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Bryon Gaskin Instructor: Perry Hollowell Econ 202 IVY TECH FALL 2002 PRINICPLES OF MICROECONOMICS ECN 202 Unit 3 Assignment The first two units explored a basic overview of the science of economics. The concept of scarcity, choice and opportunity cost was introduced. The need for economic systems was explored by introducing the market system. Both Macroeconomic and Microeconomic concepts were presented. The rest of the semester will focus on Microeconomics. Chapters 6, 7 & 8 begin this journey. Specifically the concept of price elasticity, a measure of consumers’ and producers’ responses to price changes is emphasized. I cannot stress strongly enough the need to understand how price elasticity of supply and demand, cross price elasticity, and income elasticity as it is important in element of economic analysis. Knowledge of the general nature of production costs is essential to understand how firms make decisions. Those decisions will depend upon prices (costs) of the resources essential to its production and the price the product will bring in the market place. Please include the questions with your answers. 1. (A) Explain in detail a perfectly elastic demand curve and a perfectly inelastic demand curve. When talking about a perfectly elastic demand curve and a perfectly inelastic demand curve, one must keep in mind that there is a price range that is in reference; because even such things vital medical supplies, if the price changes so drastically it would effect inelastic demand. For example, if the cost of Zocor (a cholesterol medication) has an inelastic demand curve from a price range of $70 to $90 for a month’s supply, if the price were to jump to say $250 dollars, then the inelastic demand curve would be no more because less people would being ABLE to buy. Remember for demand, that not only does the consumer have to WANT to buy it, they also have to be ABLE to buy it. A perfectly elastic demand curve is a straight horizontal line can purchase any amount of the product they want at a given price. In a perfectly elastic demand curve, the smallest change in price will cause the consumers to change their consumption by a large amount. A perfectly inelastic demand curve is represented by a straight vertical line. It represents that idea that consumers will not change the quantity of goods consumed or purchased when the price of that good changes. (B) Price elasticity along a straight-line demand curve refers to what? Price elasticity along a straight-line demand curve refers to the idea that equal changes in price means equal changes in quantity. In other words a change x unit price will mean an equal y change in quantity. So a move from a unit price of $10 to $9 will mean a change in quantity demanded to go from 500 to 475, and a change in price of $9 to $8 will mean a change in quantity from 475 to 450. A $1 dollar change in price means a 25-unit change in quantity demanded. Bryon Gaskin Instructor: Perry Hollowell Econ 202 IVY TECH FALL 2002 10 Points 2. (A) What are the major determinants of price elasticity of demand? *The existence of substitutes *The importance of the product in the consumer’s total budget *The time period in consideration. (B) Use these determinants in judging whether demand for each of the following products is elastic or inelastic. (a) Oranges Some what elastic because you can substitute other comparable fruits. (b) Cigarettes Inelastic because there really are not much in the way of substitutes, and the time frame is short for their purchase. (c) Winston cigarettes Elastic, because not everyone is brand loyal when it comes to cigarettes. (d) Gasoline Inelastic because there are no substitutes. (e) Diamond bracelets . Elastic because a diamond bracelet purchase is a very significant percentage on the average consumer’s total budget. 15 Points 3. The income elasticity of demand for movies, dental services, clothing have been estimated to be +3.4, +1.0, and + 0.5, respectively. Interpret these coefficients. MOVIES =3.4 DENTAL = 1.0 CLOTHING = 0.5 All of the goods mentioned above are normal goods, because the have coefficients above zero. In other words, when dealing with normal goods, income and quantity demanded move in the same direction. A 1% increase in come means a .5% increase in quantity demanded of clothing, a 1% increase in quantity demanded for dental services, and 3.4% increase in the quantity demanded for movies. 15 Points 4. Price discrimination is often used by businesses. Explain the conditions under which price discrimination is practiced and the economic consequences of price discrimination. Price discrimination is most common in business where you consumers can easily be divided into different groups or sectors and those sectors need not be something that is visual such as old young, rich or poor, but it can be. A personal example, is two weeks ago I sent a hard drive from work to have data recovered from it, I asked what the price cost would be and they said that if it is Hard Drive is being returned to an individual then the price is $800, if it is being returned to a business the price is $1100. The more choice that a specified group as, the more likely there is to be price discrimination. Discounts for senior citizens or children to eat or see movies, off peak minute Bryon Gaskin Instructor: Perry Hollowell Econ 202 IVY TECH FALL 2002 usage for cell phones, not paying a cover charge for arriving at a bar before 9PM or scheduling your next airfare well in advance and taking a Saturday night stay, are all examples of price discrimination at work. So why do business use price discrimination? That is the real question, obliviously there must exist a motive, and the motive is profit. By tailoring their pricing strategy to definable groups they are better able to maximize profits. For me buying items such as coffee is an inelastic demand, if it costs $.40 cents from the vending machine or over $2.00 a Starbucks has no effect on how may cups I buy. However for senior citizens a $2.00 cup off coffee would be unthinkable so might a $1.00 cup, however if a place offering a cup of coffee for a $1.00 a cup to the general public but has very few senior citizens buying coffee at a $1.00 cup, then offers coffee at $.65 a cup for anyone over 65, and increases the number of cups of coffee sold to people over 65 by 55% then, they have good reason to practice price discrimination. 