bein( a reflection of the fact that de!and is relativel* inelastic. Bn such acase4 the* !a* have to rel* on other !arketin( efforts such as advertisin( and sales +ro!otion in an atte!+t to increase !arket share./BE &'"D EI'EME CASES D/ PBCE EAS'BCB'J D/ EMA9
;arious elasticit* !easures will allow !arketin( !ana(ers to see how effective each of the de!and deter!inants )i.e.4 advertisin(4 +rice chan(e4 and e-ternal factors, is (oin( to
be. Bn this wa* !arketin( resources !a* be utili5ed !ore +rofitabl* and efficientl*.
CDSS EAS'BCB'J D/ EMA9Cross elasticit* of de!and is the res+onsiveness for one +roduct to chan(es in the +riceof so!e other +roduct4 holdin( all other factors constant. Bt !easures the closeness of substitutes or the de(ree of co!+le!entalit* of de!and. Bt is co!+uted as
1. Bf e +I V 04 (oods are substitutes. A hi(h cross elasticit* !eans that theco!!odities are close substitutes )e.(.4 coffee and tea,.
#. Bf e +I X 04 (oods are co!+le!ents. )e.(.4 hi(h%fidelit* co!+onents and Cs,.&. Bf e +I W 04 (oods are inde+endent of each other.
B9CDME EAS'BCB'J D/ EMA9Bnco!e elasticit* of de!and is the res+onsiveness of quantit* de!anded to chan(es ininco!e4 holdin( all other factors constant. Bt is co!+uted as
Bf e J V 04 +roducts are nor!al or su+erior (oods whose de!and varies directl* withinco!e4 holdin( +rices constant. A !ajorit* of consu!er (oods are su+erior (oods.Bf e J X 04 +roducts are inferior (oods. e!and will dro+ with risin( +ersonal inco!e4since4 for e-a!+le4 +eo+le turn to !ore e-+ensive foods with hi(her inco!e. E-a!+les of inferior (oods include dried beans4 reca++ed auto!obile tires4 and bud(et%+riced durable(oods.A;E'BSB9 EAS'BCB'J D/ EMA9Advertisin( elasticit* of de!and is the +ercenta(e chan(e in the quantit* sold )or !arketshare, that is associated with a +ercenta(e chan(e in the advertisin( e-+enditures of that
+roduct.
Bt is used as a !easure of short%run advertisin( effectiveness. 'his elasticit* !a* beaffected b* a nu!ber of factors such as the sta(e of the +roduct[s !arket develo+!ent4the e-tent to which co!+etitors react to the fir
