Principles of Economics
No, my friend is not correct in saying that it will not cost me anything to go and watch the cricket game. This is because of the economic concept of opportunity cost. In his book Economics An Introduction, Walter Birmingham said that
Since we cannot have all we want of everything, we have to make a choice. The cost of producing the thing we actually choose is the amount of something else we are unable to produce in consequence.
The cost of a thing is measured by the sacrifice of other things which makes possible the production of the chosen one (1966, p. 64).
The concept of opportunity cost arose because of the reality of choice. A choice has to be made if we want or if we can do at least two things but cannot have both. Assuming that I am employed and I get 100 per day. If I go with my friend, I cannot go to work and I do not get paid. The cost for me, then, is 100, which is the salary I get for the day had I worked instead of going to the game. Sometimes, the opportunity cost may be intangible, like if I went to the game with my friend, I cannot spend the day with my family because I cannot be in both places at the same time. I need to choose. This kind of opportunity cost is immeasurable since we cannot quantify it, but then, it is still a cost to me because it is an opportunity I sacrificed in favor of going to the game.
Question 1 (b)
All human beings have needs and wants which may be satisfied by tangible things that can be produced using factors of production. Factors of production are the resources which are used to produce goods and services and these are sometimes classified into land, labor, and capital (Birmingham 1966). Human needs and wants are unlimited while the supply of resources, or factors of production, available to meet these needs and wants are limited. This dilemma is what is referred to in economics as scarcity of resources. Because of
this problem of resources not being enough to meet our needs and wants, choices have to be made about how to efficiently use them. Assume, for example, that a university is considering offering three additional degree courses to its present course offerings this schoolyear. Assume further that every degree course will need at least five classrooms each. Let us also assume that in its current physical state, the university can only have 7 classroom spaces available. Assume furthermore that a 3-storey building is still under construction and is expected to add at least 15 classroom spaces and offices for professors, but is not expected to be finished within the next 12 months. The need, if it were to add three additional degree courses at 5 classrooms per course, is 15 classrooms. The university has only 7 available classrooms as of the moment. In this scenario, the need exceeds the available resource. The university, therefore, is being confronted with the problem of scarcity of resources.
Question 2 (a)
The market equilibrium for a good occurs when at a certain price per unit, the quantity demanded of the good per unit of time (Qdt) equals the quantity supplied of the same good per unit of time (Qst), other factors being held constant. The market price at which this equality occurs is called the market equilibrium price and the quantity is the equilibrium
quantity. To show this graphically, let us take a look at Figure 1, where the vertical axis measures the priceunit and the horizontal axis measures the quantity demanded andor supplied per unit of time. Let us assume, for example, a certain good, say X, is being sold in the market, and that its demand curve is D1 and its supply curve is S1, as shown in Figure 1. The point of intersection between the demand curve D1 and the supply curve S1, which is shown in the graph as E1, is the point of market equilibrium for good X. Graphically, this occurs at the price of 6 per unit. Thus, at 6 per unit, the consumers are willing to buy exactly what the sellers are willing to sell at that price, shown in figure 1 as 5 units, given a unit of time, again assuming that all the other factors affecting demand are constant (ceteris paribus).
A change in one of those non-price factors affecting demand, such as the number of consumers (population), their income (wealth), their tastes and preferences (marginal utility), or the prices of substitutes, among others, will cause a shifting of the entire demand curve, to the right of the original if there is an increase in demand, or to the left if there is a decrease in demand (Bilas 1971).
Figure 2 shows the new demand curve D2 for the same hypothetical good X. Notice that D2
is to the right of D1 which indicates an increase in demand. Assuming that there are no changes in supply S1, a new market equilibrium is restored at point E2 which is the point of intersection between the original supply curve S1 and the new demand curve D2, where
Qdt Qst, but this time at a higher price per unit.
Question 2 (b)
Cross-price elasticity of demand measures the rate of response of quantity demanded of one good, due to a price change of another good (Moffatt 2010). It therefore shows the relationship between two goods, that is, how the demand for one good, for example sugar, changes when the price of another good, for example coffee, changes. If they are complements, which means they are demanded together, such as coffee and sugar, the coefficient of cross-price elasticity will be negative an increase in the price of coffee will decrease the demand for sugar. If the two goods are substitutes, like Coca-Cola and Pepsi Cola, cross-price elasticity will be positive an increase in the price of Coke will increase the demand for Pepsi. If they are unrelated, like cellphones and paper, the cross-price elasticity coefficient will be zero a decrease in the price of cellphones does not affect the demand for paper (The Economist).
