Price Elasticity of Demand - Assignment Example

Question1:- The price elasticity of demand (PED) measures the sensitivity of quantity demanded to changes in price. The relationship is measured as the ratio of percentage changes between quantity demanded of a good and changes in its price. Water is a good example of a good whose quantity demanded does not change radically with price. On the other hand, sugar’s quantity demanded changes drastically as the price of sugar increases as there are many substitutions which consumers may switch to. Decreasing prices are usually accompanied by an increase in the quantity demanded (there are a few exceptions to this case). Now, the demand for a good is relatively inelastic when the quantity demanded is not greatly affected by a change in price as in the case of water. In the opposite case, the demand for a good is said to be relatively elastic. Now, when the price elasticity of demand for a good is inelastic, the percentage change in quantity demanded is smaller than that in price. Hence, the raised price causes the total revenue to increase, and vice versa. Similarly, when the price elasticity of demand for a good is elastic, the percentage change in quantity demanded is greater than that in price. Hence, when the price is raised, the total revenue of producers falls, and vice versa. Three other cases of elasticity are given below. When the price elasticity of demand for a good is 1, the percentage change in quantity is equal to that in price. This rarely happens in real life. When the price elasticity of demand for a good is perfectly elastic i.e. the mathematical elasticity is infinite, any increase in the price will reduce quantity demanded to zero which would cause the total revenue to fall to zero. This case only happen to good whose value is closely defined with no chances of variability e.g. a $100 bill is worth $100 at all times. When the price elasticity of demand for a good is perfectly inelastic, changes in the price do not affect the quantity demanded for the good. The demand curve is a vertical straight line; this violates the law of demand. (Wikipedia, 2008) As we have seen, it is not possible for a good to be elastic and inelastic at the same time, so either I or my colleague is right. Source: http://www.willamette.edu/~fthompso/ManEX/Sem109_Competition/elas5.GIF Question2:- A. Sunk costs are costs which once they have been incurred cannot be recovered. Now in economic theory, only the variable costs are relevant in the decision making process. Rational economic behaviour involves ignoring sunk costs, our statement to evaluate is hence completely true as all decision should be assessed on the profitability of the matter at hand and not by costs which the business has incurred but not by the specific matter which is being decided upon. Therefore, costs which have already been incurred and cannot be recovered should not affect the decision and most importantly, this sunk cost should be mistakenly accrued as a cost for the matter which is being decided upon. (Wikipedia, 2008) B. For people who own motor vehicles is a necessity. Therefore the demand curve for petrol is perfectly inelastic for such people. This statement is only true if there are no other alternative sources of fuel available to these people. If alternates are present, then for a good to be considered inelastic is very difficult as whatever the reasons behind the use of a particular good, people can easily convert to the substitute in the case where the price of the original product increases and vice versa. C. The price elasticity of supply is defined the sensitivity of the quantity supplied of a product to a change in its price. When there is a relatively inelastic supply for the good this statistic is small; in the vice versa case, this statistic is large. Now, supply is normally more elastic in the long run than in the short run for manufactured goods. This is because, as spare capacity and more capital equipment as well as other factors can be used, the supply can be increased whereas in the short run only one factor i.e. labor can be increased. There are exceptions to this norm as well. (Wikipedia, 2008) Source: http://tutor2u.net/economics/content/diagrams/supplyelasticity1.gif D. The cross price elasticity of supply is defined the sensitivity of the quantity demanded of a product to a change in the price of another product. Knowledge of this statistic can certainly help a firm in their long-run investment decisions as this statistic can enable a firm gauge the performance of its product against the performance of a substitute product or a compliment product, and then whilst it keeps the future outlooks of its compliments and/or competitors in full view, they firm can derive the long run investment decisions that they wish to undertake. (Wikipedia, 2008) Source: http://tutor2u.net/economics/content/diagrams/cross_2.gif Question 3:- A. Marginal cost is the change in total cost due to the production of exactly one unit of output. Mathematically, the marginal cost is defined as the derivative of the total cost function with respect to quantity. Now, as the marginal cost changes with volume, so at each level of production, the marginal cost is the cost of the next unit produced. Therefore, we can see that the cost incurred due to taking the production from one level to the next is solely the variable cost; hence, we can say that marginal cost