Effects of Shifts in Demand

QUESTION 1

a. Explain how shifts in demand may bring about price changes in a competitive market.

A shift in the demand for a good will either cause a price rise or a price reduction if the demand for a good exceeds or is less than the supply or the equilibrium point, the equilibrium in the market is determined by the intercept of the demand curve and the supply curve, when demand rises then the demand curve shifts up and as a result the price of the good rises. On the other hand if the demand of a good declines then the demand curve shifts downward and the equilibrium price goes down.

The diagram below shows these two effects of the shifty in demand:

When the demand of a good increases then the demand shifts upward to demand curve one and the equilibrium price rises to p1, when the demand of a good decreases the demand curve shifts downwards and the equilibrium price in the market shifts downward to p2 as shown above in the diagram.

b. A local authority introduces a licence scheme to allow motorists to enter the central business district. It decides to issue a maximum number of licences of 15,000 a year and undertake a ‘willingness to pay’ survey, which suggests the following demand schedule for licences:

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Effects of Shifts in Demand

Price (\$ p.a.)

Demand (p.a.)

0

20,000

50

18,000

100

16,000

150

14,000

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Effects of Shifts in Demand

200

12,000

250

10,000

300

8,000

350

6,000

400

4,000

450

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Effects of Shifts in Demand

2,000

i. Draw the demand and supply curves for this situation and show the market

clearing price.

The supply curve is a horizontal line which passes through 15000, the market clearing price is the point where the demand is equal to the supply, and the market clearing point is therefore 125 pounds.

ii. Explain why, in reality, such a demand curve is unlikely to be exactly linear.

The demand curve for a monopoly is a vertical, for an oligopoly market it is kinked, for the demand curve for the local authority it is likely that more of licences will demanded than estimated when prices are low, therefore the demand curve will not be linear but convex to the origin. It will be concave because as the price of licences go down then the demand increases at a increasing rate and when the price rise the demand decrease at a decreasing rate.

iii. Calculate the price elasticity of demand at the market clearing price

E = ((Q1-Q2)/Q)/ ((P1-P2)/P)

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In our case there is no change in price or quantity demanded therefore ourt price elasticity os demand at the market clearing point is equal to one.

iv. The local authority decides to change its pricing policy in order to maximise revenue received from the licences.

What price should they charge and how many licences will be sold?

To maximise revenue the local authority may choose to increase prices as follows:

Price (\$ p.a.)

Demand (p.a.)

revenue

0

20,000

0

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Effects of Shifts in Demand

50

18,000

900000

100

16,000

1600000

150

14,000

2100000

200

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Effects of Shifts in Demand

12,000

2400000

250

10,000

2500000

300

8,000

2400000

350

6,000

2100000

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Effects of Shifts in Demand

400

4,000

1600000

450

2,000

900000

From the above table it gives us the price and the revenue received as a result of charging different prices at different quantities demanded, the highest revenue is got from charging a price of 250 pounds and the quantity demanded being 10,000, therefore the revenue will be 2,500,000 which is the highest according to the table.

v. Recovery from recession increases the demand for licences by 4,000 at each and every price.

Explain, with reference to your diagram, the effect this will have on the revenue maximising price and quantity sold.

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Effects of Shifts in Demand

recession

Price (\$ p.a.)

Demand (p.a.)

new demand

New revenue

0

20,000

24,000

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Effects of Shifts in Demand

0

50

18,000

22,000

1100000

100

16,000

20,000

2000000

150

14,000

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Effects of Shifts in Demand

18,000

2700000

200

12,000

16,000

3200000

250

10,000

14,000

3500000

300

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Effects of Shifts in Demand

8,000

12,000

3600000

350

6,000

10,000

3500000

400

4,000

8,000

3200000

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Effects of Shifts in Demand

450

2,000

6,000

2700000

From the above table it is clear that the revenue maximising price now is 300 pounds from the above table which yields 3600000 pounds. Therefore our revenue maximising price increases and at the same time our revenue increases.

