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Economics For Business

Question 1, Part A
There will be an increase (rightward shift) in the demand curve of coffee
due to the expected price rise. The price of coffee is expected to rise next
week, therefore people will buy more coffee and would like to stock more
which in turn will increase the demand for coffee and compel the
consumers to buy more coffee at the given price. The purpose to observe
here is that the non-price determinant of the demand that is expectations
of the buyers is the key factor which makes them purchase early (Layton,
Robison & Tucker, 2002).

In the above figure the market demand curve for coffee shows how much
the consumers are willing to buy at several given prices. This demand
curve clearly describes that when the price decreases the quantity
increases and vice versa. In simple words, the points A, B, C, D and E
depicts the demand curve D. X axis shows the quantity of coffee in
kilograms and Y axis shows the price of coffee in dollars per kilogram. But
when there is a consumer expectation for coffee that the price of coffee is
going to rise next week, then the demand for coffee increases all of a
sudden and now at the same price consumers are willing to buy more
coffee at point F and therefore due to increase in this non-price
determinant of demand that is consumer expectation and large number of
buyers there is a change (rightward shift) in demand and we get a new
curve D1.
Market demand schedule for coffee.
Point Price in $/g. Quantity demanded in kg.
A 1 50
B 2 40
C 3 30
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D 4 20
E 5 10
F 3 50

Question 1, Part B
The diagram illustrates that there is an increase (rightward shift) in the
supply, that means additional units or products are provided at every
cost. An enhanced supply is depicted by a budge of the supply curve to
the right. There are several reasons for such a shift in the supply curve
except for price which only causes a movement in the supply curve. The
rightward shift in this supply curve is due to the change (increase) in
supply due to various non-price determinants of supply (Gillespie 2007).

This kind of rightward shift in the supply curve is possible in countless

markets and one example of such market is the Indian two wheeler
market where such a large number of two wheelers are supplied that we
have a rightward shift in the supply. As people of India are more style
oriented and want to be as mobile as possible for their daily chores, that
they prefer a two wheeler every time cited in india info line (2003). By
eyeing such a large number of consumers and opportunity in the Indian
market, hefty number of domestic and international two wheeler
manufacturers has entered into this market and supplied two wheelers at
each and every price. As this is a rapidly growing challenge for the
companies to make their presence felt, they start introducing new and
advanced models of two wheelers. (cited in the hindu business line 2003)

The five factors that have caused this right ward shift are-:
(a) A change in number of sellers.
(b)A change in technology.
(c) A change in costs.
(d)Expectations of producers.
(e) Input or resource prices.
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The factor that causes a movement along the supply curve is the price. A
amend in the price of a manufactured good is the basis for a change in
magnitude supplied; this is expressed as a movement along the supply
curve. An expansion in cost will more often than not direct to a boost in
the capacity supplied. This is recognized as an extension of supply. A
reduce in the capacity supplied is described as contraction of supply
(Gillespie, 2007).

Question 1, Part C (1)

Definition of elasticity – The thought used to appraise the reaction of one
variable to changes in another variable is known as elasticity. It computes
and articulates that responsiveness in a shorthand mathematical form.
Not only does it grant an evaluation of responsiveness, but it also gives us
a term that illustrates trade and industry affiliation (Waud et al. 1998).
Therefore, elasticity of demand is the degree of responsiveness of
quantity demanded to a change in price and the elasticity of supply is the
degree of responsiveness of quantity supplied to a change in price.

Question 1, Part C (2)

There is a reason for inconsistency in the elasticity coefficients between
the identical two points on a demand curve. The disinterested approach is
to decide on the preliminary point as a base and then work out change.
But price elasticity of demand grips adjustments between two probable
base points. Therefore to get to the bottom of this predicament of
difference base points we use a midpoint formula between the two
possible initial base points. The midpoint formula for the elasticity of
demand is-:

Ed = Change in quantity
÷
Sum of quantities
_____________________
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Change in Price
÷
Sum of Prices

This can be expressed as-:

Ed = %∆Q = Q2 – Q1
Q2 + Q1
_____________________________
P2 – P1
P2 + P1

%∆P

The midpoint formula is also usually called the arc elastic formula because
it refers to elasticity over an arc of the demand curve.