reflects the variable cost of production. The MC curve curves the ATC curve at its lowest point because at that point the cost of producing one more unit is exactly equal to the average total cost of production which means that this average cost of production represents the lowest cost of producing one unit i.e. it is basically the MC at that point. (Wikipedia, 2008) Source: http://mba651fall2007.wikispaces.com/space/showimage/AVC_Graph_3.png B. Marginal product is the change in total product due to an increase of exactly one unit of input. Now, we already know that marginal cost is the change in total cost due to the production of exactly one unit of output, so if we put the two concepts together we see that one basically determines the output per unit input and the other determines the input per unit output so we can see that taking the mathematical inverse of marginal product will bring us to marginal cost and vice versa. Hence, a firm's marginal cost curve is the inverse of the marginal product curve. (Wikipedia, 2008) C. The marginal cost curve is the same as the supply curve for a perfectly competitive firm above and ahead of the point where the MC curve intersects with the ATC curve. This is because marginal cost from this point determines the additional cost incurred due to increasing production and in accordance with the MC = MR rule of perfectly competitive market, this cost should be exactly equal to the revenue that the firm should get for its increased production. As revenue is area under the supply curve, the MC curve, hence, becomes the supply curve. Question 4:- There is a very simple answer to the hypothesis that we are testing i.e. yes, there is an optimum level of pollution. Here, in order to ascertain the optimal level of pollution, we will conduct a simple cost/benefit analysis of pollution and its relevant effects. The outlays with regards to pollution basically comprises of all the environmental decadence i.e. increase in medical cost or diminished usability of a natural resource. The basic societal benefit of pollution consists of the reduction in cost of production and the cheaper products that ensue. Here, in order to better compare the costs and the benefits, we will assign numeric currency values to these costs and benefits as we can’t compare lamps and footballs; any comparison requires measurements to be in the same units. Now, the optimal level of pollution is, therefore, determined where the marginal costs of emissions and the marginal benefits intersect each other. In their paper on efficient level of production, the Agricultural and Resource Economics graph the marginal outlays caused by pollution as the curve MD which is positively sloped. The rationale behind this is that the first unit of pollution does not cause much damage, but subsequent units cause more and increasing damage. It must be kept in mind that in practice, however, the marginal damage caused by every increasing unit of pollution is incredibly difficult to measure. Despite this apparent divergence in opinions, this theoretical model is still workable for the measurement of MD. Now, the curve MB in the graph is the firm’s marginal benefit of polluting an extra unit. Now, in order to reduce pollution, the firm has to incur costs due to decreased levels of productions. By increasing pollution, the firm reduces these costs due to decreasing production. Now, any reduction in costs is a benefit for the firm. Therefore, in the absence of any pollution regulation, the firm emits pollution at the level for which its production costs are minimized. At this point, the firm would not be able to reduce its costs by polluting an extra unit, so the marginal benefit of polluting is zero. This point is labelled eBAU in the graph. Now, the socially optimal level of pollution occurs where marginal damages of pollution equal marginal benefits of pollution. This point is reached when conflicting driving forces i.e. increase in pollution due to increase in production in order to achieve economies of scale from the producers and increase in demand for cheaper products and increase in social demand for less pollution contrive to act against each other and reach an equilibrium point where the effect of both forces are neutralized on each other. Also, we can see that this level is usually less that the unregulated level but greater than zero, showing that some pollution is helpful for the society. (ARE, 2006) Source: Agricultural and Resource Economics Bibliography 1. Wikipedia, The Free Encyclopedia “Price Elasticity of Demand” (2008) September 26, 2008 http://en.wikipedia.org/wiki/Price_elasticity_of_demand 2. Wikipedia, The Free Encyclopedia “Sunk Cost” (2008) September 26, 2008 http://en.wikipedia.org/wiki/Sunk_cost 3. Wikipedia, The Free Encyclopedia “Price Elasticity of Supply” (2008) September 26, 2008 http://en.wikipedia.org/wiki/Price_elasticity_of_supply 4. Wikipedia, The Free Encyclopedia “Cross Elasticity of Demand” (2008) September 26, 2008 http://en.wikipedia.org/wiki/Cross_elasticity_of_demand 5. Wikipedia, The Free Encyclopedia “Marginal Cost” (2008) September 26, 2008 http://en.wikipedia.org/wiki/Marginal_cost 6. Wikipedia, The Free Encyclopedia “Marginal Product” (2008) September 26, 2008 http://en.wikipedia.org/wiki/Marginal_product 7. Agricultural and Resource Economics (2006) “The efficient level of pollution and the Coase Theorem” University of California, Berkeley Read More