Question

7 what is the long run average cost curve to decline became relatively flat, and then graphs

8. using the concepts of produce and consumer surplus explain the welfare implications of major drought on producers and consumers.

9 using cobweb behavior show the long run adjustment path in an agricultural market when demand is more elastic that supply is more elastic than demand, what can be concluded from the two models?

Answer 1

Question 7.

When the long run average cost declines it becomes relatively flat for some point of time before moving up again. This is because of several reasons.

In the above graphical representation of an economy in the long run, we have cost on the Y-axis and Output on the X-axis. The Long run average cost curve as we can see is a series of several short run average cost curves. The change in the short run average total cost curves as a result of let us say, an increase in the cost of fixed inputs, leads to an increase in the output level. Due to the economies of scale this results in higher profits for the firm as the costs are decreasing as the input increases. Then comes a point when the graph tends to flatten out. This is due to the constant returns to scale, wherein the cost does not change much but the level of output is increasing. But finally it rises again as costs start rising again as the benefits of increasing the inputs start to fall as expansion beyond a certain limit results in diseconomies of scale due to rising costs of expansion.

Question 2.

Consumer surplus is when the consumer is ready to pay a higher price for a commodity than the market price. This depends on the demand for the good and the availabilty of supply of that particular good in the market. Governments use the data available on consumer surplus to frame fiscal policies such as taxation and government spending.

During a drought the availability of goods and services such as farm produce and water supply reduces. This leads to a shortage and increase in costs to produce more and/or rise in demand due to shortage of supply. This results in people willing to spend less as there is an acute price rise. This leads to a reduced consumer surplus as only a few would be willing to shell out money to buy the goods at the new price.

Producer surplus is the difference between the amount of money for which the producer sells the goods and the amount of money that the producer receives after selling the goods. The producer surplus is also affected during drought as the cost of production skyrockets due to loss of natural resources such as water. This leads to reduced supply and increase costs, ultimately resulting in price rise. Although the producer surplus may seem high due to an increased price rise, the consumer's willingness to spend also falls when the price rise is acute.

Hence, both producers and consumers take a hit during drought season due to shortage of supplies and rise in price levels.

Question 9.

The cobweb model suggests that the amount of output to be produced must be determined well in advance before observing the prices. The firms in general estimate the price levels based on the prices of the previous year. The cobweb model describes the interaction of supply and demand with the changes in the price level and the quantity of output.

Let us take an agricultural market to describe the interaction between supply and demand in the long run. In the long run, unlike in the short run, all inputs are variable and there is entry and exit of firms in the product market. The entry and exit of firms and the price levels of the products are intertwined. When the price levels are high, more firms enter the market to gain profits and as more and more firms enter the price level falls as the supply levels increase. This leads to an equilibrium price which is determined by interaction of market forces. In an agricultural market, in the long run, as the factors of input become variable and the long run average costs increase due to diseconomies of scale, there is a rise is costs to the producer and this reflects in an increase in price level. Assuming that the demand is highly elastic the consumers will shift to a substitute good for which the price is relatively lower and eventually the price level of the good in question drops.

In the long run, a product in the agricultural market which has a high elasticity of supply, will switch over to another product when the long run total average cost of production increases due to diseconomies of scale. The producer can move over to another agricultural product, and when the supply starts falling as producers start switching over to another market, the price levels rise as a result of decreased supply levels, this makes the market more attractive to potential investors who enter the market and eventually fill the supply gap to the point where an equilibrium is reached at a price level determined by market forces