To calculate the price elasticity of demand for good X between points E

and Z we use the midpoint formula as -:

E = Q2 – Q1
Q2 + Q1

P2 – P1
P2 + P1

Therefore we have Q2 = 350, Q1 = 300, P2 = 20 and P1 = 400.

Therefore E = 350 – 300

350 + 300

200 – 400
200 + 400

E = 50 / 650

200 / 600 = 50 / 600

650 / 200 = 3/13 = 0.23
Therefore demand is inelastic.
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Question 2, Part A
Quantity Total cost Marginal cost
0 $200 -
1 $900 $700
2 $1800 $900
3 $3000 $1200

Solution -:

Marginal cost (MC) = Change in Total cost

Change in quantity
= 900 – 200
1–0

= $700

Marginal cost (MC) = Change in Total cost

Change in quantity
900 = X
2
X = 900 × 2 = 1800

Marginal cost (MC) = 3000 – 1800

3–2 = 1200

Average fixed cost = Total fixed cost

Change in quantity = 200 / 3 = 66.67

Assumption: We have assumed the Fixed cost to be $200

Therefore Average fixed cost = 66.67

Question 2, Part B, (1)

Assuming that the firm is a perfectly competitive firm we are given with
the following -: ATC = $25, AVC = $20, TFC = $500, MR = $35 and MC =
$35.

TC = TFC + TVC
Q × ATC = 500 + AVC × Q
Q × 25 = 500 + 20 × Q
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25 Q = 500 + 20 Q
Q 25 – 20 = 500
Q = 500 / 5
Q = 100

Hence, the level of production for his firm should be 100 units.

Now the profit-:

Profit = Total revenue – Total cost

= (Marginal revenue × Q) – (Average total cost × Q)
= (35 ×100) – (25 × 100)
= 3500 – 2500
Profit = $1000

Therefore profit = $1000, as this company is at the level of maximum

profit and production because Marginal revenue is equal to Marginal cost,
that is $35. This is so because this firm follows a guideline called the MR =
MC rule which states that the firm enhances its earnings to a optimum
level where Marginal revenue = Marginal cost (Layton et al. 2002)

Question 2, Part B, (2)

In the perfect competition a company has no control over price, so in
order to maximize profits, the company makes only one decision that
what quantity of output to produce to. The following are the two
approaches for finding the profit maximization-:

(a) The total revenue – total cost method: As per Layton et al. (2002) this
approach is one of the very easy and efficient ways to find a profit
maximizing level for a firm in a short run. The main determinants for
this approach are output, total revenue, total cost and profit. Taking a
hypothetical example of an Indian Bicycle manufacturer, that is HERO
cycles and plotting it on the column and graphs, we can learn this
approach in detail. Our assumption here is that the market equilibrium
is $20 as this firm is a price take. As we see that total cost at zero
output due to total fixed cost is $15, total revenue is calculated as the
product price times quantity. Therefore subtracting total cost from total
revenue gives us the final profit that HERO bicycles earn at each level
of output. From 0-1 unit, the company is in a loss and then break-even
point at 2 units. If they produce 6 units per hour, they get maximum
profit of $70. As quantity enhances 7-10 units the profit decreases. The
following graph shows that maximum profit appears when the vertical
distance between total revenue and total cost is greatest.
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(b)The marginal analysis method – Brue and Mcconnell (2007) states that
this approach uses marginal analysis to determine the profit
maximization level of output for a firm in short run. The main
determinants for this approach are marginal revenue which is change
in total revenue decided by change in quantity, marginal cost, average
total cost and average variable cost. Again by taking a hypothetical
example of an Indian Bicycle manufacturer, that is HERO cycles and
plotting it on the column and graphs, we can learn this approach in
detail. Our assumption here is that, since HERO bicycles is under
perfect competition it has a perfectly elastic demand curve as it’s a
price taker and every unit of sale adds to total revenue. In this example
HERO bicycles adds $20 to its total revenue when it sells one unit.
Therefore $20 is the marginal revenue for every additional unit.
Columns of total revenue and total cost shows that, as output increases
they both also rise, comparing marginal revenue and marginal cost
tells us that marginal revenue is equal to price but marginal cost
follows a ‘U’ shape pattern. After plotting the figures in the column, we
get the following graph, where profit is maximized when marginal
revenue=marginal cost at $20 per unit. The intersection of marginal
revenue and marginal cost curves establishes the profit maximizing
output at 6 units per hour. Therefore marginal revenue=marginal cost
rule states that the firm maximizes profit or minimizes loss by
producing the output where marginal revenue equals marginal cost.
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Conclusion: In perfect competition, the company’s marginal revenue