15 Points, 5. (A) Why would an ounce of gold be priced higher than an ounce of coffee beans, even though coffee is generally considered more essential than gold? Explain the paradox in terms of marginal and total utility. The paradox of one once of gold being priced higher than one once of coffee beans given that coffee is considered more essential than gold can be explained (as in most things in economics) through supply and demand. When the quantity demanded is limited and in the case of gold finite, but the quantity demanded is high, the price people will pay for that good will eventual reach an equilibrium price determined by market forces. If one only looks at marginal utility to compare the coffee beans and gold then that would not show the real picture because we would be comparing apples to oranges. If really want to understand how these goods relate, we must equalize their satisfaction. This is done by dividing marginal utility by price. In summary, the marginal utility of coffee beans is low, but so is its price, but it’s total utility is high. The total utility of all of the coffee beans is very high when compared to total utility to all of the gold purchased. We affix a higher price to gold because the supply available is so low when compared with the highly abundant amount of coffee beans available. (B) Describe the law of diminishing marginal utility. On what assumptions is this law based? The law of diminishing marginal utility is a model for describing how when one receives an additional good in a specific time period, the level of satisfaction one receives per additional good received decreases compared to the previous good received. On what assumptions is this law based? The law of marginal utility assumes that you can measure happiness. The word Bryon Gaskin Instructor: Perry Hollowell Econ 202 IVY TECH FALL 2002 “utility” in “law of diminishing marginal utility” is term used to measure happiness or just a unit of measure. Also the assumes that at least one resource is fixed. 10 Points 6. Define overhead, how it can be reduced and how it affects consumers and retailers. Overhead are the costs that not directly related to the production process. Overhead can be greatly reduced by technology. For instance, take a company that is involved in transporting goods from a warehouse to satellite sites around the country. They then win contracts to supply five times services they currently supply over the next 2 years. So they go from a firm of 50 trucks to 200 trucks, and a work force of 75 to a work force of 250. What happened? As they increased the scale of the business they had to hire more people to perform some of administrative tasks such as tracking shipments, via fax, phone and email. This cost is not directly related to the production of the product. However; if the change t a web based computerized system using barcodes and check points, they could change their administrative costs from 75 to 100 employees, this would decrease the overhead. 15 Points 7. Explain the difference between the short run and long run. What costs do firms consider in the short run and long run? 10 Points The biggest difference between the short run and the long run is that the short run is constrained by the law of diminishing marginal returns and the long run is not constrained by this law. The reason for this is, is because short run contains at least one variable that cannot be changed. Whenever one variable cannot be changed then you will always run into a point in which adding more input will eventually decrease output. The long run does not have to be affected this way. In the long run the variable that was unchangeable in the short can be changed and therefore is not the limiting factor in production. When all of the resources in firm are changed in the long run, the change means the firm is operating at a different scale and the firm moves into a short run period. What costs do firms consider in the short run and long run? In the short run, firms are concerned about variable costs, because they cannot do anything about the fixed costs. In the long run firms are still interested in the variable costs, because what was once a fixed cost in the short run can become a variable cost in the long run. In the long run since all of the costs are variables, there are not diminishing marginal returns, for the mere fact that all of the resources are variable, it is only when you have at Bryon Gaskin Instructor: Perry Hollowell Econ 202 IVY TECH FALL 2002 least one resource that is variable are you restrained by the law of diminishing marginal returns. 8. (A) Use the concepts of economies and diseconomies of scale to explain the shape of a firm’s long-run ATC curve. First lets look at what three types economies of scale we have. 1st, economies of scale are situations were the cost of producing a unit good decreases as the quantity produced increased. 2 nd, constant returns to scale, this happens when there no change in cost of the each unit produced as the quantity produced rises. 3rd, diseconomies of scale is a situation in which the cost of producing each unit increases as the total quantity produced increases. The long run can be shaped as the normal U which represents economies of scale, constant returns to scales, and diseconomies of scale, or it can be a continuously gradual sloping line for an economy of scale or it can be a flat horizontal line when it is operating in a constant returns to scale. Regardless of which one it operates as, the long run ATC curve connects the lowest cost for each level of output represented by the Short run ATC. Even though the Long Run ATC can be different shapes, the Short Run ATC curve will always be “U” shaped because of the law of diminishing marginal returns. What is the concept of minimum efficient scale? The concept of minimum efficient scale is that it is the lowest point on the LRATC. It is the point where cost to make each unit of a product is the lowest or most efficient. (B) What bearing can the shape of the long-run ATC curve have on the structure of an industry? To explain what bearing the shape of the LRATC curve on a industry structure lets look at three main shapes. In the first shape if the average total cost descends rapidly to its minimum point and then rises very quickly there after, then the there are probably a lot of small firms in the industry. The second shape would be caused when there is a gradual descend over long range output until it reaches it’s minimum point, then there are only a few very large firms in the industry. The final shape is caused when the average total cost drops very quickly to the minimum cost over the long range of output, then industry is probably configured of large firms and small firms alike. 10 Points TOTAL 100 POINTS Bryon Gaskin Instructor: Perry Hollowell Econ 202 IVY TECH FALL 2002 If really concentrate and learned the material in these 3 chapters, the remaining chapters will be much easier to understand. I always tell my students, “Don’t get lost in this part of the course.” This is the basic language of Microeconomics.
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