Part A (Microeconomics)
Q2.
a)
When people start consuming more bread there is an increase in demand for wheat flour as wheat flour is one main ingredient used in preparing bread. Rise in demand causes an outward shift of the demand curve raising price and quantity at the new equilibrium.
Figure 1: Impact of an increase in bread consumption
b)
When a cheaper way of milling flour has been discovered it decreases the cost of producing wheat flour. This leads to an increase in supply of wheat flour (Mankiw, 2016). As a result, supply curve of wheat flour shifts rightward resulting in a surge in price at equilibrium along with a fall in equilibrium price.
Figure 2: Impact of the discovery of new cheaper way of milling flour
c)
Other grains are substitute of wheat. If price of other grains increases, demand for these grains fall. As wheat becomes relatively cheaper compared to other grains, demand for wheat flour increases. Consequently, price and quantity of wheat flour at the new equilibrium increases.
Figure 3: Impact of increase in prices of other grains
d)
Fall in price of Rice and Potatoes reduces demand of wheat flour as these can be used as a substitute of food prepared using wheat flour. As demand of wheat flour decreases, equilibrium quantity of flour decreases along with a decrease in equilibrium price.
Figure 4: Impact of fall in price of rice and potatoes
a)
Table 1: Short run costs for an imaginary firm
b)
Law of diminishing return indicates that adding more of variable inputs with fixed amount of fixed input first causes total output to increase and then falls. As soon as firm experiences diminishing return, marginal product of labor begins to fall. This in turn means total output increases at a falling rate. Since marginal product of labor is connected with marginal cost, stage of diminishing return cam be identified from the marginal cost of labor (Fine, 2016). Diminishing return starts to occur with increase in marginal cost of production. From the above table it is observed that marginal cost begins to increase since 5 units of output. Therefore, diminishing marginal return sets in corresponding to the output level of 5.
c)
Figure 5: AFC. AVC, AC and MC
Price elasticity of demand is a concept in economics that estimates percentage changes in the demand for an item because of the corresponding percentage change in price. Income elasticity of demand is an estimate measuring proportion of variation in demand for a good in response to an income change (Nguyen & Wait, 2015) Price elasticity of demand therefore measures sensitivity of demand with respect to price while income elasticity measure sensitivity of demand for a change in income.
Question 1: Free lunch and classification of goods
The formula for price elasticity of demand is given by
Suppose price of wheat increases from $10 per bushels to $15 per bushels due to which demand for wheat falls from 50 bushels to 40 bushels per day. Price elasticity of demand for wheat is therefore,
The formula for income elasticity of demand is given as
Suppose average income of consumers in a region falls from $50,000 to $40000. Because of this a local dealer experiences a decline in demand for car plummets to 5000 units from previous demand of 10,000. The income elasticity of demand therefore is,
Cross price elasticity of demand gives an estimate for variation in quantity demanded given the change in proportion of price of a related good. If the two good are substitutes, then cross price elasticity measure is positive (Cowell, 2018). The negative measure of cross price elasticity indicates that products are complementary goods.
The formula for cross price elasticity of demand is given as
Consider the case where a 50 percent increase in price of gasoline price decreases passenger vehicles’ sales by 10 percent. The cross price elasticity of demand can be computed as
The cross price elasticity is less than zero meaning gasoline price and passenger vehicles are complementary goods.
A firm or business should know difference between each of three different types of elasticity of demand. The concept of price elasticity of demand is useful for making pricing decision. Since movement of demand in response to price affects revenue business should have knowledge about price elasticity of demand.
Income elasticity of demand helps businesses to understand how demand changes when income changes (Baumol & Blinder, 2015). For goods having positive income elasticity of demand, demand grows with income which in turn boosts volume of sales.
In any business cross price elasticity is important as it helps to under how demand changes price of a related goods changes. Based on the measure of cross price elasticity, firms decide their competing strategy.
Q7.
a)
Figure 6: Four phases of business cycle
The four phases of business cycle are expansion, peak, contraction and trough.
Expansion: Expansionary phase is characterized by an increase in aggregate output, price, employment, profit and living standard.
Peak: The economy reached to the highest level of growth attaining close to full employment (Goodwin et al., 2015).
Contraction: During contraction phase aggregate output, price, employment and profit all begin to contract.