Table 1. Pairs of goods matched with the value for cross price elasticity of demand
PAIR OF GOODSVALUERELATIONSHIPCars and bicyclesConsiderably greater than zeroSubstitutesMetros and BarinasSlightly greater than zeroSubstitutesCars and PetrolConsiderably less than zeroComplementsSugar and carsZeroIndependentCars and trips to PerthSlightly less than zeroComplements
Cars and bicycles will have a considerably greater than zero coefficient of cross price
elasticity because both goods are means of transportation, and thus are good substitutes for each other. If the price of cars go up, the law of demand states that the quantity demanded of cars tends to decrease, ceteris paribus. Consumers will now be looking for other similar goods which can substitute for cars, thus the quantity demanded of these substitutes, like bicycles, would tend to increase and vice-versa. The resulting coefficient of cross-price elasticity will be positive, and should be considerably greater than zero. As for metros and barinas, the cross price elasticity of demand should be just slightly greater than zero. This means that although these two goods may be substitutes for each other as indicated by a greater than zero or positive cross price elasticity of demand, they are not good substitutes and thus, an increase in the price of barinas, for example, will have very minimal effect on the use of metros. In the case of cars and petrol, these two goods are complements. Complements are goods which are demanded together, or needed together. Thus, other factors being constant, and assuming that the price of cars decrease, then more cars will be sold, which in turn means there will be an increase in the demand for petrol because one would need petrol to run these cars, and vice versa.
Thus the coefficient of cross-price elasticity of demand will be considerably less than zero. Between sugar and cars, each is neither a complement of nor a substitute for each other, which means that any change in the price of sugar does not, in any way, affect the demand for cars, and vice versa. Thus, the resulting coefficient should be zero. These goods are unrelated or independent of each other. For cars and trips to Perth, the coefficient of cross-price elasticity should be slightly less than zero. Although these goods are complementary, which means that they may also be jointly demanded, there are many other ways to go to Perth, not just by car, so the cross price elasticity should be just slightly less than zero.
The law of demand states that, all other factors being constant, as the price of a good or service increases, consumer demand for the good decreases and vice versa (Investopedia
2010). The income effect of a price change is the change in demand resulting from the change in purchasing power, with the price ratio remaining constant. Graphically, it is the movement
from the original indifference curve to the final indifference curve (Bilas 1971). The substitution effect of a price change, on the other hand, is the change in demand resulting from a change in the price ratio, leaving the level of satisfaction or utility the same. Graphically, it is the movement along the same indifference curve (Bilas 1971).
To illustrate and explain the law of demand through the income and substitution effects using a price increase assumption, let us take a look at Figure 3.
Firstly, assume that the consumer is rational and that there are two goods that the consumer will buy good X, whose quantity demanded is measured by the horizontal axis, and good Y,
whose quantity demanded is measured in the vertical axis. IC1 and IC2 are the indifference
curves. They show the different combinations of quantities of good X and good Y which yield equal satisfaction to the consumer. They slope downward to the right since the consumer must give up one good and have it compensated for by another for his satisfaction or utility to remain constant. They are also assumed to be convex to the origin and they never intersect. All points on IC1 yield the same level of utlity or satisfaction, assuming that satisfaction is measurable quantitatively, and that this level of utility in IC1 is greater than the level yielded by IC2. Assume further that BL1, BL2 and BL3 are the budget lines for the consumer, where BL1 is the original budget line, BL2 the new budget line if we assume that the price of good Y increased but the price of good X did not change, and BL3 is the consumers budget line if we assume that the consumers income has been adjusted, taking the price increase into consideration, thus leaving the price ratio unchanged. This adjusted income is also referred to as real incomeThis assumption will enable us to isolate, and thus show hypothetically, the substitution effect. The budget line is diagonal because the amount spent by the consumer on both goods together is less than or equal to the consumers income. Remember, at the onset, we have assumed that the consumer is rational.
