” Micro Economics”
INTRODUCTION
Economics. From the Greek oikos, meaning ‘house’, and nomos, meaning ‘rule’, thus economics also means “household management”.
Economics is a social science that studies the production, distribution, trade, consumption of goods, services, and scarcity of resources and its alternatives.
Scarcity if a situation where there is limited resources at hand, such as capital, labor, or raw materials.
Economics is broadly divided into two main branches these are: microeconomics, which deals with individual agents, such as households and businesses, and macroeconomics, which considers the economy as a whole, in which case it considers aggregate supply and demand for money, capital and commodities.
Microeconomics, which literally, very ‘small economics’ is a social science which involves the study of the economic distribution of production and income among individual consumers, firms, and industries in a smaller level than that of macroeconomics. It considers an individual, both as suppliers of labor and capital and as the ultimate consumers of the final product.
It also examines firms both as suppliers of products and as consumers of labor and capital.
One of the goals of microeconomics is to analyze economic systems such as market forces that establish relative prices amongst goods and services.
Here are some exercises that will help you understand more about microeconomics:
PART A:
QUESTION 1: You are the manager of a company producing and selling jumpers. At present, you charge a price of £50 per jumper, and you have monthly sales of 100 units. You know that the price elasticity of demand of your customers is -1.5. In order to increase sales and revenues, you are planning to decrease the price to £40. Is this a good business decision?
ANSWER: The main topic in this problem is ‘price elasticity of demand’. So, in order to answer the question, let us first discuss what ‘price elasticity of demand’ is.
Price elasticity of demand (PED) is an elasticity that measures the responsiveness of the quantity demanded of a good to its price, with all other factors held constant.
Mathematically, it is represented as:
Where:
P = price
Q = quantity
Or as:
Q2 – Q1__
(Q1+Q2) / 2_____
P2-P1__
(P1+P2) /2
Where:
Q1 = Initial quantity
Q2 = Final quantity
P1 = Initial price
P2 = Final price
Since quantity demanded is inversely proportional to price, from this assumption, in this case, lowering the price from £50 to £40 would result to higher quantity demand from 100 units a month up to approximately 180 units. Therefore, lowering the price of the jumpers would be a good decision to increase sales and revenues.
QUESTION 2: Paul is a smoker and he complains to Gordon Brown (the UK Chancellor) that the price of cigarettes is too high. Gordon Brown replies that he actually thinks that the price of cigarettes is too low since the market does not acknowledge the social cost of smoking. How can you explain Gordon Brown’s point?
ANSWER: Chancellor said something about the cigarette market not acknowledging the social cost of smoking. First let us define what social cost is. In economics, social cost is the total of all the costs associated with a certain economic activity to the society. And in this case the cigarette production and consumption.
Social cost includes both costs endured by the economic agent and also all costs borne by society at large. Including the costs reflected in the organization’s production function which is called private costs, and the costs external to the firm’s private costs called external costs.
If social costs are greater than private costs, then a negative externality is present.
Negative externalities or external costs can lead to an over-production of those goods that have a high social cost. An example of this is our own case at hand. When people smoke a lot, it deteriorates their own health. And also, it adds to air pollution which is one of the major problems of every government in the world.
As a solution, Pigovian tax is levied to at least level the negative social side-effects of a certain economic activity.
Pigovian tax is a tax levied on producers who pollute the environment to encourage them to reduce pollution, and to provide revenue which may be used to counteract the negative effects of the pollution.
Also, some certain types of Pigovian taxes are sometimes referred to as sin taxes, for example taxes on alcohol and cigarettes.
The problem with Pigovian tax is that of calculating what level of tax will counterbalance the negative externality of these firms. And also, political factors such as lobbying of polluters to the government may also tend to reduce the level of the tax levied, which will tend to reduce the mitigating effect of the tax.
QUESTION 3: The main source of ‘economies of scale’ is large ‘fixed costs’. Briefly explain.
ANSWER: To answer this, let us first define what is ‘economies of scale’ and what is ‘fixed cost’.
Economies of scale refers to the decreased per unit cost as output increases. To be more precise, the initial investment of capital is diffused over an increasing number of units of output.
As a result, the marginal cost of producing a good or service decreases as production increases.
Meanwhile, fixed costs are expenses whose total does not change in proportion to the activity of a business. Examples of these are rent and utility bills insurance, and payroll.
Economies of scale is more likely to happen in an industry who has a large capital and fixed cost, which such costs are distributed in across a very large number of units of production.
A factory is a good example of this. When an investment in a machine is made (which requires electricity, or other form of fuel), a worker will be hired (which need to be paid) and begins to work on the machine to produce goods. When another worker is hired, the production will be doubled without adding significant cost of operation to the factory. Therefore, the cost of production of an additional good is less than the cost of good before.
PART B
‘Happy Chicken Ltd. ‘is a small poultry farm producing chicken meat for big supermarkets. The poultry is a competitive industry populated by a large number of small producers. At present, the industry is as its ‘long-run’ equilibrium and ‘Happy Chicken Ltd.’ is making normal profits.
A) Draw a graph showing the market demand for and supply of chicken meat and the long run equilibrium for ‘Happy Chicken Ltd.’
Remember, fear for a ‘bird flu pandemic has dramatically reduced the demand for chicken meat.
B) Use the graph you have drawn to:
a) To show short run effects of this shock on the market equilibrium and on ‘Happy Chicken Ltd.’;
b) Explain whether ‘Happy Chicken Ltd.’ Will have incentives to leave or to stay in the industry; and
c) Assuming that the effect of this shock is permanent, describe how the economy will adjust in the long run.
This is a graph showing the market demand for and supply of chicken meat and long-run equilibrium for ‘Happy Chicken Ltd.’. The ‘bird flue epidemic taken into account.
LEGEND:
AC = average total cost
AR = average revenue
MC = marginal cost
MD = market demand
MR = marginal revenue
MS = market supply
P = price (P1, P2…)
Q = quantity (Q1, Q2…)
When more people want something, the quantity demanded at all prices will tend to increase. This can be referred to as an increase in demand.
But according to our scenario, which is the ‘bird flu epidemic’. People tend not to buy chicken meat. And therefore there is oversupply or surplus on a lot of chicken products. Including ‘Happy Chicken Ltd.’ Even if they push their prices down.
‘Happy Chicken Ltd.’ is in a competitive industry and is therefore it has the freedom to enter or exit the industry.
In our scenario, ‘Happy Chicken Ltd.’ is still experiencing normal profits. It still can cover all its variable costs plus part of the fixed costs. Meaning it has no losses, and also it has no profits as well.
As long as ‘Happy Chicken Ltd.’ is having normal profits, the firm can still cover all its variable costs and the same fixed costs as well. It is till best to wait and find out whether market conditions will improve to their own advantage. Since at this point ‘Happy Chicken Ltd.’ neither has an incentive to leave or to stay in the business.
However, if ‘Happy Chicken Ltd.’ suffers Sub Normal profits or losses, they still should not take the decision to withdraw from the market immediately in the short run. But if assuming that the effects of the ‘bird flu epidemic’ are permanent, and If ‘Happy Chicken Ltd.’ continues to make losses even in the long run the firms will have ultimately to leave the industry.
And as for the economy, the prices will keep coming down until they reach the profit maximizing output level where firms will only produce normal profits. Thus, establishing a long run equilibrium level.
Credit:ivythesis.typepad.com
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