equals the price that determines the position of the firm’s horizontal
demand curve (Layton et al. 2002, p. 180).

Question 2, Part C
The curve that shows the quantities supplied by the industry at different
equilibrium prices after firms complete their entry and exit is the long run
supply curve. To explain the adjustment sequence between points in the
following figure we use the constant cost industry case, where the
expansion of industry output by the entry of new firms has no effect on
the firm’s cost curves. This graph shows that the industry is in equilibrium
at point A, producing 1500 units per week and selling units at $15 per
unit. Then industry demand increases from D1 to D2 and the equilibrium
price rises to $2 at point B. Due to this for a short while industry output
rises to 20000 units per week. Therefore firms are now earning economic
profit as they are now selling product at a higher price, which in turn
attracts new firms to enter the industry. Then once the new firm enters
the industry, it causes the short run supply curve to shift rightward from
S1 to S2, which reestablishes the price at $15 and this brings a new
industry equilibrium point at C. At point C, industry output rises to 25000
units per week and the company’s output slash back to $15 per unit. Now
the distinctive firm earns standard revenue and fresh firms stop entering
the business. We finally connect the points A, B and C which produces the
long run supply curve. (Layton et al. 2007, pg194) very strongly concludes
that under perfect competitive constant cost industry the long run supply
curve of a company is perfectly elastic.

Final learning: A favorable shift in demand (D1 to D2) might be due to

change in consumers tastes and preferences which upsets the original
equilibrium and produce economic profit. But those profits will cause new
firms to enter the industry, increasing supply (S1 to S2) and lowering
product price until economic profit are once again zero (Brue and
Mcconnell, 2007).
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Question 3, Part A, (1)

If the prices for new homes have risen and the sales of the new homes
have also risen then this is a sheer case of change in demand due to non
price determinants, as they affect the demand and causes a shift in the
demand curve. The law of demand states that there is an inverse
relationship between price and quantity, ceteris paribus (Layton et al.
2002). When as distinction between changes in quantity demanded and
changes in demand states that change in quantity demanded will cause
only a movement in the demad curve, where as change in demand will
cause a shift in the demand curve. In other words prise increase or
decrease will cause a movement along the demand curve and non-price
determinant will cause a shift in demand curve. Figure 1 shows that how
this situation might occur and following are the non-price determinants of
demad which affected the demand-:
(a) A change in the number of buyers – Over a period of time more
people may move into an area or a country, creating more potential
buyers (Gillespie 2007). For example more and more students,
migrants and workers are coming into Australia from all parts of the
world, which is thus creating more and more demand for homes in
the housing markets. Also there is a geographic shift in population
which causes people to move between states and buy new homes
(Kotler et al. 2006).
(b)A change in tastes and preferences of the buyers – Even with the
importance of consumer sovereignty, we know that fashion and
lifestyle can influence consumer preferences and demand curve
relies completely on the consumers individual preferences (Png and
Lehman, 2007). For example people living in shared
accommodation, small town houses or in rural areas are now willing
to move into cities and want to have personal and own furnished
homes, which in turn creates more demand for new homes in the
housing market (Kotler et al. 2006).
Thus in Figure 1 the demand curve shifted from D1 to D2 and there was
an upward movement along the supply curve due to the law of supply,
that higher he price higher will be the quantity supplied.
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Mccarthy and peach (2004) states that, if we take real life examples of
supply and demand forces in the housing market “over the long term” in
Australia then we get a similar curve like we got one above, but in
Australia the non-price determinants of supply play a major role in
conjunction with the non-price determinants of demand. Therefore instead
of movement along the supply curve, we get a shift in the supply curve.
Figure 2 shows how this situation occurs and following are the non-price
determinants of demand and supply which affect or causes a shift in the
demand and the supply curve in the long run.

