Question

For a single firm, explain the elasticity of demand for the good that it sells. Which of the model's assumptions bring this about. What is the effect on the firm's prices and why?

Answer 1

Elasticity is an economic tool that can be used to describe the responsiveness of consumption / sales to any given change in the price. Usually it is measured as a ratio of percentage change in the quantity demanded to the percentage change in the price of the product

For a single firm that is imperfectly competitive, the elasticity of demand is a function of marginal revenue and price such that

MR = P * (1-1/ed)

Where ed is the price elasticity of demand

In the model for imperfect competition, it is assume that the demand and the marginal revenue are downward sloping and price is greater than marginal revenue at every quantity. The flatter the demand function is, the greater will be the value of price elasticity of demand. Also, the marginal revenue function has a special relationship with the price elasticity of demand such that, when the marginal revenue is zero, price elasticity of demand is 1, when the marginal revenue is negative, price elasticity of demand is less than 1, and when marginal revenue is positive, price elasticity of demand is greater than 1, all values are in absolute terms.

Price elasticity of demand has a bearing on the price that the firm charges. If demand is relatively inelastic, firm can increase price to increase revenue. If demand is relatively elastic, firm has to decrease price to increase revenue.