Athar Ali Makin | #2001603

Economics Assignement-2

1.a) Why the Demand curve is downward sloping?

Ans:The law of demand says that a decrease in good’s own price will result in an increase in the
amount demanded, holding constant all other determinants of demand.

The law of demand states that there is a

negative, or inverse relationship between price
and the quantity of a good demanded and its
price.

This means that demand curves slope downward

Effect of shifting of demand and supply curve on equilibrium price and quantity:
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b) Suppose demand function for a commodity is Qd = 400 – 0.5 P and supply function is Qs = -200
+ P, where Q is the quantity demanded and P is the price per unit of commodity. Numerically and
graphically answer the following

i. Draw the demand and supply curve

ii. Find equilibrium price and quantity
iii. Find consumer surplus and producer surplus

Ans:i) Given equations are :

Qd =400 – 0.5P Qs = -200 + P

Or 0 = 400- 0.5 P( Lets take Qd =0) or 0 = -200 + P ( Lets Qs=0)
Or 0.5p =400 or P = 200
0r 0.5P/0.5 = 400 / 0.5 (Both side divided by 0.5)
 P = 800

Lets assume initial price is 500 for quantity Supply

 Qs =- 200 + 500
 Qs = 300

800 -
700 -
S
600 -
CS = 40000 (Assume Price 500, Qs=300)
500 -
( Pe =400 , Qd=Qs=200)
Pe=400 -
PS= 20000

300 -
200 -
100 - D

100 200 300 400 500 Q

- - - - - Qs=Qd
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ii) Find equilibrium Price and Quantity:

Condition of Market equilibrium is when Demand equals Supply.

At Pe, Quantity demanded equals quantity supply.

 400 – 0.5P= -200+ P

or 600 = 1.5 P
or 600/1.5 = P
Pe = 400

Qd = 400 -0.5 P Qs = -200 +P

= 400 – 0.5 (400) (P=Pe=400) = -200 + 400
= 400 – 200 = 200
=200

iii) Find Consumer Surplus and Producer Surplus:

Consumer Surplus: The extra benefit enjoyed by the consumers in a market who pay less for a product
then they were willing to pay for it.

CS = ½(base x hight) = ½ x 200 x 400 = 40,000

Producer Surplus:The extra benefit enjoyed by the producer in a market who sale their product for
more than they willing and able to sale it for.

PS = ½ (Base x height) = ½ x 200 x 200 = 20,000

2. a) What do you mean by price elasticity of demand?

Ans: Price elasticity of demand is a measure of how much the quantity demanded of a good responds to
a change in the price of that good.

The price elasticity of demand is the percentage change in quantity demanded divided by the
percentage change in price.

This unit free measure makes comparisons of responsiveness of different goods easier.

The Formula:
% Change in Quantity Demanded
Ped ___________________________
=
% Change in Price
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How do you measure elasticity? Discuss in brief.

 Point Estimation
Elasticity estimated at a point on the demand curve

Example: Point Estimation-Demand for Vaccination (Graph from Lec 3 slide 4)

Price Elasticity of Demand(PED)= -1% / 5% =-0.2

 What does own-price elasticity of -0.2 mean?

For a 10% increase in price we get a 2% decrease in quantity purchase

 Midpoint Method or Arc elasticity

Elasticity estimated over a range of prices and quantities along a demand curve.In this approach,
we calculate changes in a variable compared with the average, or midpoint, of the starting and final
values.
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Example: Midpoint Method

b) Graphically explain elastic, unit elastic and inelastic demand, perfect elastic and perfect inelastic
demand.

Ans:

• Elastic Demand :
If the price elasticity of demand coefficient
is greater than 1, then demand for a good or
service is said to be price elastic.

 Inelastic Demand:
If the elasticity of demand coefficient is between
0.1 and 1.0, then demand for a good or service is
said to be price inelastic.
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• Unit elasticDemand:
If the elasticity of demand coefficient is equal
to 1.0, then demand for a good or service is
considered to be unit elastic.

• Perfectly Elastic Demand Curve:

The demand curve is horizontal, any change
in price can and will cause consumers to
change their consumption.

• Perfectly Inelastic Demand Curve:

The demand curve is vertical, the quantity
demanded is totally unresponsive to the
price. Changes in price have no effect on
consumer demand.

c)What is cross price elasticity of demand? What is the type of good when cross price elasticity of
demand is positive and when negative? Also identify the type of good when income elasticity is
less than 0, greater than 0 but less than 1 and when greater than 1.

Ans:Cross price elasticity of demand:

Cross price elasticity (CPed) measures the responsiveness of demand for good X following a change in
the price of good Y (a related good).

• CPed =% change in qty D of product A

% change in price of product B
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What is the type of good when cross price elasticity of demand is positive and when negative?

Cross price elasticity will be positive for Substitutes.Substitute goods such as brands of razors, an
increase in the price of one good will lead to an increase in demand for the rival product.
– Weak substitutes – inelastic CPed
– Close substitutes – elastic CPed

The cross price elasticity of demand for two complements is negative.Complements Goods that are in
complementary demand.