Using these hypothetical indifference curves and budget constraint lines, the consumer will choose any point (or combination of goods X and Y) that will give him the highest utility (meaning, a combination that is on his highest indifference curve) and that is within his budget BL1. In figure 3, this is shown at point A, the point of tangency between the indifference curve IC1 and budget line BL1. Thus, he will buy Qx1 units of X and Qy1 units of Y. Now if the price of Y increases, no change in income and in the price of X, the budget line will pivot with respect to X. The new budget line will be BL2. Again, to maximize his utility given the price increase which decreased his purchasing power, he will move to point B, the point of tangency between the new budget line BL2 and the lower indifference curve
IC2. He will buy less of Qy (a decrease from Qy1 to Qy2) and more of X (an increase from
Qx1 to Qx2). The substitution effect of an increase in the price of good Y, as shown by Figure 3, is the movement from point A to point C, along the same indifference curve IC1. At point
C, the indifference curve IC1 is tangent to the budget line BL3 which, again, is the resulting budget line if the consumers income had been adjusted, taking into consideration the price increase for good Y, such that the price ratio of the two goods, X and Y, remains unchanged. The quantity demanded of X increases to Qx3 from Qx1 but the quantity demanded of Y decreases to Qy3 from Qy1. Quantitatively, the substitution effect is the difference between the original consumption of X and Y at point A and the new consumption at point C. The income effect, as shown also in figure 3, is the difference between the consumption of X and Y at point C and the final consumption of the same goods X and Y at point B, respectively. It must be noted that the income effect in our hypothetical illustration is a decrease in the consumption of X, from QX3 at C to Qx2 at B, and also a decrease in the consumption of Y, from Qy3 at C to Qy2 at B.
Thus, the substitution effect of a price change always works in the direction predicted by the law of demand. This is due to the assumption that indifference curves are convex to the origin. The income effect, on the other hand, may either be positive or negative, depending on the kind of good if the good is normal, income effect is positive (substitution effect also works in the same direction as income effect) if the good is inferior, income effect is negative and if the good is a Giffen good, the income effect overrides the substitution effect, that is, as the price of the good increases, the quantity demanded of this good also increases - a result that is contradictory to the law of demand, and as such, the demand for Giffen goods, therefore, is generally considered by economists as the exception to the law (Bilas 1971).
Question 3 (b)
The producers surplus is the amount that producers benefit by selling at a market price that is higher than they would be willing to sell for. Thus, it exists when actual price exceeds
the minimum price sellers will accept (Ingrimayne 2010). Consider the hypothetical firm represented in Figure 4. The supply curve S shows the minimum price at which producers would be willing to supply a given level of output. The minimum price at which this firm will supply this good in the market is at 0A. As the price increases, the quantity that the firm is willing to supply also increases. The producers surplus, therefore, is the difference between the amount that producers actually receive and the minimum amount that they would have to receive in order to supply the given level of output. Graphically, producers surplus can be shown as the area above the supply curve and below the prevailing market price, shown in figure 4 as the yellow-shaded area.
Question 4
A perfectly competitive industry is a market structure in which, for it to exist, these basic assumptions are required there must be many small firms, each of whom produces a very small percentage of the total industry output and therefore has no control over price setting there must be many individual buyers, none of whom also has any control over the market price there is perfect freedom of entry and exit from the industry to ensure that all firms will make normal profits in the long run the products being sold are perfect substitutes, which leads each firm to become price-takers and the demand curve for their product is perfectly elastic or horizontal the consumers have ready access to available information about prices and products of competing sellers and sellers have ready access to the same production techniques and there are no externalities that arise from consumption andor production (Bilas 1971). With these assumptions in place, the long run equilibrium for this industry, as well as for each seller in the industry, is where P AC MC, where P is the price, AC is the average cost which is the total fixed cost total variable cost divided by total units produced, and MC is the marginal cost which is the increase or decrease in the total cost of a production-run, for every additional unit of the item produced (Business Dictionary 2010). Figure 5 is a graphical representation of the long run equilibrium of a perfectly competitive industry.
Figure 5 Long Run Equilibrium in a Perfectly Competitive Industry
The long run industry equilibrium price is Pe, and is taken by each individual firm as their product price since they are assumed to be price-takers. At price Pe, this individual firm will produce at quantity Qe where Pe MC (point of intersection between the horizontal demand curve and MC curve) also where MC AC (point of intersection between the MC and AC curves) and where price Pe AC (point of tangency between the horizontal demand curve faced by the firm since it is a price-taker and the lowest point of the AC curve, indicating that at this quantity Qe, this firms average cost is at its lowest). Thus, the long run equilibrium is where P MC AC.
An efficient allocation of resources is achieved if it is not possible to increase societys overall satisfaction level by producing more of one good and less of another good. Such efficiency is achieved by a firm if the price of a good is equal to the marginal cost of production. With price Pe being equal to the marginal cost, each firm is maximizing profit and has no reason to adjust the quantity of output or factory size. At this price Pe, consumer and producer surplus are maximized. The equilibrium output Qe is being produced with the average cost at its lowest, or what is called the minimum efficient scale, so there is pr