According to Tollner (n.d) non-price determinants of Demand-:

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(a) A change in the number of buyers – Over a period of time more
people may move into an area or a country, creating more potential
buyers (Gillespie, 2007).
(b)A change in the Income of buyers – If consumers have an increase in
their income then their demand for property is likely to shift
(Gillespie, 2007).

According to Tollner (n.d) non-price determinants of Supply-:

(a) Suppliers expectations – This refers to the fact that supplier first
thinks what could be the aspect that might affect his economic
situation (Waud et al. 1998). This in other words mean that the
supplier uses a far sighted approach and if he determines that he
might be in profit if he supplies more then definitely he will start
producing more homes as he will have a profit motive behind it.
(b)An increase in number of sellers – If there is an increase in the
number of producers in an industry then this should lead to an
increase in supply (Gillespie, 2007). More producers may try to
enter into an industry because they are attracted by the prospects
ofhigh returns. Similar is the case with Australia, by eyeing large
demand in future and rising prices, more domestic and international
players are willing to move into the construction market.

Thus in figure 2, the demand curve shifts from D1 to D2, and the supply
curve shifts from S1 to S2, due to change demand and change in supply in
the long term.

Question 3, Part A, (2)

According to Lexis Nexis (2007) the tax Accountants are one of the best
paid in the accounting industry and has got very high value attached to
them. This can be seen in the present high demand accounting markets
such as the Middle East, Australia and some European countries which
require accountants in large numbers. The reason for this high demand is
due to the complex tasks they undertake and help a firm in maximizing
profits and variour other important jobs. They are also paid good wages
for the tasks they perform.

But in the market for tax accountants, if there is a decrease in their

wages, then that will be a different aspect altogether. If for example we
take the present scenario of Australia where accountants are paid
handsome amount and if their wages are decreased, then that will directly
affect the demand for these accountants, as they there will be less
number of people doing accounting studies and due to that there will be a
fall in the demand. This can be shown in the figure below, that when the
wages move or decreased from W1 to W2, then the quantity of
accountants also moved or decreased from Q1 to Q2. The impact of this
decrease or this change in their wages has caused a negative shift in the
demand curve from D1 to D2. There can be several other reasons for this
negative shift in demand but some of the important ones are:
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(a) Technological environment – This can be one of the prime reasons

for decreasing demand of tax accountants, as new technology
forces creates new product and manual work can now also be done
online sitting on a laptop. For example videoconferencing is hurting
the Airline industry very badly as now very less number of business
travellers travel and company’s save their travel expenses (Kotler et
al. 2007).
(b)Government encouragement – This is another reason why the
demand for tax accountants might fell. Now a days with the help of
new softwares government is encouraging people to do all of their
tax calculations on the readymade softwares online on government
websites. Due to this people are now aware and might require less
accountants. Therefore demand is shrinking for professionals such
as lawyers, doctors and accountants due to information age and the
admission to knowledge provided by internet services (Kotler et al.
2007).

