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:
Q 6) Compare the dynamics of competition in the Bertrand model between the benchmark case in which firms have the same marginal costs and a different case in which firms have different marginal costs. Criticise the assumptions of the Bertrand model in terms of their realism. Explain why it may be useful for a business person to be aware of the insights from the Bertrand model.
Answer the Question frame is:
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):.
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.
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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