2011 2012 EC161 - Grup Assignment with Individual Cmpnents Egan, Jasn (11817875) Questin B Firini, Mayra Maia (11841746) Questin C Tzilalis, Antnis (11822308) Questin A Business Management with Finance Ecnmics EC161 Seminar Grup: R Tutr: Dr. Walter Heering Date Of Submissin: 09/01/2012 Egan, Firini & Tzilalis University f Brightn, Brightn Business Schl 2011-2012
Table f Cntents: Questin A Tzilalis, Antnis... 3 Questin B Egan, Jasn... 6 Questin C Firini, Mayra Maia... 8 Questin D Grup Wrk... 12 Exercise: i... 12 A... 12 B... 12 C... 12 D... 13 E... 13 Exercise: ii... 14 A... 14 B... 14 2
Questin A Tzilalis, Antnis After Wrld War II lcal authrities in sme Eurpean cities (Berlin and Frankfurt, fr instance) prescribed ceilings n rental prices fr city flats. The idea was t make access t apprpriate dwelling space largely independent f incme. Althugh the measures served the purpse fr a while, very sn negative side-effects did appear; in particular, black markets fr flats develped, and, in the lnger run, inner cities residential huses gt dilapidated. Use ecnmic thery t explain the situatin and the cnsequences that arse. Plicymakers, r the gvernment, smetimes cnsider the market-determined price as unsatisfactry and as a result intervene and change the price. Maximum price, r price ceiling, is a frm f gvernment interventin aiming at setting the price belw the equilibrium price. In the specific case, maximum price is used because the market determined price is cnsidered t be t high. As a result, the gvernment sets the price belw the equilibrium price. The aim f this plicy, is t prtect cnsumers since they are nw ging t pay a lwer price in rder t acquire the gd - and increase cnsumptin f the particular gd fr which maximum price is set. The fllwing graph illustrates the case f maximum price. Maximum Price As seen n the diagram abve the equilibrium price is determined by the interactin f demand and supply at pint (E). Demand is defined as the relatinship between varius pssible prices and the crrespnding quantities that cnsumers are willing and able t 3
purchase per time perid, ceteris paribus 1. On the ther hand, supply is defined as the relatinship between varius pssible prices and the crrespnding quantities that prducers are willing t ffer per time perid, ceteris paribus 2. Thus, the equilibrium price is equal t P and the equilibrium quantity is equal t (Q). In this case, the rent price fr flats is equal t (P). This price is cnsidered t be t high and as a result the gvernment, r plicymakers, intervene and set a maximum price t flat rents equal t Pmax. With this maximum price, prducers (in the specific case, landlrds) are willing t ffer quantity (Q1) f the gd while cnsumers are willing and able t buy (Q2) units f the gd. In this case, demand exceeds supply and thus there is a shrtage that is equal t line segment (AB). Thus, the market mechanism fails t allcate the gd. As a result f the existing shrtage, there are several negative effects. The mst serius negative effect arising frm the shrtage is the creatin f black parallel market. Many cnsumers cannt purchase the gd n the market and they end up purchasing it n the black market. In black market, the price is really higher than in the legal market. The abve case is illustrated n the fllwing diagram. As seen n the diagram abve, in the specific case the price increases frm (P) t (P1). A cuntry s ecnmy is nt benefited at all frm black market. Everything that 1 Zigas C, Ecnmics fr the IB Diplma, 2008 2 Zigas C, Ecnmics fr the IB Diplma, 2008 4
happened in black market is nt fficially recrded and thus the ecnmic activity f a cuntry may be underestimated. Als, the gvernment lses mney frm black market taxes are nt being paid t the gvernment. In cnclusin, there are serius cnsequences when setting a maximum price. On the ne hand and at sme pint it helps cnsumers t be able t purchase a gd r a service. On the ther hand thugh, it has the serius effect that was described abve n the ecnmy. 5