Now considering other industries that may require similar skills of these
accountants, such as banking services, company financial advisors,
government civil services and finance department etc. might have an
increased supply of these tax accountants in their industry. (Here we are
assuming that they will be paid slightly lower or equilant to what they got
in their Industry) Therefore, if their wages are less or decreased they will
shift to other industries. So now we get a new curve below of other
industries which shows that as per our assumptions and free market
conditions of demand and supply where our assumption of low wage rate
will pravail as we are using the standard tools of demand and supply, the
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supply of tax accountants will rise in their industry from S1 to S2, where
as wages fell from W1 to W2.

Question 3, Part B (1, 2 and 3)

According to College cram (n.d) in most markets, prices are free to rise
and fall with changes in supply and demand, no matter how high or low
those prices might be. However, government concludes that sometimes
prices are high and low to consumers and sellers which are very
unjustified. Therefore government then interferes in the market and place
legal boundaries on how low or high prices can be. In the following case
the price ceiling has been imposed by the government in a competitive
market. By price ceiling we mean a legally established maximum price for
a product a seller can charge (Brue and Mcconnell 2007). The figure below
explains the price ceiling. In free market when price was $500 per air
ticket, there were 50,000 air tickets sold. But when the government
imposed price ceiling at $350 per ticket it caused a shortage and there
were only 40,000 tickets now available for purchase. Thus there was a
shortage of 20,000 tickets after price ceiling.
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The maple syrup market is used with a diagram as a case study to show
where a price ceiling has been used and why it was thought to be
necessary. The following are the maple syrup market conditions-:
(a) At equilibrium $3 and 50,000 bottles.
(b)Consider complaints from buyers: price is too high.
(c) Government set a price at $2 per bottle.
(d)Therefore quantity supplied: 40,000, quantity demanded: 60,000.
(e) Shortage is caused due to excess demand.
(f) Incentive for individuals to buy maple syrup at $2 and sell it to other
individuals at higher price, which creates black market.(Hall and
Lieberman, cited in Google)

In the figure above when price of maple syrup was $3 per bottle, people
were buying 50,000 bottles at point E. But after consumers complaints
government imposed price ceiling because with rising income people
purchased more cakes, French toast, wafers and ice creams and due to
that demand for maple syrup rose. Therefore government imposed ceiling
of price at $2 per bottle, but this affected the market and due to this,
there is a shortage of 20,000 bottles of maple syrup and only 40,000
available. This is denoted by points R and V.

The following are the results of government intervention-:

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(a) Shortage in supply – as shown in the figure now there is a shortage
of 20,000 bottles and not all the consumers are getting the maple
syrup, because $2 ceiling price is below $3 market clearing price
(Brue and Mcconnell 2007).
(b)Wasted resources – people will spend their valuable time and money
finding the maple syrup in the market (Krugman and Wells 2004).
(c) Black marketing – As shown in the figure even at low quantity
available of 40,000 and low price at $2, sellers might sell same
quantity at $4 per bottle (Krugman and Wells 2004).

The better way to deal with this issue is that the government should use
rationing method. Government should provide printed coupons with limit
to quantity to every household so that they cannot buy more of that in a
given period and that every level of society whether rich or poor should
receive similar amount (Krugman and Wells 2004).

Question 3, Part C (1, 2 and 3)

A negative externality is a charge forced on people other than consumers
and producers of a good or service. In simple words it can be called
spillover production or consumption costs imposed on third parties
without compensating to them (Layton et al. 2002). For example if USA
wants any of its old, outdated and rusty ships to be scrapped in Taiwan,
then negative externalities arise when Taiwan destroy that ship in its bay
and its marine life, sea food and fishing industry is affected badly. USA is
only paying Taiwan for scrapping the ship but instead Taiwan has lost
more natural resources due to that. This is a negative externality which is
explained in the figure below. Therefore is such case the government
intervention is very necessary as because as per government of Taiwan
it’s creating pollution and external costs are being bearded by Taiwan.
Government intervention in such case may include-:
(a) Legislation and regulation – Government of Taiwan may pass certain
laws to control certain type of behavior by the externality causing
body. Laws affect a number of business behaviors such as health,
safety and consumer protection (Gillespie 2007).
(b)Subsidies and taxes – These can be used to encourage or deter
certain types of behavior. Government of Taiwan may tax more the
USA ship firms so that free market position move to more social
optimal level (Gillespie 2007).
To sum up government intervention, we saw that it is required to gain
economic efficiency when negative externality is going to affect huge
amount of people or when a particular area, industry or domestic
business is at risk (Brue and Mcconnell 2007).

