Principles of Economics

Questions:

For each pair of items below, determine which product is more price elastic (would have a higher
price elasticity of demand in absolute value). Explain your answer including identifying the
determinant of elasticity.
1. Carton of milk and the purchase of high quality jewellery
2. A bag of oranges and a tank of petrol for your car
3. Tip top bread or all brands of bread (bread in general)
Use the following graph to answer questions 4 and 5.
P ($)
3.00
2.50
4. Use the mid-point formula to calculate the price elasticity for demand curve D1 between
points A and C. Then calculate the price elasticity for demand curve D2 between points A and
B. Which curve is more inelastic? Must show workings and explain your answer.
5. If the price falls from $3.00 to $2.50 what will be the change in revenue if the demand curve is
D1? Now calculate the change in revenue if demand is D2. Compare the two and explain the
difference. Must show workings.
D1
D2
200 225 300
A
B C
3
6. Is the cross-price elasticity of demand between petrol and fuel-efficient small cars positive or
negative? Is the cross-price elasticity of demand between petrol and large not-very-fuelefficient
SUVs positive or negative? Briefly explain.
Watch the following video clip (BTN takes a look at the factors behind the rise in price of bananas)
and answer questions 7 and 8.
link to video
7. Using supply and demand curves explain how the cyclone would affect the price and quantity
of bananas in the very short run. In drawing your demand and supply curves pay close
attention to elasticity.
8. The bananas were called luxuries in the video. Do you think that this is strictly true in
economic terms? If bananas were luxuries what would this mean for the supply and demand
curves? Hint: note that the price of bananas rose by a large amount as stated in the video.

Explain whether the following events in questions 1 to 3 will affect fixed costs or variable costs
(make sure you justify your answer):
1. Samsung signs a new contract changing the price it pays for transistors that are used in its
mobile phones.
2. The federal government applies a levy per mobile phone provider of $1, 000, 000
3. Samsung decides to increase the amount it spends on designing the next version of its mobile
phone.
4. Which of the following is an example of a firm experiencing technological change? (A) The firm
reduces its workforce and is able to maintain its initial level of output; or (B) The firm
rearranges the layout of its factory and finds that by using its initial set of inputs it can
produce exactly as much as before.
5. Suppose the total cost of producing 10 000 tennis balls is $30 000 and the fixed cost is $10 000.
What is the variable cost? When output is 10 000, what are the average variable cost and the
average fixed cost? Assuming that the cost curves have the usual shape, is the dollar
difference between the average total cost and the average variable cost greater when the
output is 10 000 tennis balls or when the output is 30 000 tennis balls? Explain.
6. Online booksellers have captured a very large portion of the retail book market over the past
several years. Companies that have a large online presence, such as Amazon and Barnes &
Noble, now dominate this market. Over the past 15 years, the number of independent ‘bricks
and mortar’ bookstores has fallen. Briefly explain what role costs may have played in
explaining the large decline in independent booksellers. Use a graph to explain your answer.
5
Task 4: Market Power and Business Strategy
1. A sceptic says, ‘marketing research and brand management are redundant. If a company
wants to find out what customers want, it should simply look at what they are already
buying’. Do you agree with the comment? Explain (hint under what conditions are firms able
to earn economic profits).
2. What is a price taker? When are firms likely to be price takers?
3. ‘To maximise profit, a firm should produce the quantity where the difference between
marginal revenue and marginal cost is the greatest. If a firm produces more than this quantity,
then the profit made on each additional unit will be falling.’ Briefly explain whether you agree
with this reasoning.
Godrickporter and Star Connections are the only two airport shuttle and limousine rental service
companies in the mid-sized town of Godrick Hollow. Each firm must decide whether to increase its
advertising spending to compete for customers. The following figure shows the payoff matrix for
this advertising game. Answer questions 4, 5 and 6.
4. Define dominant strategy. Is there a dominant strategy for Godrickporter and, if so, what is it?
Explain.
5. Let’s suppose the game starts with each firm adhering to its original budget so that
Godrickporter earns a profit of $6000 and Star Connections earns a profit of $12 000. Is there
an incentive for any one firm to increase its advertising budget? Explain.
6. Define Nash equilibrium. What is (are) the Nash equilibrium(s) in this game? Explain.
6
Read the following excerpt and answer questions 7 and 8
CSR and Boral have announced the intention to form a joint venture of
Australian east coast brick operations, citing reduced brick usage as a major
cause for consolidation. The companies have proposed to combine brick
operations in New South Wales, Victoria, Queensland, South Australia,
Tasmania and the ACT. The move is subject to clearance by the Australian
Competition and Consumer Commission (ACCC). A joint statement from the
companies explains brick demand in Australia has experienced a sustained
structural decline, with bricks becoming an increasingly smaller component
of the broader cladding market. Despite a general increase in construction
activity over this period, total brick production in Australia has fallen by 46
per cent from its peak in 1981, according to Boral and CSR.
Author David Wheeldon
Source: Infolink web site (http://www.infolink.com.au/articles/news/csr-and-boral-join-forcesas-brick-demand-falls-in-line-with-australian-design-trends-n2505885#71JLP4W4bY3OD3Tg.99)

