Question

2. define price elasticity and how it is measured?

3. discuss the profit maximising position of a monopolist in both long and short run?

4.1. define

4.1.1 Constant returns to scale

4.1.2 increasing returns to scale

4.1.3 Decreasing returns to scale

Answer 1

2. The price elasticity of demand measures the sensitivity of the quantity demanded to changes in the price. Demand is inelastic if it does not respond much to price changes, and elastic if demand changes a lot when the price changes.

• Necessities tend to have inelastic demand.

• Luxuries tend to have elastic demand.

• Demand is elastic when there are close substitutes.

• Elasticity is greater when the market is defined more narrowly: food vs. ice cream.

• Elasticity is greater in the long run, as people are more free to adjust their behavior

Price elasticity of demand = Percentage change in quantity demanded/ Percentage change in price

3. Monopolistic competition is the economic market model with many sellers selling similar, but not identical, products. The demand curve of monopolistic competition is elastic because although the firms are selling differentiated products, many are still close substitutes, so if one firm raises its price too high, many of its customers will switch to products made by other firms. This elasticity of demand makes it similar to pure competition where elasticity is perfect. Demand is not perfectly elastic because a monopolistic competitor has fewer rivals than would be the case for perfect competition, and because the products are differentiated to some degree, so they are not perfect substitutes.

Monopolistic competition has a downward sloping demand curve. Thus, just as for a pure monopoly, its marginal revenue will always be less than the market price, because it can only increase demand by lowering prices, but by doing so, it must lower the prices of all units of its product. Hence, monopolistically competitive firms maximize profits or minimize losses by producing that quantity where marginal revenue equals marginal cost, both over the short run and the long run.

In the short run, a monopolistically competitive firm maximizes profit or minimizes losses by producing that quantity that corresponds to when marginal revenue = marginal cost. If average total cost is below the market price, then the firm will earn an economic profit.

However, if the average total cost is above the market price, then the firm will incur losses, equal to the average total cost minus the market price multiplied by the quantity produced. It will still minimize losses by producing that quantity where marginal revenue equals marginal cost, but eventually the firm will either have to reverse the losses, or it will have to exit the industry.

If the competitive firms in an industry earn an economic profit, then other firms will enter the same industry, which will reduce the profits of the other firms. More firms will continue to enter the industry until the firms are earning only a normal profit.

However, if there are too many firms, then firms will incur losses, especially the inefficient ones, which will cause them to leave the industry. Consequently, the remaining firms will return to normal profitability. Hence, the long-run equilibrium for monopolistic competition will equate the market price to the average total cost, where marginal revenue = marginal cost,

Because monopolistically competitive firms do not operate at their minimum average total cost, they, therefore, operate with excess capacity.

4.1.1 Constant returns to scale- When an increase in inputs (capital and labour) cause the same proportional increase in output. Constant returns to scale occur when increasing the number of inputs leads to an equivalent increase in the output.

4.1.2 Increasing returns to scale- Increase in output that is proportionally greater than a simultaneous and equal percentage change in the use of all inputs, resulting in a decline in average costs.

4.1.3- Decreasing returns to scale- This occurs when an increase in all inputs (labour/capital) leads to a less than proportional increase in output. For example, if a car firm increases its variable inputs (capital, raw materials and labour) by 50%, but the output of cars, increases by only 35%, then we say there are decreasing returns to scale from increasing the quantity of inputs.