Reference: Foundations of Economicsby Andrew Gillespie

McConnell A 2007 'Book Review: Local Government in the United Kingdom
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Therefore in the figure above we see that before government intervention

the USA ship firms were getting their work done at point A(free market)
and were paying just $1000 per ton for breakage of ships. But after
government intervention when they were taxed they started paying
$2000 per ton and curved moved from point A to B. Therefore the net gain
to Taiwan is when we combine the points A, B and C and also it brought
down the quantity of ship breakage from 5000 tonnes (quantity free
market) to 3500 tonnes (quantity optimum). The following are the ways
and options to correct negative externality-:
(a) Environmental standards – They can make a rule to protect their
environment by specifying actions by producers (Krugman & Wells
2004).
(b)Emmissions tax – It is that tax which relies on the quantity of
pollution an activity has produced (Krugman & Wells 2004).
(c) Tradable emmissions permits – It is a kind of license to emit limited
amount of pollutants that can be brought or sold (Krugman & Wells
2004).

The case study choosen here is from the capital city New Delhi of India,
where it is shown that how the industrial sector pollutes the main river
Yamuna by the industrial waste. Due to rapid globalization, expansion,
high investment by foreign firms, rising population, rising income,
urbanization, large scale improvement in infrastructure and improvement
in lifestyle huge number of industries are set up at the banks of the
Yamuna river and pollutes it to such an extent that the government
intervaention has now beconme mandatory and the government therefore
has taken serious measures and effective steps to improve the situation.
The graphical demonstration below will help us understand where the
problem of deadweight loss is and how it can be resolved. (CPCD 2001)
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In the figure above resources are over allocated at inefficient equilibrium

point A and S(Private) is the industries supply curve. If the industries are
required to pay tax on the pollution they do, the economy can move
towards the efficient equilibrium point B. Therefore point A, B and C
denotes the net benefit to society after taxing the industries. It can be
clearly seen that when the government intervened and levied regulation
and taxes, these industries moved the their production from 65000 tonnes
(quantity free market) per year to 40000 tonnes (quantity optimim) per
year and this also affected their price per unit which went up from INR700
per unit (price free market) to INR1200 per unit (price optimum). The
government addressed the situation in a very straightforward and
stringent manner stating that minimum desired water quality of class-C
should be achieved, water standard should be maintained, gave directions
to the administration to set time limit till pollution levels come down, no
industrial constructions along the river and taxing the polluting industries.
(CPCD 2002)

The better way of dealing with the issue should be, that the government
should follow an environmental based approach to find solutions for
negative externalities. Worthington et al. (2005) p. 450 claims that human
action alone is not responsible for causing all the environmental problems
faced by the society. Natural processes are also a contributory factor.
Therefore environmental problems resulting from various sources vary
along a number of dimensions in the follwing ways-:
(a) Geographical scale – Local, national, regional and global.
(b)Duration – Short term, long term and permanent.
(c) Source – Individual, firm and industry.
However, Layton et al. (2002) suggests that, the government should be
more inclined towards tax based solution in this case, as it not only
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provides a higher efficiency but it also allows a higher amount of flexibility
to both the polluter and the government. Under this system the polluting
industries can have a choice between paying tax or installing pollution
control equipment and the government can easily vary the tax rates.