First Principles of Economics - Assignment Example

Assignment Contents Contents 2 Answer a) 2 Answer b) 4 Answer c) 6 Answer d) 8 Answer 2) 11 References 14 Answer a) A market economy is characterised by existence of the free market forces and free trade. The buyers and sellers interact in such a market freely and the equilibrium price and quantity is determined by the market forces of demand and supply. Most of the countries that follow the capitalist model of the economy are the market economies. These countries include Germany and US. Very little government involvement is existent in the market. That is the government has very little role to play in the determination of the prices and the quantity that would be sold. Very different from the capitalistic model of the economy is the communist economy where free market is not allowed to operate. There is presence of public enterprises throughout the country and the private players would not operate in most of the major industries. Even if private players are present their roles would be limited. The decisions regarding the allocation of the resources and the prices remain at the discretion of the government. This is true not only for the commodity markets but also for the other markets like the labour markets. The government often imposes tariffs and quotas in the quantities that need to be produced and the ownership of the means of production is with the government. China has adopted this kind of economic structure during the 1960s. At the present day North Korea and Cuba are nations that practice communism. A third type of economic system where there is coexistence of public and private ownership of the means of production is known as a Mixed Economy. The government as well as the private players have equal role to play in such an economy. Countries like China and India at the present day has a mixed economy structure. The sectors like railways are under the control of the government. On the other hand there are other manufacturing companies like mobile handset producers who are private players in the same market. Therefore it cannot be definitely said that there would be one right alternative for a market economy. Both mixed economy and command economy have their benefits and disadvantages. However, a mixed economy model has been adopted by a lot of nations because there is a need for government intervention as well as trade for a country. The restriction to perform free trade makes the command economy an unpopular one. Answer 1 b) The quantity demanded and the price in a particular market is determined by the market forces of demand and supply. There exists an inverse relationship between the price of a commodity and the demand for the particular commodity. In case of increase in the income of the consumers more consumers would be willing to buy mobile handsets. As a result the demand for handset will increase. However, this change will be of a non-price variable (Perloff, 2008, p. 83). In this case it is income. Therefore instead of change in the demand along the demand curve there will be a shift in the demand curve. This has been explained with the following diagram. (Lipsey and Harbury, 1992, pp. 32-45) In the above figure we see that the initial demand curve and the initial supply curve resulted in the equilibrium price of P1 and the equilibrium quantity of Q2. Now due to an increase in the income of the consumers the demand curve shifts to the right. At the same level of supply the new quantity demanded will be Q2 and the new price will be set at P2. Thus the rightward shift of the demand curve takes place due to an increase in the consumer income. As a result the quantity demanded for handsets will increase and the market price will also increase at the same level of supply (Black, 1995, pp. 318-422). (Lipsey and Harbury, 1992, pp. 79-89) Due to a technological advancement the cost of production of the handsets will decrease as a result the firm will be able to undertake more production at the same cost. This will help the firm in supplying more handsets in the market. As a result there will be a decrease in the market price for handsets and equilibrium quantity will go up. In the figure we see that the initial demand and supply curve resulted in the market equilibrium at the price P1 and quantity Q1. A technological development will result in the shift in the supply curve in the rightward direction. If the quantity demanded in the market remains the same then the shift in the supply curve will lead to decrease in the price at which the handsets would be supplied and the total quantity demanded in the handset market will increase. The fixed line telephone is a perfect substitute for the handset phones. Therefore the decrease in the price of the substitute product will affect the demand for the handsets and it will result in a change in the equilibrium price and quantity of the handsets. (Frank, 2010, pp. 211-242) In the figure the price of the fixed line phone goes down. As a result the demand for the fixed line phone goes up. The price of fixed line phone changes from P2 to P1 and the quantity demanded for the phones increase from Q2 to Q1. This has an effect on the demand for the handsets. The quantity demanded in the market for handsets goes down from Q1 to Q2. Thus at the same level of supply of the handsets the market price of handsets goes down From P1 to P2. Thus the price of the substitute goods has an effect on the market price and quantity demanded of the handsets (Pindyck and Rubinfeld, 2001, pp. 24-52). Answer 1 c) The income elasticity of demand is the percentage change in the demand for a particular good due to a unit change in the income of the individuals. Since the demand for a particular product depends on the income of that individual the income elasticity of demand will determine how much the demand responds to the changes in the income. Thus the income elasticity of demand can be represented in the following formula. Now the food products are necessary goods and thus the income elasticity of demand for food product lies between zero and one. This means that for one percent increase in the income the quantity demanded for food products will increase by less than or equal to one percent. However, in the rich countries the quantity demanded for the food products is always compensated by the supply and people generally do not change their consumption of food drastically due to changes in the prices (Mas-Colell, Whinston and Green, 1995, pp. 315-327). Because even if the prices are high the people would buy only limited amounts of the necessary products. Thus despite the influence of business cycles and the changes in the income the demand curve will remain more or less same. Thus demand curve for food products in poor countries would be inelastic. (Marshall, 1961, pp.124-141) In the figure it can be seen that the demand curve for food grains in the high income countries would be the one that has an income elasticity of less than one. The demand curve for food grains would be steeper than the demand for any other goods in this case. The income elasticity of demand is generally high for the luxury goods. This means that when the income of the individuals increase the demand for luxury products increase at a much higher rate as compared to the other products. The luxury products that the people of higher income countries buy are the luxury cars, designer clothes or airline travel services. When the income of the individual increases he would increase his spending by buying the designer clothes which otherwise he could not have bought. On the other hand if the income decreases he would cut down on his spending and would buy a few dresses less than what he would actually have bought. The income elasticity of demand is very well reflected in the market