The theory of demand and its relation with a commodity’s price
1. The price of beef rises and yet it is observed that the sales of beef increase. Does this mean that the demand curve for beef is sloping upward? Explain.
2. Suppose a news article reports, “Poor wine-grape harvests in France have brought financial gains to Australian winemakers. Sales of Australian wines in France are booming and wine prices are the best ever”
a) How has the market for French wines been affected by the poor harvest?
b) How has the change in the French wine market affect the market for Australian wines?
3. What is the effect on the equilibrium price and equilibrium quantity of orange juice if the price of apple juice decreases and the wage rate paid to orange grove workers increases? (Hint: Look at all possible outcomes. There is more than one)
4. In Australia, governments set the fares that taxi owners/drivers can charge. At various times, taxi owners/drivers stage protests asking to be allowed to increase their taxi fares so that their total revenue will increase.
a) What are taxi owners/drivers assuming about the price elasticity of demand for taxi rides, given their confidence that an increase in price will increase their revenue?
b) Why do they have such an assumption? Is it a realistic assumption?
5. A monopolistically competitive firm is producing 50 units of output in the short run where marginal cost is $3.00, average total costs are $5.00, price is $4.50, average variable cost is $4.00 and marginal revenue is $3.00.
a) Represent the above in a graph and calculate how much profit is the firm making?
b) What output recommendation would you make for the firm?
The theory of demand suggests an inverse relation between price and quantity demanded of a commodity. This implies if other demand determinant factors remain constant then rise in price of a good is associated with a decline in demand. Following this law of demand, a downward sloping demand curve is obtained. An upward sloping demand curve on the other hand indicates rise in demand along with a rise in price. In the give scenario, it has observed that sales of beef increases despite increase in price (Carlton and Perloff 2015). However, only from this observation it cannot be said that the demand curve slopes upward. This is because apart from price there are several other factors that influence demand and sales. The sales of beef might be increased because of a much greater increase in price of substitutes like chicken, lamb or such others. If price increase of beef is relatively lower than that of its substitutes then beef demand increases. With a relatively lower price, beef seems to be cheaper alternative. Therefore, with knowing condition of other factors influencing demand, it is not possible to derive demand relation with price.
Factors influencing demand besides price
Supply of a good depends on the available supply of inputs. The main input in wine production is wine grapes. The poor harvest of wine grape in France affects supply of wine grapes in the wine industry. The reduced supply of wine grapes thus hampers the production of wine French wine. The reduced production of French wine shifts he supply curve upward (Varian 2014). The shortage of wine supply in French market increases equilibrium price while reducing equilibrium supply of French wine.
Figure 1: Effect of poor wine harvest on French wine
(Source: as created by Author)
The poor harvest thus reduces supply of French wines, which leads to an increase in wine price to P1 and reduces available supply to Q1.
Australian wine is a substitute to French wine. The supply shortage of French wine increases price French wine. Faced with a higher price, consumers of wine in France now try to find an alternative cheaper substitute (Baumol and Blinder 2015). High price of French wine thus make Australian wine relatively cheaper. People now tend to consume more Australian wine. As demand for Australian wine increase, market of Australia wine expands with an increase in both equilibrium price and quantity.
Figure 2: Effect on Australian wine market
(Source: as created by Author)
Increased demand of Australian wine as a substitute of French wine us shown from the outward shift of the demand curve to D1D1. The Australian wine market expands, with an increase in price to P2 and rise in equilibrium quantity to Q2.
