Answer to Question #190745 in Macroeconomics for Abdul basit

Question

What is Elasticity of Demand? Explain Price, Cross and Income Elasticity of Demand used in managerial decision making process.

What do you mean by Monopoly? How price and output is determined in short and long run in Monopoly Competition?

Answer 1

Solution:

The elasticity of demand refers to how sensitive demand for a good is compared to changes in other economic factors such as price or income. Elastic demands mean that there is a significant change in quantity demanded when another economic factor changes, normally the price of the good or service.

The price elasticity of demand is a measurement of the change in consumption of a product or service in relation to a change in its price. Companies take into account the price elasticity of demand when they managerial decisions regarding the pricing of goods and services. This is because a change in the price of a product or service will bring about a change in the quantity demanded depending upon the coefficient of price elasticity. The company will be able to know the effect on sales when it decides to increase the price of a particular product or service by a certain percentage. The company will also be able to tell how large a reduction in the price of a product or service is required to increase sales by a certain percentage.

Cross elasticity of demand measures the responsiveness of demand for one commodity or service to changes in the price of another product or service. The cross elasticity of demand measure can help the company to establish whether or not it is a good idea to increase or decrease selling prices, or to substitute one product or service for another to generate greater revenues.

The income elasticity of demand measures how demand responds to a change in consumer's income. The income elasticity of demand for an inferior good is always negative while for a normal good it is positive. It measures the relationship between sales and consumer’s income.

The management of a company can use income elasticity of demand to predict future demand for any product or service in a situation where producers have knowledge of the possible future income of the consumers. Therefore, it is essential for production planning and management in the long run. It can help in making investment decisions, forecasting the demand for the goods and services, and categorizing goods and services, whether normal, inferior, or essential enabling them to select on which ones to produce or focus their attention on.

A monopoly refers to a market structure characterized by a single seller, selling a unique product or service in the market and can dominate one sector or industry. The company owns all the market share and can control prices and output. The seller faces no competition and there are no close substitutes in the market.

A monopoly determines its price and output in the short run by applying two techniques which are TR and TC method or AR and AV and MR and MC method. A monopoly will earn profit and it will be in equilibrium when the AR is greater than its AC (AR>AC) and MC is equal to MR (MR = MC), where the MC curve cuts the MR curve from its below and not from above. A monopoly will, therefore, choose the output where MR = MC and select the profit-maximizing price on its demand curve from a dotted line drawn straight up from the profit-maximizing quantity. The price should be above the AC curve.  

A monopoly determines its price and output in the long run at a point where the LMC = MR, and LMC cuts MR from below and the LAC curve is tangent to the AR curve. Therefore, in the long run, equilibrium is determined when firms are earning only normal profits, where AR = AC. The output chosen will be where the LMC = MR, while the price chosen will be the one tangent with the AR curve, a straight line from the output maximizing profit.