accessed 8th April 2014
7. Using the concept of economies of scale to explain why the two companies’ MUST merge due
to the significant fall in demand (start by explaining why CSR and Boral were able to operate
as separate companies before the fall in demand). For this question assume that CSR and Boral
are the only two companies in the market and form an oligopoly (Hint: think about the cost
curves and the market demand curve)? As part of this question you need draw and explain the
appropriate graph that outlines the argument in support of the merger.
8. If the joint venture is allowed to proceed, how would you describe the new market? What
would be the impact on price, quantity and profit? Explain using a graph.

Answers:

Task 2:

  1. Milk is a necessity with high and stable demand; and is consumed by both rich and poor. There are no close substitutes of milk. While high quality jewellery on the other hand, comes under luxury. It is affordable mainly by the rich. Necessities have a price inelastic demand, that is, price does not affect the quantity demanded. People will consume if even if the prices rise significantly. Also there are no close substitutes of milk. Jewellery is highly price elastic. A small change in its price will modify the demand significantly. People will not buy jewellery if it its prices rise sharply. They may switch to artificial jewellery or other accessories in case of high prices.

High quality jewellery will have higher price elasticity in absolute terms.

  1. Petrol has a high demand with not many close substitutes available. The price elasticity of petrol is inelastic. Even if the prices rise, the demand does not fall significantly. People have no other good to switch to. Oranges have a relatively elastic demand because in case of price rise, people can switch to some other fruits which are close n taste to oranges, like tangerine. Thus, demand for oranges is relatively elastic(Fouquet, 2010).

Price elasticity will be higher in for the oranges’ bag, in absolute terms.

  1. If the monetary value of tip top bread rises, people have many choices to switch to. Many other brands offer similar breads which makes Tip Top bread price elastic. Bread in general does not have substitutes. Price rise will not affect the consumption of bread as a whole. It is a necessity. Thus, bread in general is price inelastic.

Price elasticity will be higher for Tip Top.

  1. Price elasticity of demand curve, D1 (mid-point formula):

18

Price elasticity of demand curve D2:

Therefore, we can say that the demand curve D2 is more inelastic since its magnitude is 0.75 as compared to D2 which has the magnitude of 3. Also, curve D2 is steeper than D1, making D2 relatively inelastic.

  1. Revenue= Price * Quantity

Demand curve D1:

Revenue if price is $3.00 and demand is 200 units

Revenue= $3.00 * 200 = $600

Revenue if price is $2.50 and demand is 300 units

Revenue= $2.50 * 300 = $750

Here, the increase in revenue from fall in the price is ($750- $600) $150.

Demand curve D2:

Revenue if price is $3.00 and demand is 200 units

Revenue= $3.00 * 200 = $600

Revenue if price is $2.50 and demand is 225 units

Revenue= $2.50 * 225 = $562.5

Here, decrease in revenue due to fall in price is ($600- $562.5) $37.5.

As we can see, the revenue increases in case of D1 demand curve which is relatively elastic. The demand increases significantly due to fall in prices. In case of D2, the revenue falls by $37.5. D2 is relatively inelastic. Demand does not increase enough to compensate for the falling prices.

  1. Demand’s cross-price elasticity amongst petrol cars and fuel-efficient small cars may be regarded as positive. When people buy cars, they take future fuel prices also into consideration. If they expect the future prices of petrol to be higher, they will tend to buy fuel-efficient cars. Thus, the demand for fuel-efficient cars will increase in case of increase in prices of petrol. Less fuel-efficient cars like SUVs will have negative cross price elasticity with petrol. If the prices of petrol will rise, people will tend to buy fuel-efficient cars and thus increasing the demand for fuel-efficient cars.
  2. Due to the cyclone, the crops were damaged and there was sharp decline the supply of the bananas, shifting the supply curve backwards. The shift is not up to the extent of the crops damaged but a little less since some bananas were imported. There will be no change in the demand. The demand was relatively elastic while the supply was inelastic. Increased prices were an incentive for the producers to supply more but it will take time. Also, there were restrictions to trade.

