Economics Assignment Writing description analysis Topic: Price elasticity of demand
Question 1.
Is the elasticity of demand useful in terms of predicting the new equilibrium price and
quantity in a market following a shock to the supply curve?
Question 2
Under perfect competition, describe the long and short run outcomes if a demand curve were to shift to the left.
Question 3
How are oligopolistic markets different from monopolies? Describe how the short run and long run equilibria may differ for each market case.
Question 4.
Describe how the assumptions for the different markets (perfect competition, monopolistic competition, oligopoly and monopoly differ from each other. How would, therefore, their profits differ from each other?
Question 5
Consider the following game table, indicating the payoffs of firms A and B, depending on their strategies regarding how much to spend on advertising:
Economics Assignment Writing description analysis Review Topic: Price elasticity of demand
Answer 1:
Yes, price elasticity of demand definitely has a role to play in predicting the equilibrium price and quantity in a market following a supply shock.
A shock to the supply curve means that the supply has unexpectedly changed because of some factors in the external environment. These unexpected changes cause a sudden change in productivity or production costs, which in turn has an impact on the supply. The oil supply shock of the 70s was one such shock which caused a steep rise in the price of oil (A Koutsoyiannis, 2000):.
A favorable supply shock (which causes supply to increase) brings down the price unexpectedly while an adverse supply shock (one that decreases supply) causes prices to shoot up.
Because supply shocks cause steep changes in prices, the price elasticity of demand has a role to place in predicting the new equilibrium quantity and price in the market following the supply shock.
Price elasticity of demand is:
Percentage change in quantity demanded / Percentage change in price.
In a supply shock the supply curve shifts either to the right or to the left. The changes in demand are along the demand curve (A Koutsoyiannis, 2000):.
In the diagram above (Fig 1) an adverse supply shock causes the supply curve to shift left and upwards to S’’ from S’. This causes the new equilibrium point to shift from A to B. The amount or length of this shift in equilibrium point is dependent on the price elasticity of demand and the change in price which the supply shock has caused. For a given change in price the shift AB in the supply curve will be much larger for a higher price elasticity of demand. So price elasticity of demand definitely has a role to play in predicting the equilibrium price and quantity in a market following a supply shock.
Answer 2:
In perfect competition the industry demand curve is downward sloping while the supply curve is upward sloping. In the short run only the variable factors can be changed while fixed factors cannot be.
So if demand curve shifts to the left in the short run, this means that demand has gone down. So suppliers will reduce supply in response, but this reduction in supply will only be along the supply curve. So in the short run the changes caused by a leftward shift in the demand curve will look like:
In the above figure (Fig 2) in the short run demand curve shifts from D to D’. In response to this supply too comes down along the supply curve and the new equilibrium point is B ( the earlier equilibrium point was A).
In the long run the suppliers will also be able to reduce their fixed capacity in response to the shift in demand curve to the left, therefore the supply curve will shift upwards and to the left.
In the long run, in response to the leftward shift in the demand curve, the supply curve will also shift upwards and to the left. The new equilibrium point in perfect competition will be upwards and to the left.
Answer 3:
In oligopoly the entire supply to the market is supplied by a few suppliers only. On the other hand, in monopoly the entire supply to the market is supplied by one supplier only. Oligopolies can be collusive or non-collusive. In collusive oligopoly the suppliers collude to fix price and output. So, collusive oligopoly is more like a monopoly. In non-collusive oligopoly there is no collusion or collaboration between the suppliers.
In short run in a non-collusive oligopoly, the equilibrium in case of a shift in demand curve is depicted in figure 5. Supply will only change along the supply curve in response to a shift in demand curve.
The long run equilibrium will be at a lower price and higher quantity point b because of a corresponding shift in the supply curve.
In the short run the monopoly firm’s response to a shift in demand curve will be same as that of firms in a non-collusive oligopoly. In the long run, however, a firm in monopoly may choose to expand or not expand its supply in response to a rightward shift in the demand curve. It may continue to supply so that its profits are maximized. Maximum profit is earned by a monopoly at production point where Marginal Revenue is equal to Marginal Costs.
Answer 4:
In perfect competition the main assumptions are (A Koutsoyiannis, 2000):
i) There are large number of suppliers and buyers in the market.
ii) The product supplied by each supplier is homogenous.
iii) All the suppliers have horizontal demand curves curves i.e. they can sell any amount at a given price.
iv) There are no asymmetries of information.
v) There are no barriers to entry.
vi) There is no government intervention.
In monopolistic competition the main assumptions are:
i) The products supplied by suppliers in perfect competition are differentiated.
ii) There are large number of buyers and suppliers in the market.
iii) There are no barriers to entry.
In oligopolistic competition the main assumptions are:
i) There are only a few firms or suppliers in the industry.
ii) There are barriers to entry.
iii) Firms indulge in strategic interactions i.e. the strategies are determined by the behavior of the competitors.
In monopoly the main assumptions are:
i) Only one firm supplies to the whole market.
ii) There are very high barriers to entry.
iii) Economies of scales are very large.
A firm in perfect competition earns zero economic profits in the long run while it earns some economic profits in the short run. Its long run equilibrium is given by:
Marginal Revenue = Marginal Cost = Average Cost = Price.
A firm in monopolistic competition earns some excess profits in the short and long run because of its product differentiation. Its profits are maximized at the point where Marginal Revenue = Marginal Costs.
A firm in oligopoly too earns excess profits in the short and long run because of barriers to entry. The firm in monopoly earns maximum profits in both long run and short run because of economies of scale and barriers to entry. Firms in oligopoly, monopolistic competition and monopoly indulge in mark-up pricing while firms in perfect competition are price takers.
Answer 5:
a) The dominant strategy for Firm A is to have a high expenditure on advertising. No matter whatever be the strategy of firm B, A will be better off if it chooses the higher advertising strategy. The dominant strategy for Firm B is also high advertising strategy.
b) A Nash equilibrium is one in which no player can improve his or her payoff given the other player’s strategy (Paul Samuelson, William Nordhaus, 2000). There is a Nash Equilibrium in this game which occurs at (High Advertising ,High Advertising ) point for the firms. Both firms will indulge in high advertising in this equilibrium and their payoff will be 5 each.
c) The Prisoner’s dilemma situation is one where the firms or the participants collude or cooperate. In this game if the firms A and B collude and resort to low advertising then both of them will end with better pay-offs of 7 each.
Answer 6:
In the benchmark case of Bertrand’s model where the firms have the same marginal costs, both the firms will cut their costs, in response to a cut by the other up to the point where Bertrand’s equilibrium is reached.
In the case in which firms have different costs, the firm having higher marginal cost will stop reducing the price in response to a price cut by its rival, at the point where its prices are just enough to cover its costs with a normal profit; the assumption of the firm having lower marginal costs that the price of the competitor will remain constant will be true below this point. Any price cut by him below this point will not be met by a corresponding cut by the rival having higher marginal costs. The result will be that the firm having lower marginal costs will end up maximizing its profits. This point will occur at production level where Marginal Revenue will be equal to its marginal costs.
It is useful for a business person to be aware of the insights of the Bertrand model, because it shows that competitors do not in reality behave naively and they usually respond to price cuts with cuts. It also shows that the pricing decision is usually the main decision with which the firms are concerned with (Paul Samuelson, William Nordhaus, 2000).
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