Questin B Egan, Jasn Cnsider a perfectly cmpetitive market in lng-run equilibrium where all firms perate under the same cst cnditins. Suppse a new technlgy becmes available which reduces marginal prductin csts. Explain graphically and verbally what happens t the market in the shrt run and in the new lng-run equilibrium if factr prices and demand are assumed t remain the same as befre. Hint: Yu have t use tw parallel diagrams, ne fr an individual (representative) firm and ne fr the industry. Given that demand is assumed t stay the same, in the extreme shrt run, the change in the demand curve and the marginal curve will stay the same, with the tw been perfectly elastic as the market is assumed t stay perfectly cmpetitive. When the firms marginal csts start t reduce the desire t beat thers in cmpetitin and prtect their cmpetitiveness, this will pass n the benefits f cst reductin t cnsumers, leading t a dwnward shift in the demand curve in the lng run. If new technlgy enables the cmpany t reduce marginal csts, thus leading t a dwnward shift f the marginal cst curve f all the firms in the market. Depending n the advancement f the new technlgy the shift in the marginal cst curve will vary. In the shrt-run by using new technlgy it may cause a change in fixed csts depending n the technlgy. If the technlgy leads t a change in fixed csts fr all the firms in the market, it may take sme time fr the numerus firms t seek investment, (equipment) which may lead t sme firms deciding t adapt the new technlgy befre ther firms. By adapting the new technlgy befre their cmpetitrs this will enable them t make nrmal prfit at the new lwer price ffered, as the will be prducing at new cst levels cmpared t cmpetitrs wh may endure less than nrmal prfits r a lss. Depending n the accessibility f the new technlgy available t each firm this may have varius effects t each cmpany, if the technlgy is patent prtected which means it is nt available t all firms, this will lead t the firms which are using the new technlgy t frce ut its cmpetitrs, causing the market t change frm perfectly cmpetitive t a mnplistic r ligplistic market depending n the number f firms wh can access the technlgy. Assuming ver the extreme lng run all cmpanies will have the same technlgy this will lead t marginal csts f all firms shifting dwnwards, (expressed n a graph) causing the equilibrium pint t be at a higher level f utput whilst the price might stay the same. 6
With the ability t prduce mre quantity at lwer cst levels this may lead t higher levels f cmpetitiveness frm varius firms in the market, this may cause the price t drp which may lead t marginal revenue als decreasing. Even with this fall in prices and marginal revenue, the equilibrium demand and supply quantity will be greater than the previus equilibrium quantity, which means the new equilibrium price may be lwer than the riginal equilibrium price at time. In the shrt run, if the new technlgy takes time t be intrduced, the equilibrium utput will stay the same, with the firms having new technlgy reaping super nrmal prfits due t lwer marginal csts and ther firms suffering frm prfits less than the nrmal prfit. In the lng run, firms with new technlgy will ffer lwer prices t pass n the benefits f lwer csts cnsumers and their prfit maximising utputs will rise at the expense f ther firms. Over time mre adjustments will be necessary when the price returns t the same level as the riginal with higher equilibrium demand and supply. With the market remaining perfectly cmpetitive the demand curve will stay the same as befre. 7
Questin C Firini, Mayra Maia Cnsider the ptimal chice f a cnsumer between tw gds, A and B, given prices f the gds, the cnsumer s budget and preferences. Suppse the price fr gd A dubles. Shw graphically and explain verbally the substitutin effect f this change in prices. Nw suppse the price fr gd B dubles as well. Shw graphically and explain verbally the incme effect f this change in prices. Cnsidering the ptimal chice f a cnsumer between tw gds, A and B, and given the prices f thse gds, cnsumer s budget and preferences the fllwing Graph I can be created: G d B Optimal Chice C Graph I Budget Line i Indifference Curve i Gd A This graph shws the cnsumer s budget line and indifference curve. Cnsumer s ptimal chice can be shwn as pint C, where the budget line and indifference curve meet. If price f gd A dubles, there is a reductin f ttal quantity affrdable fr the cnsumer if n gd B is purchased. The budget is reduced giving a new Budget line ii as shwn n Graph II: 8
G d B D C Graph II BL ii Hiptetical Line BL i IC i Gd A The substitutin effect creates the hypthetical pssibility t ignre budget limitatins in rder t allw the custmer's riginal ptimal chice t cntinue within the same indifference curve. The new budget line is shifted right, t create a hypthetical line with a new ptimal chice in the riginal indifference curve, creating a hypthetical ptimal chice D. This shws the change in preferences since nw the cnsumer wuld prefer buying higher quantities f gd B and lwer quantities f gd A. The new hypthetical line has than t be shifted t fit budget limitatins, creating a new budget line ii and a new ptimal chice, E, within a new indifference curve that appears n Graph III: G d B E D C Graph III BL ii BL i IC i IC ii Gd A 9
