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ASSIGNMENT No. 1
Q.1 (a) What is PEST analysis? Explain in detail.(b) What is opportunity cost and why today’s manager calculate opportunity cost?
Differentiate between scarcity and shortage.
Q.2 Consider an imaginary economy that produces only three goods: steaks, eggs and milk information on the quantities and prices of each good sold for two years is given below.
Output 1997 2001Steak (kgs) 10 7Eggs (dozens) 10 13Milk (bottles) 8 11PriceSteak (per kg) $9.10 $11.50Eggs (per dozen) $1.10 $1.30Milk (per bottle) $6.00 $6.50
For this hypothetical economy, calculate each of the following:a) Nominal GDP.b) Real GDP in constant 1997 dollars (i.e., 1997 is the base year).c) GDP deflator.d) The percentage change in real GDP and the GDP deflator between 1997 and
2001.
Q.3 (a) Describe the role of price as rationing device.(b) Explain the supply and demand model in detail.
Q.4 (a) Discuss why the price elasticity of demand is greater or goods and services that have better close substitutes.
(b) If demand is price inelastic, does revenue increase when price rises? Explain with examples.
Q.5 Critically write about the present economic situation of Pakistan and its consequences.
Question 1(a) What is PEST analysis? Explain in detail?
Answer 1(a)
PEST analysis It stands for "Political, Economic, Social, and
Technological analysis" and describes a framework of macro-
environmental factors used in the environmental scanning component of
strategic management.
o Political factors How and to what degree a government
intervenes in the economy. Specifically, political factors include
areas such as tax policy, labour law, environmental law,
trade restrictions, tariffs, and political stability. Political
factors may also include goods and services which the
government wants to provide or be provided (merit goods) and
those that the government does not want to be provided (demerit
goods or merit bads). Furthermore, governments have great
influence on the health, education, and infrastructure of a nation.
o Economic factors Include economic growth, interest rates,
exchange rates and the inflation rate. These factors have
major impacts on how businesses operate and make decisions. For
example, interest rates affect a firm's cost of capital and therefore
to what extent a business grows and expands. Exchange rates
affect the costs of exporting goods and the supply and price of
imported goods in an economy
o Social factors Include the cultural aspects and include health
consciousness, population growth rate, age distribution,
career attitudes and emphasis on safety. Trends in social
factors affect the demand for a company's products and how that
company operates. For example, an aging population may imply a
smaller and less-willing workforce (thus increasing the cost of
labor). Furthermore, companies may change various management
strategies to adapt to these social trends (such as recruiting older
workers).
o Technological factors Include technological aspects such as
R&D activity, automation, technology incentives and the rate of
technological change. They can determine barriers to entry,
minimum efficient production level and influence outsourcing
decisions. Furthermore, technological shifts can affect costs,
quality, and lead to innovation.
o Environmental factors Include ecological and environmental
aspects such as weather, climate, and climate change, which
may especially affect industries such as tourism, farming, and
insurance. Furthermore, growing awareness of the potential
impacts of climate change is affecting how companies operate and
the products they offer, both creating new markets and
diminishing or destroying existing ones.
Legal factors Include discrimination law, consumer law, antitrust law,
employment law, and health and safety law. These factors can affect
how a company operates, its costs, and the demand for its products.
Application of the Factors The model's factors will vary in importance
to a given company based on its industry and the goods it produces. For
example, consumer companies tend to be more affected by the social
factors, while a global defense contractor would tend to be more
affected by political factors. Additionally factors that are more likely to
change in the future or more relevant to a given company will carry
greater importance. For example, a company which has borrowed
heavily will need to focus more on the economic factors (especially
interest rates)
Question 1(b) What is opportunity cost and why today’s manager.
Calculate
Opportunity cost? Differentiate between Scarcity and Shortage.
Answer 1(b)
Opportunity cost The cost related to the next-best choice available to
someone who has picked between several mutually exclusive choices. It
is a key concept in economics. It has been described as expressing "the
basic relationship between scarcity and choice. The notion of
opportunity cost plays a crucial part in ensuring that scarce resources
are used efficiently. Thus, opportunity costs are not restricted to
monetary or financial costs the real cost of output forgone, lost time,
pleasure or any other benefit that provides utility should also be
considered opportunity costs. The concept of an opportunity cost was
first developed by John Stuart Mill
Scarcity of resources is one of the more basic concepts of economics.
Scarcity necessitates trade-offs, and trade-offs result in an opportunity
cost. While the cost of a good or service often is thought of in monetary
terms, the opportunity cost of a decision is based on what must be given
up (the next best alternative) as a result of the decision. Any decision that
involves a choice between two or more options has an opportunity cost.