– Weak complements – inelastic CPed

– Close complements – elastic CPed

Identify the type of good when income elasticity is less than 0, greater than 0 but less than 1 and
when greater than 1.

When the income elasticity is: The good is classified as:

Greater than 0.0 A normal good

A luxury (and a normal) good

Greater than 1.0

Less than 1.0 but greater than A necessity (and a normal) good
0.0

Less than 0.0 An inferior good

(d)Explain tax incidence on consumer and producer when demand is elastic and when demand is
inelastic.

Ans:The relative burden, or incidence, of an indirect tax is determined by the price elasticity of demand
(PED) of the consumer in response to a price rise. If the consumer is unresponsive, and PED is inelastic,
the burden will fall mainly on the consumer. However, if the consumer is responsive to the price rise, and
PED is elastic, the burden will fall mainly on the firm.

When demand is elastic, the tax burden is mainly on the producer.

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When demand is inelastic the tax burden is mainly on the consumer.

3. a) Explain the concept of a production function.

Ans:a) The Production Function specifies the maximum output that can be produced with a given
quantity of inputs.

 We write this symbolically as Q = F(L,K), where Q is the quantity of output, L is the quantity of
labor used

Example: The production process F(2,1) = 9 combines 2 units of L with 1 unit of K to produce 9 units
of output each period.

It is simply the physical relationship that describes how inputs are transformed into outputs.
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Use graphs and carefully explain total, average and marginal products of a factor of production.Be
sure you relate the total product with the average and the marginal products of the factor of
production

Following data has takes to explain to explain Total, Average and Marginal products of a factor of
production

Total production, which designates

the total amount of output produced.
From the above data it shows how
total product responds as the amount
of labor applied is increased. The total
product starts at zero for zero labor
and then increases as additional unites
of labor are applied, reaching a
maximum of 3900 unites where 5
unites of labor are used.
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The term “marginal” means “rxtra”.The

marginal product of an input is the extra
output produced by 1 additional unit of that
input while other inputs are held constant.

Here we assume that we are holding land,

machinery, and all other inputs constant. Then
labor’s marginal product is the extra output
obtained by adding 1 unit of labor.

Above data shows the marginal product of labor

starts at 2000 for the first unite of labor and
then falls to only 100 unites for the fifth unite.

The final concept is the Average

product,which equals total out put
divide by total unites of inputs.

The forth column of the data shows the

average product of the labor as 2000
unites per worker with one worker,
1500 unites per worker with two
workers, and so forth. Average product
falls through the entire range of
increasing the labor input.
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b) Graphically explain the stages of production. Why does a firm produce at stage II?

When one factor of production is varied and

the other factor is kept constant the
production process can be divided into
three stages. They are:

Stage I: The first stage is called the stage of

increasing returns to the factor of
production. In this stage, MP increases at
first and then decreases. AP increases
through out this stage. It happens because
the quantity of fixed factor is high relative to
the quantity of variable factor.TP increases
sharply during this stage.
Stage II: The second stage is known as stage of
diminishing returns. In this stage AP starts to
diminish while MP continues to diminish although
MP is still positive. Here, TP increases at a diminishing rate unit it reaches the maximum point.

According to Joan Robinson, ”The law of (Diminishing returns) as it is usually formulated, states that with
a fixed amount of any factor of production, successive increases in the amount of otherfactorswill, after a
point , yield diminishing increments of output.”

Stage III:This stage is called the stage of negative. In this stage, TP declines, MP becomes negative and
falls below the X-axis.

In this is stage, the quantity of the variable factor is so large compared to the fixed factor that the former
comes in the latter’s way, thereby reducing the efficiency of the fixed factor, thus resulting in fall in the
total product.

Why does a firm produce at stage II

In the short run, rational firms should only be operating in Stage II.
• Why Stage II?
• Why not Stage III?
Firm uses more variable inputs to produce less output!
• Why not Stage I ?
Underutilizing fixed capacity.
Can increase output per unit by increasing the amount of the variable input.
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c)How does firm take decision about optimal level of input utilization? Discuss.

The Principle:
• MRPL> MCL and until MRPL = MCL
– where MRP = Marginal Revenue Product (the extra revenue generated by the use of an
additional unit of input),
– MCL is the amount that an additional unit of the variable input adds to the firm’s total costs
(i.e., Marginal Cost) - MCL= ¶TC/ ¶L

• MRPL= DTR/DL, MRPL = (MPL)*(P)

– P is the price of the product
Total Revenue, TR = Total Output x Price= QxP

• Let: Q = 98L - 3L2

P = $20; W = $40.
• What is optimal level input(Labor Demand)?
• Solution:
The Total revenue = P*Q
P*Q = TR = 20(98L - 3L2)
MRPL = dTR/dL= 20(98 - 3L2) = 20(98 - 6L)
MCL = 40
MRPL = MCL [Rule]
20(98 - 6L) = 40
1960 - 120L = 40, -120L = -1920,
L* = 16 (derived demand for labour)

4. a)Briefly explain the concepts: economic cost, sunk cost, total cost, variable cost, fixed cost,
average variable cost, marginal cost.