Question 2: Market price of wheat flour
Trough: At this stage the economy extents to the lowest level of growth.
b)
In the business cycle, the upper turning point occurs when an economy enter to economic contraction or recession from its peak. This occurs mainly due to a decline in demand due to internal and external economic shocks. Continuous decrease in output, employment, price and profits moves the economy toward depression. The lower turning point in the business cycle occurs during the transition from trough to expansion (Uribe & Schmitt-Grohe, 2017). Economic expansion results from increase in aggregate demand either due to increase in economic activities to due to expansionary policy measure.
c)
The main forms of unemployment exist in an economy are structural unemployment, frictional unemployment and cyclical unemployment. Structural unemployment comes into existence due structural change leading skill mismatch to the available jobs. Cyclical unemployment is the result of decline in aggregate demand of the economy during recessionary phase of business cycle. Transition from one job to another causes frictional unemployment.
d)
Money market functions by the interaction of demand and supply for money. Money demand shows amount of money demanded at different interest rates. Demand for money moves in opposite direction of interest rate and therefore money demand curve has a downward slope. The supply of money in contrast shows amount of money available at the given interest rate. Supply of money is fixed in the economy and depends on decision of central bank. Money market equilibrium occurs where demand for money matches with the supply of money.
Figure 7: Function of money market
a)
Demand pull inflation is when aggregate demand in an economy increases at a faster rate compared to aggregate supply. On the other hand, when general price level increases following a shortage of aggregate supply which in turn resulted from increase in price of factor inputs is defined as cost-push inflation.
Figure 8: Demand-pull inflation
Figure 9: Cost-push inflation
b)
Causes of demand-pull inflation
Economic growth: When an economy accounts a higher growth, income increases. Increasing income of household increases aggregate demand and raises price level.
Discretionary fiscal policy: Fiscal policy expansion by increasing government spending or by reducing tax rate stimulates aggregate demand and cause demand-pull inflation.
Wage inflation: Increase in wage paid to workers increases production cost which lowers supply causing cost-push inflation (Guilmi, Gallegati & Landini, 2017)
Natural disaster: During natural disaster, natural resources depleted which hampers aggregate supply and causes cost-push inflation.
Question 3: Law of diminishing marginal returns and perfectly competitive firms
c)
In an economy the demand and cost-push inflation interacts with each other. When price increase following an increase in aggregate demand profits of businesses increase. This encourage to increase production raising demand for factor income and factor prices. Rise in factor price increases production cost which further increases cost-push inflation (Heijdra, 2017) similarly, during cost push inflation when factor price increases factor income intensifies which in turn increases aggregate demand resulting in demand-pull inflation.
Figure 10: Interaction between demand-pull and cost-push inflation
a)
When Central Bank within the economy lifts interest rates, it increases borrowing cost and discourage investment. Lower investment reduces aggregate demand which in effect lowers real GDP and price level in the short run.
Figure 11: Impact of a lift in interest rate
b)
Increase in private domestic investment spending surges aggregate demand. With a rise in aggregate demand real GDP and price level in the short run increases.
Figure 12: Impact of increase in private domestic investment
c)
Increase in good and service tax discourage productive activities which in effect lowers aggregate supply (Brown & Narasimhan, 2019). Fall in level of aggregate supply in the short run brings down GDP while increases price level.
Figure 13: Impact of increase in good and service tax
d)
Appreciation or rise in value of foreign exchange increase relative cost of exported goods while lowers the price of imported good in the international market. As export falls and import increase net export falls. This lowers aggregate demand causing GDP and price level to contract.
Figure 14: Impact of appreciation of foreign exchange value
e)
Decline in real estate price decrease wealth level and hurts confidence of consumers. This adversely affects consumption spending which decreases aggregate demand. Along with aggregate demand real GDP and price level declines.
Figure 15: Impact of a fall in real estate price
References
Baumol, W. J., & Blinder, A. S. (2015). Microeconomics: Principles and policy. Nelson Education.
Brown, C., & Narasimhan, S. (2019). Principles of Macroeconomics. Economics, 2020, 300.
Cowell, F. (2018). Microeconomics: principles and analysis. Oxford University Press
Fine, B. (2016). Microeconomics. University of Chicago Press Economics Books.
Goodwin, N., Harris, J. M., Nelson, J. A., Roach, B., & Torras, M. (2015). Macroeconomics in context. Routledge.
Guilmi, C. D., Gallegati, M., & Landini, S. (2017). Interactive Macroeconomics. Cambridge Books.
Heijdra, B. J. (2017). Foundations of modern macroeconomics. Oxford university press.
Mankiw, N. G. (2016). Business economics. Cengage Learning.
Nguyen, B., & Wait, A. (2015). Essentials of Microeconomics. Routledge.
Uribe, M., & Schmitt-Grohe, S. (2017). Open economy macroeconomics. Princeton University Press.
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