for automobiles. Due to a rise in the income level of the individuals living in an economy, the quantity demanded for cars would go up. The people who do not have cars may think of purchasing one and the people who already own one would go for purchasing a higher version. Thus the income elasticity of demand for normal goods and luxury goods would be greater than one as shown in the figure. Again due to increase in the income individuals would spend more on travelling for going on a vacation and therefore the demand for airline eservices would go up. Answer 1 d) Perfectly Competitive Markets are characterised by lack of barriers to entry and exit. Thus any firm operating in such market is free to enter and exit the competition. Since there are a large number of producers in the market the entry or exit of one particular firm will have very little effect on the market equilibrium of a perfectly competitive market. But this kind of a market structure does not exist in reality. In case of the different types of markets the barriers to entry and exist vary. There are various kinds of setbacks that the firms operating in a particular market faces. For example often the firms that try to enter into the market for the first time find it difficult to incur the advertisement expenditure. The extent to which the expenses have to be made has to be huge because the companies would have to outdo the image of the existing brands. Along with that the firms that are already in the market have better access to the various resources that are necessary for production as compared to the new entrant. The new entrants would also find it difficult to achieve economies of scale in the initial days. The pricing strategies that the existing companies may adopt may create an entry barrier for the potential entrant. This is because the existing companies would achieve economies of scale and the price at which they would be offering would be much less than what the new entrant would offer. Thus the new company would not be able to survive the price competition and will be forced to exit. Barriers to entry may also come in form of governmental controls and the licensing policies. If there is a limitation on the number of firms that can be set up in a particular economy then the firms would not be able to set up factories at their free will. Again for some products the switching cost would be very high for the customers who would make them stick to the existing brands. Economies of scale are achieved by a firm when the level or the scale of production of a particular firm gets increased. This happens mainly when the firm is operating in the market for quite some time and it has been able to recover the initial costs that it had incurred while setting up the firm and the production technology. The cost of machines gets reduced because the company has been able to break even in such a case by recovering the start up costs. (Pindyc and Rubinfeld, 2001, pp. 174-187) In the figure it can be seen that the average cost of the firm was much higher at the initial units of production at Q1. With the increase in the units of production the average cost is falling. When the unit of production is at Q2, the firm has the least average cost and has been able to achieve economies of scale. The Long run average cost curve thus goes down in case of this firm. Another reason for the reduction in the cost is the adaptation of specialisation in the activities undertaken by the firm. Specialisation allows for the utilisation of resources in the efficient manner. This enables the firm to reduce its costs. Again with the growth of the companies over a period of time the bargaining power in the market for raw materials increases. All these provide the existing firms a cost advantage over the other companies. Thus the degree of competitiveness based on the pricing strategies of the firm is determined by how much the firm has been able to achieve economies of scale in the market. Answer 2) The concentration of monopoly power generally brings in a lot of power in the hands of the single producer that dominates the market. The government of the various countries try to restrict the emergence of any monopoly control through the imposition of regulations and controls and by introducing competitive market framework for a particular industry. (Mas-Colell, Whinston and Green, 1995, pp. 386-391) In the above figure cost and price conditions of a monopolist and a firm operating in the competitive framework has been constructed. The monopolist will optimise at the point where the marginal revenue is equal to the marginal cost curve and will produce a lower quantity of output. The price that the monopolist will fix will be higher than the competitive price as shown in the above diagram. On the other hand the producer in the perfectly competitive market will produce at the point where Marginal cost curve will be equal to the average revenue curve i.e. at P=MC. Therefore as the market moves from monopoly towards competition the price tends to come down and the quantity supplied by the producers get increased (Frank, 2010, pp. 393-405). The monopolist produces at a much lower cost and sells at a much higher price. The difference in the monopolistic price and the competitive price is the profit that the monopolist makes. If competition is introduced in the market then each of the firm would try to reduce the cost of production to offer the same product at a lower price. This would also force the already existing player who had a high price to lower his price to remain in the market. If this is not done the firm will be forced to move out because consumers would go to the sellers who are providing the products at a better or cheaper rate. The price of the oligopolies would remain somewhere between the price of the monopolist and the price of the perfectly competitive market. Since perfect competition does not exist in the real world it is assumed that due to the removal of the monopoly power from the market a situation of oligopoly would be created. (Mas-Colell, Whinston and Green, 1995, pp. 386-416) Due to the introduction of a few players in the market the resulting market structure would be of oligopoly. The number of buyers would remain large in this case also. The huge changes in the costs of the oligopolist would have a small impact on the equilibrium price of the good (Kreps, 1990, pp. 135-165). The figure depicts the changes in the costs that a firm operating in an oligopoly market would face. As the marginal cost curve shifts towards the left by a large amount the price change takes place but to a little extent because the firm has to offer something close to the competitive price set by all players to remain in the market. For example suppose initially in a particular economy, there is only one producer of shoes. The price at which the seller sold was $ 20. Now new players enter into the market and for capturing the market share they start selling at $15 per pair. In such a situation the initial player has to reduce the price in order to remain in the market because otherwise the consumers would not by from him. Thus introduction of completion remove any monopoly power and is beneficial from the consumer and point of view of society. References Lipsey, R.G. and Harbury, C., 1992. First Principles of Economics. New York: Oxford University Press. Frank, R H., 2010. Microeconomics and Behavior. New York: McGraw-Hill Irwin. Kreps, D. M., 1990. A Course in Microeconomic Theory. New York: Harvester Wheatsheaf. Mas-Colell, A., Whinston, M. D. and Green, J. R., 1995. Microeconomic Theory. New York: Oxford University Press. Perloff, J., 2008. Microeconomics Theory & Applications with Calculus. London: Pearson. Marshall, A., 1961. Principles of Economics: Notes. New Delhi: Osprey Publishing. Read More