vi. Define what is meant by ‘consumer surplus’ and calculate its value before the demand shift at both the market clearing and the revenue maximising prices

consumer surplus can be defined as the difference that exist between what the consumers are willing to pay and what the consumers actually pay for a good or service. Consumer surplus is the area shown below:

The consumer surplus will therefore be the area above the equilibrium price and below the demand curve:

450-125 = 225

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15000 – 0 =15000

= 225 X 15000 =3375000

So consumer surplus is equal to 3,375,000

d. Using appropriate diagrams and with reference to the concept of marginal utility explain the optimal level of consumption of:

iv. One freely available good (e.g. unmetered water)

every good experiences diminishing marginal utility as the consumption of that good increases, for example when one consumes one fruit he or she gets high level of utility for this first utility than the additional units he consumes after, for a free good the optimal consumption is the point at which the marginal utility is zero, this means that the optimal consumption is reached when the utility level stops to increase, the diagram below shows the utility level of a good and the optimal level of consumption:

Assumptions

There exist diminishing marginal utility as the consumption of the good increases

v. Two priced goods.

The optimal consumption of two priced good is derived by indifference curves, the indifference curves depict the combination of two goods that derive the same level of utility, for these goods

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Effects of Shifts in Demand

the optimal level is derived from where the indifference curve touches the budget line of the consumer, the diagram below shows the optimal level of consumption:

Assumptions of these is that there exist only two good in the market The consumer makes rational decisions

The consumer aims at maximising his or her utility

The consumer spends all his or her disposable income on only the two goods.

QUESTION 2

a. Explain why production costs per unit of output tend to fall then rise with increased output:

i. in the short run

In the short run when the production of a good increases then the cost per unit falls, this is because as we increase production the cost per unit falls as a result of the total fixed costs being distributed to more units of the good reducing per unit cost of production in terms of fixed costs.

ii. In the long run.

In the long run the cost per unit of production will fall because of increased production, this is because in the long run the firm will expand its premises increasing fixed cost but still the unit cost of production will fall due to the distribution of costs to many units of production, this can be

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seen where the administration cost per unit of production is distributed to more goods.

b. Compare and contrast the characteristics and predictions of perfect competition and any model of an oligopolistic market.

The prices in a free market is determined by the demand and supplyof a good in the market, where the demand and supply intercept that where the price will be, therefore for a free market it will be very easy to predict the prices in case the demand or the supply changes.

For an oligopoly this is where we have only two firms producing similar goods in the market, in this case the firms takes into consideration the actions of its competitor before making decisions, this is referred to as the game theory, when one firm increases the prices the other firm will not increase prices, when one firm reduces prices then the other must reduce its prices. Therefore for the oligopoly and the free market it’s different in the way we predict the market, that the reason why the oligopoly market has a kinked demand curve.

QUESTION 3

a. With reference to the theories of factor demand and factor supply, explain the influences on urban land prices in a market system.

Urban land market price is known to fluctuate in terms of a sudden rise and a sudden fall in price, when the demand of this land increases the price rises and as more and more people demand this land the price rises to very high levels that cannot be explained by any economic value factor, the price reaches the peak where it suddenly drops to zero value. This is what is referred to as an asset bubble.

b.

i. Generally how may free markets fail?

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Free market fail as a result of failing to cater for the externalities, either positive externalities or negative externalities, negative externalities include pollution or other usage of resources that are not paid for but used up in the production process. Positive externalities can be defined as the benefits that are received but are unpaid for. Therefore the market may fail to cater for the externalities and this is where the government has to intervene and distort the market to provide conducive environment for economic growth.

ii. Specifically, how may free urban land markets fail?

Asset bubbles are associated with the urban land market, asset bubbles is a rise in price of an asset and this rise in price cannot be explained by any economic factor, when the price rises it reaches a point where the price suddenly drops to near zero and this is referred to as a bubble burst. The bubble burst is associated with the fall of the market price of urban land.

## References:

Stratton (1999) Economics: A New Introduction, McGraw Hill Publishers, New York

Philip Hardwick (2004) Introduction to Modern Economics, Pearson Education Press, UK

Anthony Samuelson (1964) Economics, McGraw-Hill publishers, New York

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