Examples
o Opportunity cost contrasts to accounting cost in that accounting
costs do not consider forgone opportunities. Consider the case of an
MBA student who pays Rs 60,000 per year in tuition and fees at a
private university. For a two-year MBA program, the cost of tuition
and fees would be Rs 120,000. This is the monetary cost of the
education. However, when making the decision to go back to
school, one should consider the opportunity cost, which includes the
income that the student would have earned if the alternative
decision of remaining in his or her job had been made. If the
student had been earning RS 50,000 per year and was expecting a
10% salary increase in one year, Rs 55,000 in salary would be
foregone as a result of the decision to return to school. Adding this
amount to the educational expenses results in a cost of Rs230,000
for the degree.
o A person who has Rs 150 can either buy a CD or a shirt. If he buys
the shirt the opportunity cost is the CD and if he buys the CD the
opportunity cost is the shirt. If there are more choices than two,
the opportunity cost is still only one item, never all of them.
o A person who invests Rs 10,000 in a stock denies herself or
himself the interest that could have accrued by leaving the Rs
10,000 in a bank account. The opportunity cost of the decision to
invest in stock is the value of the interest.
o A person who sells stock for Rs 10,000 denies himself or herself
the opportunity to sell the stock for a higher price (say Rs 12,000)
in the future, inheriting an opportunity cost equal to the future
price of Rs 12,000 (and not the future price minus the sale price).
Note that in this case, the opportunity cost can only be
determined in hindsight.
o A person who decides to quit their job and go back to school to
increase their future earning potential has an opportunity cost
equal to their lost wages for the period of time they are in school.
Conversely, if they elect to remain employed and not return to
school then the opportunity cost of that action is the lost potential
wage increase.
o An organization that invests Rs 1 million in acquiring a new asset
instead of spending that money on maintaining its existing asset
portfolio incurs the increased risk of failure of its existing assets.
The opportunity cost of the decision to acquire a new asset is the
financial security that comes from the organization's spending the
money on maintaining its existing asset portfolio.
o If a city decides to build a hospital on vacant land it owns, the
opportunity cost is the value of the benefits forgone of the next
best thing that might have been done with the land and
construction funds instead. In building the hospital, the city has
forgone the opportunity to build a sports center on that land, or a
parking lot, or the ability to sell the land to reduce the city's debt,
since those uses tend to be mutually exclusive. Also included in
the opportunity cost would be what investments or purchases the
private sector would have voluntarily made if it had not been
taxed to build the hospital. The total opportunity costs of such an
action can never be known with certainty, and are sometimes
called "hidden costs" or "hidden losses" as what has been
prevented from being produced cannot be seen or known.
o Opportunity cost is assessed in not only monetary or material
terms, but also in terms of anything which is of value. For
example, a person who desires to watch each of two television
programs being broadcast simultaneously, and does not have the
means to make a recording of one, can watch only one of the
desired programs. Therefore, the opportunity cost of watching Geo
could be enjoying dancing. Of course,
o If an individual records one program while watching the other, the
opportunity cost will be the time that individual spends watching
one program versus the other.
o In a restaurant situation, the opportunity cost of eating steak
could be trying the salmon. For the diner, the opportunity cost of
ordering both meals could be twofold - the extra Rs 200 to buy the
second meal, and his reputation with his peers, as he may be
thought gluttonous or extravagant for ordering two meals.
o A family might decide to use a short period of vacation time to
visit Disneyland rather than doing household improvements. The
opportunity cost of having happier children could therefore be a
remodeled bathroom.
Relative Price Opportunity cost is expressed in relative price, that is, the price of one
choice relative to the price of another. For example, if milk costs $4 per
gallon and bread costs $2 per loaf, then the relative price of milk is 2
loaves of bread. If a consumer goes to the grocery store with only $4 and
buys a gallon of milk with it, then one can say that the opportunity cost of
that gallon of milk was 2 loaves of bread (assuming that bread was the
next best alternative).In many cases, the relative price provides better
insight into the real cost of a good than does the monetary price.
Applications of Opportunity Cost The concept of opportunity cost has a wide range of applications including:-
o Consumer choice
o Production possibilities
o Cost of capital
o Time management
o Career choice
o Analysis of comparative advantage
Evaluation of Opportunity Cost The consideration of opportunity costs
is one of the key differences between the concepts of economic cost
and accounting cost. Assessing opportunity costs is fundamental to
assessing the true cost of any course of action. In the case where there is
no explicit accounting or monetary cost (price) attached to a course of
action, or the explicit accounting or monetary cost is low, then, ignoring
opportunity costs may produce the illusion that its benefits cost nothing
at all. The unseen opportunity costs then become the implicit hidden
costs of that course of action. Note that opportunity cost is not the sum
of the available alternatives when those alternatives are, in turn,
mutually exclusive to each other. The opportunity cost of the city's
decision to build the hospital on its vacant land is the loss of the land for
a sporting center, or the inability to use the land for a parking lot, or the
money which could have been made from selling the land, as use for any
one of those purposes would preclude the possibility to implement any of
the others. However, most opportunities are difficult to compare.
Opportunity cost has been seen as the foundation of the marginal
theory of value as well as the theory of time and money. In some cases
it may be possible to have more of everything by making different
choices; for instance, when an economy is within its production
possibility frontier. In microeconomic models this is unusual, because
individuals are assumed to maximise utility, but it is a feature of
Keynesian macroeconomics. In these circumstances opportunity cost is
a less useful concept.
Shortage In a perfect world, supply and demand would work flawlessly
and there would always be an appropriate supply of every product.
However, things are not always that simple. To produce a good or service,
certain resources are required. These resources may be natural in form
like water, wood, ore or any number of other types of raw materials.
Resources can also be in the form of human labor, which means the need
for people that have a certain level of skill, knowledge or natural ability.