17

Figure 1: Cyclone changes the supply and its elasticity. The price increases from P to P’ and quantity decreases from Q to Q’.

  1. Bananas turned into luxury because the prices rose sharply and not everyone could afford it. Demand for bananas would have increased with the fall in prices. Luxury goods are relatively elastic in nature. Supply curve in case of luxury goods is relatively elastic but in practical, the supply could not be changed instantly with increase in price. Thus, when the prices increased due to decrease in supply, the demand fell significantly. Demand curve for luxuries is relatively inelastic in short-run and elastic in the long-run.

Task 3:

  1. Cost associated with transistors will be variable cost since its value will change with the change in output, that is, mobile phones. The cost will be zero at that time of no output. Hence, there will be a change in variable cost of Samsung.
  2. Tax of $1,000,000 is a fixed cost to the firm. It is a direct tax and is not levied on the commodities. This cost is independent of the output produced. Amount of tax will not change with the change in output; hence, it will affect the fixed cost of the firm.
  3. Investment is done in R&D of Samsung. It will increase the fixed cost of the firm. It will be the same whether one or several commodities are produced. This cost will exist even at zero level of output. It is independent of the level of output produced.
  4. In case of technological advancement, a new method is devised with either increases the output with the given resources or produces the same output with lesser resources. In (A), the firm maintains its level of output with lesser number of workers. IN (B), the firm uses the same resources to produce the same output as before. Hence, there is technological change only in case (A).
  5. Variable cost refers to the total cost over and above the fixed cost. It can be calculated as:

Variable Cost= Total Cost- Fixed Cost

Variable Cost= $30,000 – $10,000 =$20,000

Average Variable Cost= Variable Cost/ Total Output

Average Fixed Cost= Fixed Cost/ Total Output

When the output is 10,000,

Average Variable Cost= $20,000/ 10,000 = $2

Average Fixed Cost= $10,000/ 10,000 = $1

Average Variable Cost (AVC) is a U-shaped curve because of law of variable proportion. AVC decreases at first and then starts to increase with the increase in output because of law of diminishing returns. It will fall until fixed input, like the capital, is increased. Average Total Cost (ATC) curve is also U-shaped like AVC curve since the fixed cost is the same and the deviation come from the variable cost. Initially it declines (not as sharp as AVC curve) due to the fixed cost which spreads over a larger output (economies of scale). Eventually it starts to increase because of diminishing returns to the factors (Aurora, 2013).

Initially fixed cost is higher than the variable cost but eventually the variable cost outgrows the fixed cost. There is increase in both variable cost and total cost. This forces both the curves to converge with the increase in output. Hence, the difference in AVC and ATC curves will be greater at output of 10,000 tennis balls.

  1. Online booksellers have affected the retail book market by reducing fixed costs like the distribution cost and storage costs. Cost of storage of the books is a cost to the retails stores but it is not the case with online stores. Retailers have to keep stock depending on the demand, which is often difficult to access and may result into loss of sales. There are costs like rent of the stores and other charges of physical stores. Often the stores keep fewer copies of books so as to incorporate a large variety of books. This result in higher costs compared to bulk orders. This is avoided in case of online stores. The books often wear out over the years, during handling and transportation. Also, there are commissions associated with retails by the publishers depending on the sales. These costs are also reduced in the online transactions.

16

Figure 2: Increase in Fixed Costs

Fixed cost increases the total cost but the slope does not change (no change in the variable cost).

The fixed costs associated with the physical stores like Bricks and Mortar is high. They need to keep a lot of stock in a small place. The decision of number of copies to be kept is tedious. When the demand of certain books is high, the time associated with publishing and distribution also affects the sales. Estimate of copies to be printed is avoided in online stores like Amazon. The wearing out of books due to handling and storage does not impact the online stores.

Task 4:

