Economics Assignment
Question B: Consider a perfectly competitive market in long-run equilibrium where all firms operate under the same cost conditions. Suppose a new technology becomes available which reduces marginal production costs. Explain graphically and verbally what happens to the market in the short run and in the new long-run equilibrium if factor prices and demand are assumed to remain the same as before. Hint: You have to use two parallel diagrams, one for an individual (representative) firm and one for the industry.
As the market is considered to be perfectly competitive, the demand curve will remain perfectly elastic in correlation to the market price. This is because firms selling similar products cannot make any real economic profit so cannot drop their prices as they would most likely go out of business, they also cannot raise the price as customers would not be willing to pay more for a product when they could get it from a second firm for cheaper hence the demand curve is perfectly elastic/horizontal. So in the short run there would be no change to the demand curve or marginal revenue curve.
If a firm reduces their marginal costs, then the ability to beat other firms in competition and protect their competitive advantage would only lead to customer benefits from cost reductions. This in turn would cause a downwards shift to the long run demand curve. The availability of new technology to a firm which allows a lower marginal cost of production would cause a downward shift to the marginal cost curve meaning a reduced marginal cost at all levels of output. The amount of the downward shift is dependent on the efficiency of the technology. The more efficient the technology the greater the shift and the lower the marginal cost becomes.
The availability of the new technology to all firms in the market is something to consider. Take for example the new technology doesn’t require any new fixed investment and doesn’t raise overall fixed costs by much, all the firms within the market have easy access to the new technology and all that would happen is an increase to the equilibrium point, being at a higher output level in the short run, however on the contrary if the new technology is only accessible to few firms due to high fixed costs or a lot of time and effort, then those firms would be at an advantage as they are able to gain early access and make a normal profit at a lower price where as other firms unable to invest in the new technology may suffer a loss or a reduced profit effecting the firms revenue. If the case at hand continues then those firms with access to the new technology will soon dominate the market and drive other competitors out of business turning the market into a monopolistic or oligopolistic one.
If all firms in the market have access to the new technology then the marginal costs will shift downwards for all the firms, this causes the equilibrium of demand and supply to be at a higher level of output. The price may stay the same however it could fall to a lower equilibrium price due to price wars/competition within the market conditions this would also affect the marginal revenue causing it to be reduced.
In the short run firms can make super normal profits as they are able to reduce marginal costs due to access to new technology whilst other firms without access may make losses.
The supernormal profit gained by the firm in the short run acts as an incentive for other firms to join the market leading to an increase in supply which causes the market price to fall for all firms until only a normal profit is made.
Question D – Group Work
Exercise: i
A
Gross Domestic Product is defined as the value of all final goods and services actually produced within an economy over a certain period of time (usually a year).
The components of GDB are the following:
• Consumption Expenditures
• Investment Spending
• Government Expenditures
• Net Exports (Exports – Imports)
Thus the GDP equation is: GDP = C + I + G + NX
GDP = 828,081 + 238,531 + 286,812 + (369,691 – 424,128)
GDP = 1,298,987
B
The output approach of the GDP at market prices is the sum of output (value-added) produced in the economy.
As a result the following formula is used: GDP at factor cost = GDP at market price – indirect business tax + subsidies
GDP = 1,298,987 – 635
GDP = 1,298,352
C
Gross national Product is found by adding GDP at market prices + net income factor from abroad.
GNP = 1,298,352 + 17,334
GNP = £ 1,315,686 (millions)
D
Net national product is defined as the total market value of all final goods and services produced within an economy over a certain time period, minus fixed capital consumption.
NNP = GNP – Fixed Capital Consumption
NNP = 1,315,686 – 133,936
E
NNP at market prices is found by subtracting indirect taxes from initial NNP.
NNP = 1,193,757 – 144,663
NNP = £ 1,049,094 (millions)
Exercise: ii
Price Elasticity of Demand (PED) is the percentage change in quantity divided by the percentage change in price. The percentage change in quantity can be established by the PED multiplied by the percentage change in price:
PED = %∆Q =
%∆P %∆Q = PED x %∆P
Supposing a government increases taxes on cigarettes from ₤1 to ₤2 per pack sold, raising the prices from ₤4 to ₤5 per pack, and assuming price elasticity on this demand to be constant, the percentage change in total taxes can be calculated.
A – If price elasticity of demand equals -0.2:
PED = -0.2 ∆P = ₤5 – ₤4 = ₤1 %∆P: ₤4 = 100% ₤1 = 25%
%∆P =25% or 0.25
%∆Q = PED x %∆P %∆Q = (-0.2) x 0.25 %∆Q = -0.05 = -5%
The increase in taxes from ₤1 to ₤2, consequently increasing prices of each pack from ₤4 to ₤5, would decrease quantity demanded by 5%.
Supposing 100 packs were sold before the increase in prices, the quantity sold after the change would be 5% less, or 95 packs. At the original price the overall taxes acquired by the government were 100 x ₤1 = ₤100. Now that quantity demanded decreased, overall taxes are 95 x ₤2 = ₤190.
The increase in taxes and prices increase overall taxes by ₤90.
B – Supposing price elasticity of demand equals -2:
PED = -2 ∆P = ₤5 – ₤4 = ₤1 %∆P: ₤4 = 100% ₤1 = 25% %∆P = 0.25
%∆Q = PED x %∆P %∆Q = (-2) x 0.25 %∆Q = -0.5 = -50%
If the original quantity demanded was 100 packs of cigarettes, the increase in taxes would reduce quantity demanded by 50%, reducing quantity of packs bought to 50 packs.
At the new prices the overall taxes would be 50 x ₤2 = ₤100.
There would be no change on overall taxes received.
It is possible to say that Price Elasticity of Demand affects decisions about price changes. It can predict the behaviour of the demand curve and establish if overall profits will remain the same, increase or decrease. If PED is elastic (over 1) the demand curve is elastic and will react to changes in price. When PED is inelastic (between 1 and 0) the demand curve is inelastic and will not change significantly in reaction to changes in p