When products are manufactured and placed in the marketplace, the price
placed on an item will determine the demand for it. If the price is set too
high, the demand will be low. The converse is true also; a lower price will
increase the demand. Fluctuations in the price will occur until the supply
and demand are equal. The supply of a product will rise and fall based on
its profitability. If the price the market will bear on an item realizes a lower
profit than a different item the manufacturer makes, then it is in the best
interest of the manufacturer to produce less of the first item and more of
the alternate item. This increases the overall profit for the manufacturer.
Decreased production results in the supply of the first item dropping, at
which point the price will adjust to a higher value until the new price
matches the demand for the reduced supply. The reduction in the
supply of the item is then termed a shortage. A shortage occurs
when a producer cannot or will not produce an item for the current price.
A good example of this is what happens during a gas shortage. During the
1970’s, the gas shortage experienced in the US was due to the fact that
the oil companies were raising the price of gas and consumers were forced
to cut back on the amount that they used due to the high cost.
Government stepped in, established an excess profits tax on the oil
companies, and fixed the price of gasoline. The oil companies had plenty
of gas in their storage facilities but were unwilling to sell more than a
certain amount at the price dictated by the government. Because of this,
the market had less gas to distribute to consumers at the government
defined price. The results of this were lines to buy gas and rationing.
Scarcity The scarcity of a product, on the other hand, is due to the
unavailability of resources or materials to manufacture the product.
When the demand of a product is limitless because of need or desire on
the part of the consumer and the resources to manufacture the product
are limited, the market experiences a scarcity of the product. When a
scarcity exists, the market price of the product will be driven up until the
purchase price of the product is equal to the available supply. An example
of a scarcity is the availability of fresh strawberries year-round.
Strawberries are a resource that has limited availability based on growing
season and crop production. During the strawberry season, the price of
fresh strawberries is low and the availability is high. As the season wanes,
the amount of fresh strawberries on the market drops off and the price
rises significantly. By the middle of winter, there are no fresh strawberries
to be found and there is a scarcity of them.
Difference between scarcity and shortage The main difference
between scarcity and shortage, then, is that one is based on limited
resources and the other is based on the decision of the seller to not sell
more than a certain amount of a product at the current selling price.
Economics is the study of how to distribute scarce resources over our
unlimited wants. Scarcity has the meaning of finite amount or limited.
Clean air is a good example. Since air can be cleaned at any one time
there is only so much clean air. Another example, copper has been used
as a metal for several thousand years but there is only so much copper. It
can be reused and reused so that it is available but it is always limited
given the potential uses for it. Copper is always scarce. Where, as
shortage has to do with the relationship between the quantity the
suppliers are willing to supply and the given price in a specific time
period. Therefore as prices go up, the suppliers will work to supply more of
the product and as the prices go down the supplier will cut back the
amount they are willing to supply. However if prices are fixed for some
reason, say by the government, then the demand (what people want at
that price) and the supply may not be equal. Therefore a shortage may
occur. However, if prices are allowed to move, as the price goes up, the
suppliers increase the quantity supplied and the consumers reduce the
quantity they are willing to buy. The shortage goes away over time. In
very short time periods you still may have temporary shortages. The
difference between scarcity and shortage must be viewed with an
economic eye on the problem. These terms are related to goods and
services that are produced for public consumption. When the public
chooses to consume a good or service, they pay a monetary price for the
ability to use the item or service. All of these things are interrelated in the
economic sense. Supply is the availability of a good or service. Demand
is the number of consumers that desire the good or services. The price of
a good or service is set by measuring the point at which the supply equals
the demand.
Question 2(a) Consider an imaginary economy that produces
only three goods: steaks, eggs and milk information on the
quantities and prices of each good sold for two years is given
below.
Output 1997 2001
Steak (kgs) 10 7
Eggs (dozens) 10 13
Milk (bottles) 8 11
Price
Steak (per kg) $9.10 $11.50
Eggs (per dozen) $1.10 $1.30
Milk (per bottle) $6.00 $6.50
For this hypothetical economy, calculate each of the
following:
a) Nominal GDP.
b) Real GDP in constant 1997 dollars (i.e., 1997 is the
base year).
c) GDP deflator.
d) The percentage change in real GDP and the GDP
deflator between 1997 and 2001.
Answer 2
(a) Nominal GDP in1997=10*9.10+1.10*10+6*8=150$
(b) Nominal GDP in2001=(7*11.50)+(13*1.30)+(11*6.50)
=80.5+16.9+71.5=168.9 dollars
(c) Real GDP in constant 1997=
(7*9.10)+(1.1*13)+(6*11)=144$
(d)GDP deflator in1997=base year=1 by definition
GDP deflator in2001=$y/y=$168.90/$144=1.17
(e)% Change in y=-4%
(f)% change in the deflator is17%
Question 3 (a) Describe the role of prices as rationing device?