  1. Profits are maximised when Marginal Revenue (MR) is equal to the Marginal Cost (MC). When there are economic profits in an industry, new firms are attracted. This increases the level of competition in the industry and reduces the market share of the company and the economic profits. In this case, a company can maximise its profits by providing what the customers want at lower prices. It can gain economic profit when there is low level of competition and with technological improvements. Market research and brand management helps identify the needs of the customers and implement changes required to capture the market. It helps the company to gain market share by achieving first-mover advantage. Technological advancement will help achieve the economies of scale and provide lower prices to the customers. Due to this, the cost of entry for new firms will increase and the market share will not change. Thus, the statement given by the sceptic is wrong.
  2. Price takers are the firms which are not able to influence the prices of the product in the market. The firm and its output are too small to affect the prices. It has to take the prices of the industry. Industry prices are observed by the market forces of demand and supply. This happens in the perfect competition, where there are a large number of firms with low level of product differentiation. If the firm increases its prices, it may lose its market share to its competitors. Hence, only product differentiation can help the firm to influence its product’s prices without losing the market share.
  3. Initially marginal revenue (MR) is higher than marginal cost (MC). As the output is increased, MR reduces and MC increases. Producer increases its production in this case to gain more profits. He stops the production when MR is equal to MC; because after that, costs are higher than the revenues. There are losses after that point. Thus, a firm should produce till the point where,

MR = MC (Profit Maximisation)

When,

MR > MC     : scope for increase in production

MC < MR     : need to decrease the production

  1. Dominant strategy is the strategy which is best for an individual or firm, irrespective of what the other firms do. Dominant strategy is the best strategy for the firm under all circumstances.

In the given pay-off matrix, dominant strategy for Godrickporter will be to increase the budget of advertising. Once Star Connection decides to increase the budget of advertising, Godrickporter also chooses to increase its budget of aadvertising. But when Star Connection chooses to leave the advertising budget unchanged, Godrickporter again, chooses to increase the advertising budget. Godrickporter is well-off by increasing the advertising budget in both the cases. Hence, increasing the advertising budget is a dominant strategy n case of Godrickporter.

  1. Since, Godrickporter’s dominant strategy is to increase the budget on advertising; it is better-off by increasing the budget on advertising. When Godrickporter increases budget on advertising, profits increase by $10,000 (when Star Connections increases the budget on advertising). Profits increase by $2,000(when Star Connections does not increase advertising budget). Star Connections has incentive to increase advertising budget only when Godrickporter leaves its budget on advertising unchanged.
  2. Nash equilibrium is the condition where each firm decides or chooses its best strategy with the highest pay-offs, given the strategy of the other firm.

Here, the Nash equilibrium is identified where Godrickporter increases its advertising budget while Star Connections does not increase its advertising budget. It comes with a pay-off of ($8,000, $10,000). It is the dominant strategy of Godrickporter firm to increase advertising budget. Given the dominant strategy of Godrickporter, Star Connections is well-off by not increasing the advertising budget.

Nash Equilibrium: (Increase advertising budget, Leave advertising budget as it is)

  1. CSR and Boral are the only organizations in the bricks market. They both charged prices according to the prices of the other firm. Being an oligopoly market, ththere is interdependenc. The prices do not vary significantly in the oligopoly market. There is product differntiation of some level. Due to high demands, they were able to operte as separate firms and charge high prices, given the competitors’ prices. As the demand fell, their profits and market also declined. This resulted in higher cost due to decreased demand. They both lost their economies of scale and had to charge higher for the product. The decision to merge is beneficial for both the firms to achieve economies of scale with larger scale production. This can be explained with the help of following diagram:

 15

Figure 3: Economies of Scale achieved by increasing the size of production

As we can see, the cost declines with the increase in output. When the two firms merge, they now have access to larger market compared to when they operated individually. To meet the demand, they will increase their production. This will lead to efficient use of resources and reduced costs. This will enable the firm to charge lower price without cutting down on the profits. Economy of scale is an important factor initiating mergers.

  1. When the two firms merge, the resources can be efficiently used and the prices can be reduced. Economies of scale plays an important role to reduce the costs and decrease the market prices. Reduced prices can also increase the demand for the product. The total market will expand and the profits will start to increase.

Eventually, the market will become a monopoly of the merger firm and it can increase the prices to gain higher returns. The barriers of entry will also increase due to high investment and low prices.

Impact:

Prices: fall because of economies of scale

Quantity produced: expand due to monopoly and increased market share

Profits will increase due to lower costs

Costs reduce as the firm merges to form a monopoly, this can be shown with the help of following graph:

14

Figure 4: Average costs fall in the long-run and there are economies of scale achieved.

As the firms merge, they gain monopoly over the market. The market has no other option to resort to. They will be willing to pay higher cost for the same product, since there are no close substitutes available. The quantity demanded of the product will increase. As the economies of scale takes place, there is decline in the prices. This increases the profit margin for the merger firm.

References:

Aurora, B.-B.C., 2013. Cost of Production under Direct Costing and Absorption Costing- A Comparative Approach. Economy Series, (02).

Fouquet, R., 2010. Trens in Income and Price Elasticities of Transport Demand (1850-2010). Energy Policy, 50, pp.50-61.

 

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