The substitutin effect is always negative t the price increased gd, since its demanded quantities are always reduced. When prices f gd B dubles, we have the fllwing effect as seen n Graph IV: G d B E F G BL ii BL iii IC ii Graph IV IC iii Gd A The Substitutin effect creates a new hypthetical line that determines a new hypthetical ptimal chice F within the current indifference curve. The Incme Effect creates a new budget line iii which represents the budget's reductin in purchase pwer. The hypthetical line created by the substitutin effect has t be shifted left t fit budget s new purchase pwer. The affrdable quantity decreases fr bth gds, creating a new ptimal chice at pint G, at a new indifference curve iii. The increase in price was prprtinal in bth cases creating a new budget line iii that is parallel t the first budget line i. Budget line i verall mvement was a shift t the left shwing the decrease f the cnsumer's purchase pwer that can be cnfirmed by Graph V. 10
G d B C G BL iii IC i BL i Graph V IC iii Gd A One can cnclude that the change in prices f ne gd affects all gds in the cnsumer s ptimal chice. The substitutin effect is the realizatin f thse changes, cnsumer s preferences is affected when prices change. The incme effect realizes the budget limitatins, a change in prices with incme remaining cnstant affects the purchase pwer f cnsumers, reducing r increasing the quantities affrdable fr each gd. 11
Questin D Grup Wrk Exercise: i A Grss Dmestic Prduct is defined as the value f all final gds and services actually prduced within an ecnmy ver a certain perid f time (usually a year). The cmpnents f GDB are the fllwing: Cnsumptin Expenditures Investment Spending Gvernment Expenditures Net Exprts (Exprts Imprts) Thus the GDP equatin is: GDP = C + I + G + NX GDP = 828,081 + 238,531 + 286,812 + (369,691 424,128) GDP = 1,298,987 B The utput apprach f the GDP at market prices is the sum f utput (value-added) prduced in the ecnmy. As a result the fllwing frmula is used: GDP at factr cst = GDP at market price indirect business tax + subsidies GDP = 1,298,987 635 GDP = 1,298,352 C Grss natinal Prduct is fund by adding GDP at market prices + net incme factr frm abrad. GNP = 1,298,352 + 17,334 GNP = 1,315,686 (millins) 12
D Net natinal prduct is defined as the ttal market value f all final gds and services prduced within an ecnmy ver a certain time perid, minus fixed capital cnsumptin. NNP = GNP Fixed Capital Cnsumptin NNP = 1,315,686 133,936 E NNP at market prices is fund by subtracting indirect taxes frm initial NNP. NNP = 1,193,757 144,663 NNP = 1,049,094 (millins) 13
Exercise: ii Price Elasticity f Demand (PED) is the percentage change in quantity divided by the percentage change in price. The percentage change in quantity can be established by the PED multiplied by the percentage change in price: PED = % Q = % P % Q = PED x % P Suppsing a gvernment increases taxes n cigarettes frm 1 t 2 per pack sld, raising the prices frm 4 t 5 per pack, and assuming price elasticity n this demand t be cnstant, the percentage change in ttal taxes can be calculated. A - If price elasticity f demand equals -0.2: PED = -0.2 P = 5-4 = 1 % P: 4 = 100% 1 = 25% % P =25% r 0.25 % Q = PED x % P % Q = (-0.2) x 0.25 % Q = -0.05 = -5% The increase in taxes frm 1 t 2, cnsequently increasing prices f each pack frm 4 t 5, wuld decrease quantity demanded by 5%. Suppsing 100 packs were sld befre the increase in prices, the quantity sld after the change wuld be 5% less, r 95 packs. At the riginal price the verall taxes acquired by the gvernment were 100 x 1 = 100. Nw that quantity demanded decreased, verall taxes are 95 x 2 = 190. The increase in taxes and prices increase verall taxes by 90. B - Suppsing price elasticity f demand equals -2: PED = -2 P = 5-4 = 1 % P: 4 = 100% 1 = 25% % P = 0.25 % Q = PED x % P % Q = (-2) x 0.25 % Q = -0.5 = -50% If the riginal quantity demanded was 100 packs f cigarettes, the increase in taxes wuld reduce quantity demanded by 50%, reducing quantity f packs bught t 50 packs. At the new prices the verall taxes wuld be 50 x 2 = 100. There wuld be n change n verall taxes received. 14
It is pssible t say that Price Elasticity f Demand affects decisins abut price changes. It can predict the behaviur f the demand curve and establish if verall prfits will remain the same, increase r decrease. If PED is elastic (ver 1) the demand curve is elastic and will react t changes in price. When PED is inelastic (between 1 and 0) the demand curve is inelastic and will nt change significantly in reactin t changes in price. 15