Answer 2(a)
Rationing In economics, it is often common to use the word "rationing"
to refer to one of the roles that prices play in markets, while rationing
(as the word is usually used) is called "non-price rationing." Using prices
to ration means that those with the most money (or other assets) and
who want a product the most are first to receive it. Such rationing
happens daily in a market economy. Non-price rationing follows other
principles of distribution. Below, we discuss only the latter, dropping the
"non-price" qualifier, to refer only to marketing done by an authority of
some sort (often the government). In market economics, rationing
artificially restricts demand. It is done to keep price below the
equilibrium (market-clearing) price determined by the process of supply
and demand in an unfettered market. Thus, rationing can be
complementary to price controls. An example of rationing in the face of
rising prices took place in the Netherlands, where there was rationing of
gasoline in the 1973 energy crisis. A reason for setting the price lower
than would clear the market may be that there is a shortage, which
would drive the market price very high. High prices, especially in the
case of necessities, are unacceptable with regard to those who cannot
afford them. Economists argue, however, that high prices act to reduce
waste of the scarce resource while also providing incentive to produce
more. In wartime, it is usually imperative for a government to maintain
the support of this part of the population, to maintain "equality of
sacrifice," especially since in most countries, the working-class and poor
families contribute most of the soldiers. Rationing using coupons is only
one kind of non-price rationing. For example, scarce products can be
rationed using queues. This is seen, for example, at amusement parks,
where one pays a price to get in and then need not pay any price to go
on the rides. Similarly, in the absence of road pricing,
Price rationing Prices serve to ration scarce resources when demand
in a market outstrips supply. When there is a shortage of a product, the
price is bid up – leaving only those with sufficient willingness and ability
to pay with the effective demand necessary to purchase the product. Be
it the demand for tickets among England supporters for the 2006 World
Cup or the demand for a rare antique, the market price acts a
rationing device to equate demand with supply. First, prices perform a
means of rationing scarce goods and services. This price rationing
function answers the third basic question that economic systems must
address: who gets the goods and services that are produced?
Remember, goods are not freely available (there is no free lunch). For a
good to be freely available, there must be enough to go around freely to
everyone who wants it. While this may be true for a handful of goods,
virtually all of the millions of goods and services exchanged in any
economic system are not freely available. Because there is not enough
to go around freely, not everyone who wants a good will be able to get
it. Such goods must be rationed, which means there must be some
mechanism for deciding who gets some of the goods and who does not.
In market systems, such rationing is done by price. You can have a
particular good if you are willing and able to pay the market price. If not,
you look for some alternative. Consider the following figure that shows
the effects of closing some of the lobster waters off the coast of Maine in
order to reduce over-harvesting.
Since some of the lobster waters are closed, fewer lobsters will be
harvested. A shifting of the supply curve to the left indicates this
decrease in supply. There are fewer lobsters to go around, which
means some people that used to eat lobsters will not be eating any,
or at least not eating as many as they were before. Who decides
which people will be cutting back and by how much? We do! As a
result of the decrease in supply, there is an increase in price. Fewer
people will be willing and able to pay the new, higher price for
lobster. It is the price itself that rations the available lobsters.
Question 3 (b) Explain the supply & demand model in detail?
Answer 3(b)
Supply & Demand Supply and demand is an economic model of
price determination in a market. It concludes that in a competitive
market, price will function to equalize the quantity demanded by
consumers, and the quantity supplied by producers, resulting in an
economic equilibrium of price and quantity.
The graphical representation of supply and demand The
supply-demand model is a partial equilibrium model representing
the determination of the price of a particular good and the quantity of
that good which is traded. Although it is normal to regard the
quantity demanded and the quantity supplied as functions of the
price of the good, the standard graphical representation, usually
attributed to Alfred Marshall, has price on the vertical axis and
quantity on the horizontal axis, the opposite of the standard
convention for the representation of a mathematical function.
Determinants of supply and demand other than the price of the good
in question, such as consumers' income, input prices and so on, are
not explicitly represented in the supply-demand diagram. Changes in
the values of these variables are represented by shifts in the supply
and demand curves. By contrast, responses to changes in the price of
the good are represented as movements along unchanged supply
and demand curves.
Supply schedule The supply schedule, depicted graphically as the
supply curve, represents the amount of some good that producers
are willing and able to sell at various prices, assuming ceteris
paribus, that is, assuming all determinants of supply other than the
price of the good in question, such as technology and the prices of
factors of production, remain the same.
o Under the assumption of perfect competition, supply is
determined by marginal cost. Firms will produce additional
output as long as the cost of producing an extra unit of output
is less than the price they will receive.
o By its very nature, conceptualizing a supply curve requires that
the firm be a perfect competitor—that is, that the firm has no
influence over the market price. This is because each point on
the supply curve is the answer to the question "If this firm is
faced with this potential price, how much output will it be able
to sell?" If a firm has market power, so its decision of how much
output to provide to the market influences the market price,
then the firm is not "faced with" any price and the question is
meaningless.
o Economists distinguish between the supply curve of an
individual firm and the market supply curve. The market supply
curve is obtained by summing the quantities supplied by all
suppliers at each potential price. Thus in the graph of the
supply curve, individual firms' supply curves are added
horizontally to obtain the market supply curve.
o Economists also distinguish the short-run market supply curve
from the long-run market supply curve. In this context, two
things are assumed constant by definition of the short run: the
availability of one or more fixed inputs (typically physical
capital), and the number of firms in the industry. In the long
run, firms have a chance to adjust their holdings of physical
capital, enabling them to better adjust their quantity supplied
at any given price. Furthermore, in the long run potential
competitors can enter or exit the industry in response to
market conditions. For both of these reasons, long-run market
supply curves are flatter than their short-run counterparts.