The market dynamics of orange juice depends on both demand and supply condition. Change in either demand or supply or both bring a change orange juice market with a change in both equilibrium price and quantity. A substitute of orange juice is apple juice. If the price of apple juice decreases then demand for apple juice increase depressing the demand for orange juice. Increase in wage paid to orange grove workers led to an increase in production cost of orange juice (Nicholson and Snyder 2014). This reduces supply of orange juice. Market for orange juice thus faces a decline in both demand and supply. The effect on equilibrium quantity is clear. Contraction of both supply and demand causes equilibrium quantity to fall. The impact on equilibrium price however is uncertain. Supply shortage resulted from an increase in production cost creates an upward pressure on price. Increase in orange juice demand on the other hand push price down. The impact on equilibrium price is thus depend of relative strength of demand and supply. If increase in demand dominates decrease in supply then price will decrease in new equilibrium (Hildenbrand 2014). Price will increase if the supply shortage dominates demand declines. Price remained unchanged if demand and supply changes by the same magnitude.
The effect of poor wine harvest on French wine supply
Figure 3: Demand change exceeds supply
(Source: as created by Author)
Figure 4: Supply change exceeds demand
(Source: as created by Author)
Revenue of firms depend in both price and quantity of goods sold. Changes in price causes a change in quantity and hence, changes revenue. Firms often raise price to increase revenue. Increase in revenue however depends on magnitude of change in both price quantity. Similarly, taxi owners’ revenue depend on demand of taxi rides and taxi fares. If demand for taxi rides is relatively inelastic in nature, then rides will not reduce even when fare increases. This therefore leads to an increase in revue of taxi owners/drivers. The policy of raising fares will not be an effective policy in case of elastic demand for taxi rides (Azevedo and Leshno 2016). In this situation, increase in fares will reduce demand for taxi rides largely leading to a decline in revenue. The confidence on part of the taxi drivers regarding the fact that increase in fare increases revenue thus indicate assumption of a relatively inelastic demand.
A number factor influence the price elasticity of demand. The main factor responsible for making demand for taxi rides inelastic is the flexibility of services. People can avail their own rides irrespective of time and place. Other available transportation service like private or public transportation are imperfect substitute of taxi rides. The preference for tax rides is increasing following the easy availability and flexibility of taxi services (Taylor et al. 2014). This provides support to the assumption of taxi owners/driver regarding relatively inelastic demand for taxi rides.
Given that, short run output (Q) of the monopolistically competitive firm is 50. The output is sold at a price (P) of $4.50.
From this, revenue of the firm is obtained as
Average cost of the firm is $5.00. From this, total cost is estimated as
Profit is the difference between total revenue and total cost.
As total cost exceeds total revenue, the firm in the short run is making loss of $25
Profit maximizing condition of firm requires marginal revenue should be matched with marginal cost. However, the firm is making a loss but still short run equilibrium satisfies profit maximization condition. Loss is incurred, as price charged by the firm is lower than average total cost of $5(Frank 2015). The firm is making a loss of $25. The firm however should continue operation at existing level of output price is excess of average variable cost. If the loss continues in the long-run then the firm should close down its operation.
Reference list
Azevedo, E.M. and Leshno, J.D., 2016. A supply and demand framework for two-sided matching markets. Journal of Political Economy, 124(5), pp.1235-1268.
Baumol, W.J. and Blinder, A.S., 2015. Microeconomics: Principles and policy. Cengage Learning.
Carlton, D.W. and Perloff, J.M., 2015. Modern industrial organization. Pearson Higher Ed.
Frank, R.H., 2015. Principles of microeconomics, brief edition. Mcgraw-Hill.
Hildenbrand, W., 2014. Market demand: Theory and empirical evidence. Princeton University Press.
Nicholson, W. and Snyder, C.M., 2014. Intermediate microeconomics and its application. Cengage Learning.
Taylor, T., Greenlaw, S.A., Dodge, E.R., Gamez, C., Jauregui, A., Keenan, D., MacDonald, D., Moledina, A., Richardson, C., Shapiro, D. and Sonenshine, R., 2014. Principles of microeconomics. OpenStax College, Rice University.
Varian, H.R., 2014. Intermediate Microeconomics: A Modern Approach: Ninth International Student Edition. WW Norton & Company.
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