Question 1:

1. Income elasticity of demand (e1)

Income elasticity of demand (e1) is used to measure how changes in quantity demanded respond to a change in real income of the consumers when other variables such as prices of other goods and taste are kept constant. Normal goods usually have a positive income elasticity of demand which means that as the customer’s income increases, output demanded increases at each price level and vice versa. This means that there is an outward shift in demand. Goods that are normal necessities have an e1 of between 0 and +1. For example, if a consumers income decrease by 10% and the demand for doctors services decreasing by 3%, then the income elasticity will be +0.3. The demand rises less than proportionate to the rise in income. For luxuries, their income elasticity of demand is greater than 1 which means that the quantity demanded rises more than proportionate to a change in income. For example a decrease of the income by 10% might lead to a 30% fall in the in the demand for furniture. The income elasticity in this case will be +3. Demand is very sensitive to the increase in the income. For inferior goods, the income elasticity of demand is always negative and demand falls as the income increases

1. Competition

Competition refers to a situation where firms and individuals strive to a gain a greater market share to buy or sell commodities. Products could be competing on three levels: di5rect competition, substitution competition and budget competition. In direct competition, products that perform the same function compete against each other for instance a brand of cars may compete against each other. In substitution competition close substitutes for one another compete. For example margarine may compete with butter. Budget competition is the broadest form of competition where all products compete for the available money to be spent. In this case, compact discs and restaurant meals could be competing on the basis of budget where they will be both competing for the available money.

1. Interpretation of Income Elasticity of Demand (YED) values

Normal goods usually have a positive income elasticity of demand which means that as the customer’s income increases, output demanded increases at each price level and vice versa. This means that there is an outward shift in demand. Goods that are normal necessities have an e1 of between 0 and +1. This means that an income elasticity of + 0.5 is that of a normal good. For inferior goods, the income elasticity of demand is always negative and demand falls as the income increases and therefore an income elasticity of -2.5 is of an inferior good.

1. Cross price elasticity (XED)

Cross price elasticity (XED) is a measure of the responsiveness of the quantity demanded of a commodity following changes in the prices of related goods. XED makes it possible to make a distinction between complementary and substitute goods and services. With substitute goods such as cereals, increase in the price of one good, will lead to increased demand of the substitute good. Cross elasticity of substitute goods is always positive. A low XED indicates that the products are weak substitutes while a high XED indicates that the products are close substitutes. In this case an XED of +0.6 indicates that the product is a substitute. Goods that are in complementary demand with each other have a negative XED. Those with low XED are weak complements while those with high XED are close complement. An XED of -2.2 therefore indicate that the products are complementary.

Question 2

Diminishing marginal returns

The law of diminishing marginal returns sates that when increasing amount of a variable factor are used with a given amount of a fixed factor, there will come a point when each extra unit of the variable factor will produce less extra output than the previous unit. Production in the short run is subject to diminishing returns. To illustrate how this law underlies short-run production let us take the simplest possible case where there are just two factors: one fixed and one variable. Take the case of a farm, assume that the fixed factor is land and the variable factor is labour. Since the land is fixed in supply, output per period of time can be increased only by increasing the amount of workers employed; this is represented in the diagram by point A. But imagine what would happen as more workers crowded on to a fix area of land. The land cannot go on yielding more and more output indefinitely. After a point the additions to output from each extra employee will begin to diminish. This can also be explained by the diagram below.

Decreasing economies of scale

The concept of increasing returns to scale is closely linked to that of economies of scale. A firm experiences economies of scale if cost per unit of output fall as the scale of production increases. Clearly, if a firm is getting increasing returns to scale from its factors of production, then as it produces more it will be using smaller and smaller amount of factors per unit of output, other things being equal, this means that it will be producing at a lower average cost. However, any further expansion in the scale of production beyond the limit will actually create negative effects which would increase the costs of production. The negative effects to a company are referred to as diseconomies of scale (decreasing economies of scales). The negative effects arise as a result of the company’s unwieldiness, inflexibility and lack of communication as it grows in size. This increases the cost per unit of output; these costs give rise to decreasing economies of scales. Some of the Sources of decreasing economies of scale include;

• Increase in the cost of transporting raw materials, components and the finished product

• Labour unrest or disputes and lack of commitment from the employees because they are not involved in decision-making

• Lack of adequate finances for further expansion of the firm

• Changing consumer tastes which may not be fulfilled immediately because decision-making may take too long

The following diagram explain decreasing economies of scale

Fro the diagram, as the firm produces more units, the higher the cost incurred in producing one unit.