Demand schedule The demand schedule, depicted graphically as
the demand curve, represents the amount of some good that
buyers are willing and able to purchase at various prices, assuming
all determinants of demand other than the price of the good in
question, such as income, personal tastes, the price of substitute
goods, and the price of complementary goods, remain the same.
Following the law of demand, the demand curve is almost always
represented as downward-sloping, meaning that as price decreases,
consumers will buy more of the good.
o Just as the supply curves reflect marginal cost curves, demand
curves are determined by marginal utility curves. Consumers
will be willing to buy a given quantity of a good, at a given
price, if the marginal utility of additional consumption is equal
to the opportunity cost determined by the price, that is, the
marginal utility of alternative consumption choices. The
demand schedule is defined as the willingness and ability of a
consumer to purchase a given product in a given frame of time.
o As described above, the demand curve is generally downward-
sloping. There may be rare examples of goods that have
upward-sloping demand curves. Two different hypothetical
types of goods with upward-sloping demand curves are Giffen
goods (an inferior but staple good) and Veblen goods (goods
made more fashionable by a higher price).
o By its very nature, conceptualizing a demand curve requires
that the purchaser be a perfect competitor—that is, that the
purchaser has no influence over the market price. This is
because each point on the demand curve is the answer to the
question "If this buyer is faced with this potential price, how
much of the product will it purchase?" If a buyer has market
power, so its decision of how much to buy influences the
market price, then the buyer is not "faced with" any price and
the question is meaningless.
o As with supply curves, economists distinguish between the
demand curve of an individual and the market demand curve.
The market demand curve is obtained by summing the
quantities demanded by all consumers at each potential price.
Thus in the graph of the demand curve, individuals' demand
curves are added horizontally to obtain the market demand
curve.
Equilibrium It is defined to the price-quantity pair where the
quantity demanded is equal to the quantity supplied, represented by
the intersection of the demand and supply curves.
Changes in market equilibrium Practical uses of supply and
demand analysis often center on the different variables that change
equilibrium price and quantity, represented as shifts in the respective
curves. Comparative statics of such a shift traces the effects from
the initial equilibrium to the new equilibrium.
Demand curve shifts http://en.wikipedia.org/wiki/File:Supply-demand-
right-shift-demand.svg http://en.wikipedia.org/wiki/File:Supply-demand-right-
shift-demand.svgAn outward (rightward) shift in demand increases
both equilibrium price and quantity. When consumers increase the
quantity demanded at a given price, it is referred to as an increase in
demand. Increased demand can be represented on the graph as the
curve being shifted to the right. At each price point, a greater
quantity is demanded, as from the initial curve D1 to the new curve
D2. In the diagram, this raises the equilibrium price from P1 to the
higher P2. This raises the equilibrium quantity from Q1 to the higher
Q2. A movement along the curve is described as a "change in the
quantity demanded" to distinguish it from a "change in demand," that
is, a shift of the curve. In the example above, there has been an
increase in demand which has caused an increase in (equilibrium)
quantity. The increase in demand could also come from changing
tastes and fashions, incomes, price changes in complementary and
substitute goods, market expectations, and number of buyers. This
would cause the entire demand curve to shift changing the
equilibrium price and quantity. Note in the diagram that the shift of
the demand curve, by causing a new equilibrium price to emerge,
resulted in movement along the supply curve from the point (Q1, P1)
to the point Q2, P2).If the demand decreases, then the opposite
happens: a shift of the curve to the left. If the demand starts at D2,
and decreases to D1, the equilibrium price will decrease, and the
equilibrium quantity will also decrease. The quantity supplied at each
price is the same as before the demand shift, reflecting the fact that
the supply curve has not shifted; but the equilibrium quantity and
price are different as a result of the change (shift) in demand.
Supply curve shifts http://en.wikipedia.org/wiki/File:Supply-demand-right-
shift-supply.svg http://en.wikipedia.org/wiki/File:Supply-demand-right-shift-
supply.svgAn outward (rightward) shift in supply reduces the
equilibrium price but increases the equilibrium quantity When the
suppliers' unit input costs change, or when technological progress
occurs, the supply curve shifts. For example, assume that someone
invents a better way of growing wheat so that the cost of growing a
given quantity of wheat decreases. Otherwise stated, producers will
be willing to supply more wheat at every price and this shifts the
supply curve S1 outward, to S2—an increase in supply. This increase
in supply causes the equilibrium price to decrease from P1 to P2. The
equilibrium quantity increases from Q1 to Q2 as consumers move
along the demand curve to the new lower price. As a result of a
supply curve shift, the price and the quantity move in opposite
directions. If the quantity supplied decreases, the opposite happens.
If the supply curve starts at S2, and shifts leftward to S1, the
equilibrium price will increase and the equilibrium quantity will
decrease as consumers move along the demand curve to the new
higher price and associated lower quantity demanded. The quantity
demanded at each price is the same as before the supply shift,
reflecting the fact that the demand curve has not shifted. But due to
the change (shift) in supply, the equilibrium quantity and price have
changed.
Elasticity It is a central concept in the theory of supply and demand.