Ans:Economic cost: Economics cost refers the sum of explicit and implicit costs. These costs must be
distinguished from accounting costs, which refer only to the firm’s actual expenditure, or explicit cost,
incurred for purchased or hired inputs.

Sunk cost: A cost that has already been incurred and that cannot be recover. In economic decision
making, sunk cost are treated as bygone and re not taken into consideration when deciding whether to
continue an investment project.

Total cost: Total cost is the lowest total expenses needed to produce at each level of output, And total
cost rises as level of output rises.Total cost consist of two categories of cost: total Fixed Cost (TFC) and
Total Variable Cost (TVC). TC = TFC+ TVC.

Variable cost:Variable costs are costs that vary with output. Generally variable costs increase at a
constant rate relative to labor and capital. Variable costs may include wages, utilities, materials used in
production.

Fixed cost: Fixed costs are costs which do not change with change in output as long as the production is
within the relevant range. It is the cost which is incurred even when output is zero. FC often include rent,
building, machinery etc.
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Average variable cost: AVC cost is the variable cost per unit. Variable cost are such cost which vary
directly with change in output. AVC equals total variable cost (VC) divided by output (Q).

AVC = VC/Q ; AVC = ATC-AFC

Marginal cost: MC is the change in the total cost that arises when the quantity produced is incremented
by one unite; that is the cost of producing one more unit of a good.

MC =  TC /Q; Where  = Change, TC = Total cost, Q = Quantity

d) Graphically explain relationship between MC, ATC and AVC. Explain why MC cuts AC and AVC at
their minimum values. Consider the data in following table and calculate the TC, VC, FC, AC, AVC,
and MC. Also plot the AC and MC curves.

Ans:Relationship between MC, ATC and AVC:

If MC > ATC, then ATC is rising
If MC = ATC, then ATC is at its minimum
If MC < ATC, then ATC is falling

If MC > AVC, then AVC is rising

If MC = AVC, then AVC is at its minimum
If MC < AVC, then AVC is falling

Explain why MC cuts AC and AVC at their minimum values.

When MC is less than AC and AVC, MC pulls

both of them downwards. Similarly, when MC is
more than AC and AVC, MC pulls both of them
upwards. As a result, MC curve cuts AC curve (at
‘A’) and AVC curve (at ‘B’) at their minimum
points.
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Consider the data given in the table calculate the TC, VC, FC, AC, AVC, and MC.

Output(Q Land Labor Land Labor TC VC FC AC AVC MC

) Inputs Inputs Rent Wages (FC (3)x(5) (2)x(4) (TC (VC (Diff of TC
Tons of (acres (Worker) $ per $ per + /(1) /(1) per unit
Wheat ) (3) acre worker VC) production)
(1) (2) (4) (5)
0 15 0 12 5 180 0 180 180 180 180
1 15 6 12 5 210 30 180 210 30 30
2 15 11 12 5 235 55 180 117.5 27.5 25
3 15 15 12 5 255 75 180 85 25 20
4 15 21 12 5 285 105 180 71.25 26.25 30
5 15 31 12 5 335 155 180 67 31 50
6 15 45 12 5 405 225 180 67.5 37.5 70
7 15 63 12 5 495 315 180 70.71 45 90

Drawn below AC and MC curve from above calculated value:

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5. a) Write down conditions for competitive market. How does a competitive firm maximize its
profit? Explain with graph.

Ans: a) Conditions for competitive market:

i) Products are identical.

ii) Many buyers and sellers
iii) Producers and consumers are price taker.
iv) Has no transaction cost.
v) Firm can easily enter an exit in the market.

How does a competitive firm maximize its profit? Explain with graph:

Profit-maximizing rule for a perfectly competitive firm:

Produce the level of output where marginal revenue equals marginal cost

At the profit maximization level of q 1

where MC = MR, the average revenue
is p1 which is the price but the
associated average cost is only p2. The
difference between AR and AC gives
us the average profit per unit. The
total abnormal profit in this case is
written as abnormal profit = (p 1-p2)
q1.

b) Graphically explain the short run supply curve for a perfectly competitive market? Explain
shutdown condition of a firm.

The short run supply curve for a perfectly competitive market:

A competitive firm will chose to produce in the short run: P >= AVC.
A competitive firm will produce the level of output where: MR= MC; P* = MC.
We can combine this information to drive the firm’s short run supply curve.
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When the market price is less than the

average variable cost, the firm will
temporarily shutdown and produce a
quantity of zero.
The price corresponding to the minimum of
the AVC is called the “shutdown price”.
For any level of marginal revenue that is
greater than or equal to the shutdown price,
the profit maximizing quantity is found
where MR intersects the MC curve.
We can now trace out the firm’s short run
supply curve.
An individual firm’s short run supply curve
starts at the minimum of AVC from where
MC intersect AVC and follows up its MC
curve.
Adding up individual firm’s supply curve
will yield the market supply curve.

Shutdown condition: The shutdown

point comes where revenues just cover
variable costs or where losses are equal to
fixed cost. When the price falls below
average variable cost, the firm will
maximize profits (minimize its loss) by
shutting down.