# BUSINESS MICROECONOMICS Essay Example

Economics iv

Assignment Questions, Semester 2 2014

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Question 1

1. Figure 1 below is pertinent in the discussion covering on the nature of various curves.

Figure 1: Cost Curves

Total Product

1. The marginal cost curve: The marginal cost is the change in overall cost brought about by the change in output. The curve is U-shaped because of the law of variable proportions. Initially, the curve falls in accordance with rising marginal product when there are increasing returns to a factor. The curve then starts to rise in response to the law of diminishing returns to a factor. By adding additional units of variable input to a fixed input, the output might increase but at a decreasing rate. It is also visible in the diagram that MC cuts AC at its lowest point.

2. Average cost curve: The curve is U-shaped because of the law of variable proportions. The curve tends to fall due to the increasing returns to a factor and stabilises in response to constant returns to a factor. However, it eventually falls owing to diminishing returns to a factor.

3. Average fixed cost curve: The curve assumes a rectangular hyperbola shape to show that AFC declines with an increasing output.

4. Average variable cost curve: This is the variable cost per unit of output. Initially, the average variable cost falls but later starts to rise. The fall in AVC is in line with the increasing returns to a factor while the rise in AVC is a reflection of diminishing returns to a factor effectively resulting in a U-shaped curve.

1. Marginal cost curve intersects the average cost curve at its minimum point because average cost will be at the lowest point when marginal cost is equal to average cost. This is explained by the fact that as long as MC is less than AC, then AC will be drawn downwards. Immediately MC becomes greater than AC, then AC is pulled upwards. At the minimum point of AC, there is equality between MC and AC hence no changes. In summary, MC is always to the left of AC and must cut the AC at its lowest position.

2. The AVC attains its minimum point at a lower level of output compared with AC because of the effects brought about by the falling AFC that is added to AVC to get the AC. The difference between AC and AVC is the AFC, which reduces with an increase in rate of output.

Question 2

1. A good is said to be price inelastic if the change in price of the good yields a less than proportionate change in quantity demanded (McEachern, 2013). Medicine is considered very price inelastic because the quantity demanded by consumers is unresponsive to changes in price. Concisely, when the price of medicine goes up, it is rather impossible to cut on it. At the same time, an individual cannot increase the quantity of medicine taken when the price goes down. A person is only allowed a doss as prescribed by a doctor hence the price does not really have any impact on quantity consumed.

2. Inelastic demand for medicine

Figure 2: Inelastic demand for medicine

Figure 2 shows that there is a very small change in quantity for a given change in price. This is comparable to the definition of price elasticity of demand i.e. for every change in price, there is, less than proportionate change in quantity demanded.

1. A pharmaceutical company must be able to relate price elasticity, revenue, and price setting when running its business. Considering the fact that medicine faces inelastic demand, it means that total revenue will increase as price increases (Mankiw, 2012). This denotes that price and total revenue tend towards the same direction. In summary, the company will be able to generate more revenue by increasing the price of medicine.

Question 3

1. The economist’s model of perfect competition is based purely on several assumptions, which may not be practical in the real world. One of the assumptions is that the industry has large number of firms supplying homogeneous goods. Besides, the market has large number of buyers, easy entry and exit, and that the buyers and sellers have full information concerning the market. In the real world situation, a market that satisfies all the stated assumptions does not exist.

2. The short-run perfectively competitive equilibrium of the firm and the industry is shown figure 3:

Figure 3: Short-run perfectly competitive equilibrium

Industry

S=sum of MC

Price and cost

Price and Cost

Units of Output

Units of Output

The intersection of demand and supply determines the price faced by a firm in the short-run. A firm is classified as a price taker hence takes the price from the industry. In the short-run, the equilibrium point is E. At the price determined by the industry, the output that maximizes profit for a firm is deduced as x units.

1. A monopolistic competitor earns supernormal profits in the short-run given that the demand in the market is not shared. According to Tewari (2003), such profits induce new firms to join the market, which eventually eliminates supernormal profits. The long-run situation for new and old firms is that they will earn only normal profits given that the market is shared with new entrants. The short-run and long-run condition is illustrated using the figure 4 below.

Figure 4: short-run and long-run for a monopolistically competitive firm

Short-run

Long-run

1. Firms in perfectly competitive market structure exhibit productive efficiency given that output is produced using the most efficient combination of available resources. It is also allocatively efficient since the goods that have been produced are the ones that are valued by consumers. The market allocates goods in such a manner that marginal cost of the final unit that has been produced is the same as marginal value that consumers attach to the final unit.

Question 4

The statement that a monopolist will charge the highest price the market can bear is not true. The monopolist will always produce where marginal revenue is equal to marginal cost (Tucker, 2010). The diagram below shows that a monopolist will set the price above the competitive price.

Figure 4: Monopoly and competitive market (Taylor, 269)

Competitive market

Monopolist

Market demand

Market Supply

A market that is ruled by a monopolist will maximize profit when
i.e. at the point labelled
and quantity. It is apparent from the figure that a monopolist is able to charge higher price than a firm in competitive market is. Even though the monopoly can charge higher than a perfect competitor can, it must follow the law of demand. If it decides to charge the highest price, profits will not be maximised. The point of reference is therefore the point on the curve where MC = MR.

Question 5

One of the reasons for the plummeting oil prices is the low global oil prices. Secondly, there is a reduced demand from countries such as China, Japan, and the European following weakness in the respective economies. There is also an increased oil production in the United States, which means that US will demand less from other nations. Previously supply from Arab countries had been disrupted but is now on track. This has contributed to the surplus in the market leading to low prices. Moreover, OPEC, operating as a cartel, continues to produce oil with a view of retaining its market share. The effect is a downward tendency of the price.

References

Mankiw, G. N. (2012).
Principles of Microeconomics. Florence KY: Cengage Learning.

Tewari, D. D. (2003). Principles of Microeconomics. New Delhi: New Age International.

Tucker, I. B. (2010). Macroeconomics for Today. New York: Cengage Learning.

McEachern, W. A. (2013). Microeconomics: A Contemporary Introduction. Vancouver, WA: Cengage Learning.

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