In this context, elasticity refers to how strongly the quantities
supplied and demanded respond to various factors, including price
and other determinants. One way to define elasticity is the
percentage change in one variable (the quantity supplied or
demanded) divided by the percentage change in the causative
variable. For discrete changes this is known as arc elasticity, which
calculates the elasticity over a range of values. In contrast, point
elasticity uses differential calculus to determine the elasticity at a
specific point. Elasticity is a measure of relative changes. Often, it is
useful to know how strongly the quantity demanded or supplied will
change when the price changes. This is known as the price
elasticity of demand or the price elasticity of supply.
o If a monopolist decides to increase the price of its product,
how will this affect the amount of their good that customers
purchase? This knowledge helps the firm determine whether
the increased unit price will offset the decrease in sales
volume. Likewise, if a government imposes a tax on a good,
thereby increasing the effective price, knowledge of the price
elasticity will help us to predict the size of the resulting effect
on the quantity demanded.
o Elasticity is calculated as the percentage change in quantity
divided by the associated percentage change in price. For
example, if the price moves from $1.00 to $1.05, and as a
result the quantity supplied goes from 100 pens to 102 pens,
the quantity of pens increased by 2%, and the price increased
by 5%, so the price elasticity of supply is 2%/5% or 0.4.
o Since the changes are in percentages, changing the unit of
measurement or the currency will not affect the elasticity. If the
quantity demanded or supplied changes by a greater
percentage than the price did, then demand or supply is said to
be elastic. If the quantity changes by a lesser percentage than
the price did, demand or supply is said to be inelastic. If supply
is perfectly inelastic; that is, has zero elasticity, then there is a
vertical supply curve.
o Short-run supply curves are not as elastic as long-run supply
curves, because in the long run firms can respond to market
conditions by varying their holdings of physical capital, and
because in the long run new firms can enter or old firms can
exit the market.
o Elasticity in relation to variables other than price can also be
considered. One of the most common to consider is income.
How strongly would the demand for a good change if income
increased or decreased? The relative percentage change is
known as the income elasticity of demand.
o Another elasticity sometimes considered is the cross elasticity
of demand, which measures the responsiveness of the quantity
demanded of a good to a change in the price of another good.
This is often considered when looking at the relative changes in
demand when studying complements and substitute goods.
Complements are goods that are typically utilized together,
where if one is consumed, usually the other is also. Substitute
goods are those where one can be substituted for the other,
and if the price of one good rises, one may purchase less of it
and instead purchase its substitute.
At this point, we have developed two behavioral statements, or
assertions, about how people will act. The first says that the amount
buyers are willing and ready to buy depends on price and other
factors that are assumed constant. The second says that the amount
sellers are willing and ready to sell depends on price and other
factors that are assumed constant. In mathematical terms our model
is
Qd = f (price, constants)
Qs = g (price, constants)
This is not a complete model. Mathematically, the problem is that we
have three variables (Qd, Qs, price) and only two equations, and this
system will not have a solution. To complete the system, we add a
simple equation containing the equilibrium condition:
Qd = Qs.
In other words, equilibrium exists if the amount sellers are willing to
sell is equal to the amount buyers are willing to buy.
Supply and Demand Curve If we combine the supply and demand
tables in earlier sections, we get the table below. It should be obvious
that the price of $3.00 is the equilibrium price and the quantity of 70
is the equilibrium quantity. At any other price, sellers would want to
sell a different amount than buyers want to buy.
Supply and Demand Together
Price of
Widgets
Number of Widgets
People Want to Buy
(Demand)
Number of Widgets
Sellers Want to Sell
(supply)
$1.00 100 10
$2.00 90 40
$3.00 70 70
$4.00 40 140
The same information can be shown with a graph. On the graph, the
equilibrium price and quantity are indicated by the intersection of the
supply and demand curves.
If one of the many factors that is being held constant changes, then
equilibrium price and quantity will change. Further, if we know which
factor changes, we can often predict the direction of changes, though
rarely the exact magnitude. For example, the market for wheat fits the
requirements of the supply and demand model quite well. Suppose there
is a drought in the main wheat-producing areas of the United States.
How will we show this on a supply and demand graph? Should we move
the demand curve, the supply curve, or both? What will happen to
equilibrium price and quantity?
A dangerous way to answer these questions is to first try to decide what
will happen to price and quantity and then decide what will happen to
the supply and demand curves. This is a route to disaster. Rather, one
must first decide how the curves will shift, and then from the shifts in
the curves decide how price and quantity would change.
What should happen as the result of the drought? One begins by asking
whether buyers would change the amount they purchased if price did
not change and whether sellers would change the amount sold if price
did not change. On reflection, one realizes that this event will change
seller behavior at the given price, but is highly unlikely to change buyer
behavior (unless one assumes that more than the drought occurs, such
as a change in expectations caused by the drought). Further, at any
price, the drought will reduce the amount sellers will sell. Thus, the
supply curve will shift to the left and the demand curve will not change.
There will be a change in supply and a change in quantity demanded.
The new equilibrium will have a higher price and a lower quantity. These
changes are shown below.
What should one predict if a new diet calling for the consumption of two
loaves of whole wheat bread sweeps through the U.S.? Again one must
ask whether the behavior of buyers or sellers will change if price does
not change. Reflection should tell you that it will be the behavior of
buyers that will change. Buyers would want more wheat at each possible
price. The demand curve shifts to the right, which results in higher
equilibrium price and quantity. Sellers would also change their behavior,
but only because price changed. Sellers would move along the supply
curve.
Question 4 (a) Discuss why the price elasticity of demand is greater
or goods and services that have better close substitute?
Answer 4(a)
Price Elasticity of Demand Price elasticity of demand refers to the
way prices change in relationship to the demand, or the way demand
changes in relationship to pricing. Price elasticity can also reference the
amount of money each individual consumer is willing to pay for
something. People with lower incomes tend to have lower price
elasticity, because they have less money to spend. A person with a
higher income is thought to have higher price elasticity, since he can
afford to spend more. In both cases, ability to pay is negotiated by the
intrinsic value of what is being sold. If the thing being sold is in high
demand, even a consumer with low price elasticity is usually willing to
pay higher prices.
o Elasticity implies stretch and flexibility. The flexibility or the price
elasticity of demand will change based on each item. Changing
nature of both price and demand are affected by a number of factors.
o Generally, goods or services offered at a lower price lead to a
demand for greater quantity. If you can get socks on sale you might
buy several pairs or several packages, instead of just a pair. This
means that though the seller offers the socks at a lower price, he
usually ends up making more money, because demand for the
product has increased. However if the price is set too low, the retailer
may lose money by selling too many pairs of socks at a reduced rate.
o Price elasticity of demand evaluates how change in price influences
demand. In certain circumstances, demand remains inelastic, despite
higher prices. This is true of a number of medications that are
available to treat certain conditions, where there is no substitute.
Demand remains constant in spite of high prices.
o It’s also true of fuel consumption, where few substitutes exist. In
2006, when gasoline prices skyrocketed, demand for gasoline was
only slightly affected. Some people were able to use less gas for their
cars, or to purchase cars that were hybrids, but these were in short
supply. Since few alternatives existed, people continued to buy
gasoline, and demand was thus considered inelastic. Price didn’t
significantly alter demand. Other utilities, like water, often are highly
inelastic in price because they have no substitute to which a
consumer can turn.
o Price elasticity of demand also explains that price becomes more
elastic when higher prices may turn away most consumers who can
choose to buy something else that is less expensive. When a good or
service has numerous substitutes, prices are more elastic and will
change with demand. In fact, availability of substitution is often a
better predictor of price elasticity than is demand. Amount of
competition, numerous companies offering the same items, can also
affect price elasticity of demand. Usually, competition in the
marketplace keeps prices lower and more flexible. Generic
equivalents of certain items have lowered the demand for brand
name items, thus lowering their price.
o In economics, complex formulas show how the price elasticity of
demand can be either profitable or detrimental to the seller. These
formulas describe how good or bad price elasticity of demand
functions. Examples of good (for the seller) price elasticity of demand
include inelastic pricing. In this example, a small drop in demand is
made up for by higher prices. A unit price elasticity that raises
demand can also be profitable for a company. On the other hand, bad
price elasticity occurs when quantity demand increases, but does not
make up for discounted price, causing a drop in company profits.
Question 4 (b) If demand is priced in elastic, Does revenue increases
when price rises? Explain with examples.
Answer 4(b)
Elasticity The degree to which a demand or supply curve reacts to a
change in price is the curve's elasticity. Elasticity varies among
products because some products may be more essential to the
consumer. Products that are necessities are more insensitive to price
changes because consumers would continue buying these products
despite price increases. Conversely, a price increase of a good or service
that is considered less of a necessity will deter more consumers because
the opportunity cost of buying the product will become too high.
A good or service is considered to be highly elastic if a slight change in
price leads to a sharp change in the quantity demanded or supplied.
Usually these kinds of products are readily available in the market and a
person may not necessarily need them in his or her daily life. On the
other hand, an inelastic good or service is one in which changes in price
witness only modest changes in the quantity demanded or supplied, if
any at all. These goods tend to be things that are more of a necessity to
the consumer in his or her daily life.
To determine the elasticity of the supply or demand curves, we can
use this simple equation:
Elasticity = (% change in quantity / % change in price)
Elastic Demand If elasticity is greater than or equal to one, the curve is considered to
be elastic. If it is less than one, the curve is said to be inelastic. As we know, the demand
curve is a negative slope, and if there is a large decrease in the quantity demanded with a
small increase in price, the demand curve looks flatter, or more horizontal. This flatter
curve means that the good or service in question is elastic.
Inelastic Demand It is represented with a much more upright curve as
quantity changes little with a large movement in price.
Elastic supply works similarly. If a change in price results in a big
change in the amount supplied, the supply curve appears flatter and is
considered elastic. Elasticity in this case would be greater than or equal
to one.
Inelastic supply On the other hand, if a big change in price only results
in a minor change in the quantity supplied, the supply curve is steeper
and its elasticity would be less than one.
Factors Affecting Demand Elasticity There are three main factors
that influence a demand's price elasticity:-
o The availability of substitutes This is probably the most
important factor influencing the elasticity of a good or service. In
general, the more substitutes, the more elastic the demand will be.
For example, if the price of a cup of coffee went up by $0.25,
consumers could replace their morning caffeine with a cup of tea.
This means that coffee is an elastic good because a raise in price
will cause a large decrease in demand as consumers start buying
more tea instead of coffee. However, if the price of caffeine were to
go up as a whole, we would probably see little change in the
consumption of coffee or tea because there are few substitutes for
caffeine. Most people are not willing to give up their morning cup of
caffeine no matter what the price. We would say, therefore, that
caffeine is an inelastic product because of its lack of substitutes.
Thus, while a product within an industry is elastic due to the
availability of substitutes, the industry itself tends to be inelastic.
Usually, unique goods such as diamonds are inelastic because they
have few if any substitutes.
o Amount of income available to spend on the good - This
factor affecting demand elasticity refers to the total a person can
spend on a particular good or service. Thus, if the price of a can of
Coke goes up from $0.50 to $1 and income stays the same, the
income that is available to spend on coke, which is $2, is now
enough for only two rather than four cans of Coke. In other words,
the consumer is forced to reduce his or her demand of Coke. Thus if
there is an increase in price and no change in the amount of income
available to spend on the good, there will be an elastic reaction in
demand; demand will be sensitive to a change in price if there is no
change in income.
o Time - The third influential factor is time. If the price of cigarettes
goes up $2 per pack, a smoker with very few available substitutes
will most likely continue buying his or her daily cigarettes. This
means that tobacco is inelastic because the change in price will not
have a significant influence on the quantity demanded. However, if
that smoker finds that he or she cannot afford to spend the extra $2
per day and begins to kick the habit over a period of time, the price
elasticity of cigarettes for that consumer becomes elastic in the
long run.
Question 5 Critically write the present economic situation of Pakistan
and its consequences?
Answer 5
Economy – Overview Pakistan, an impoverished and underdeveloped
country, has suffered from decades of internal political disputes and low
levels of foreign investment. Between years 2001-07 however, poverty
levels decreased by 10%, as Islamabad steadily raised development
spending. Between 2004-07 GDP growth in the 5-8% range was spurred by
gains in the industrial and service sectors despite severe electricity
shortfalls. But growth slowed in 2008-09 and unemployment rose. Inflation
remains the top concern among the public, jumping from 7.7% in 2007 to
20.8% in 2008, and 14.2% in 2009. In addition, the Pakistani rupee has
depreciated since 2007 as a result of political and economic instability. The
government agreed to an International Monetary Fund Standby
arrangement in November 2008 in response to a balance of payments
crisis, but during 2009 its current account strengthened and foreign
exchange reserves stabilized - largely because of lower oil prices and
record remittances from workers abroad. Textiles account for most of
Pakistan's export earnings, but Pakistan's failure to expand a viable export
base for other manufactures have left the country vulnerable to shifts in
world demand. Other long term challenges include expanding investment
in education, healthcare, and electricity production, and reducing
dependence on foreign donors.
o GDP (purchasing power parity)
$448.1 billion (2009 est.)
$436.4 billion (2008 est.)
$422 billion (2007 est.)
note: data are in 2009 US dollars
o GDP (official exchange rate)
$166.5 billion (2009 est.)
o GDP - real growth rate
2.7% (2009 est.)
3.4% (2008 est.)
6% (2007 est.)
o GDP - per capita (PPP)
$2,600 (2009 est.)
$2,500 (2008 est.)
$2,500 (2007 est.)
note: data are in 2009 US dollars
o GDP - composition by sector
agriculture: 20.8%
industry: 24.3%
services: 54.9% (2009 est.)
o Population below poverty line
24% (FY05/06 est.)
o Labor force
55.88 million
note: extensive export of labor, mostly to the Middle East, and
use of child labor (2009 est.)
o Labor force - by occupation
agriculture: 43%
industry: 20.3%
services: 36.6% (2005 est.)
o Unemployment rate
15.2% (2009 est.)
13.6% (2008 est.)
note: substantial underemployment exists
o Household income or consumption by percentage share
lowest 10%: 3.9%
highest 10%: 26.5% (2005)
o Distribution of family income - Gini index
30.6 (FY07/08)
41 (FY98/99)
o Investment (gross fixed)
18.1% of GDP (2009 est.)
o Budget
revenues: $23.21 billion
expenditures: $30.05 billion (2009 est.)
o Public debt
45.3% of GDP (2009 est.)
51.2% of GDP (2008 est.)
o Inflation rate (consumer prices)
14.2% (2009 est.)
20.3% (2008 est.)
o Central bank discount rate
15% (31 December 2008)
10% (31 December 2007)
o Commercial bank prime lending rate
NA% (31 December 2008)
o Stock of money
$NA (31 December 2008)
$52.76 billion (31 December 2007)
o Stock of quasi money
$NA (31 December 2008)
$18.42 billion (31 December 2007)
o Stock of domestic credit
$NA (31 December 2008)
$65.05 billion (31 December 2007)
o Industries
textiles and apparel, food processing, pharmaceuticals,
construction materials, paper products, fertilizer, shrimp
o Industrial production growth rate
-3.6% (2009 est.)
o Electricity - production
90.8 billion kWh (2007 est.)
o Electricity - production by source
fossil fuel: 68.8%
hydro: 28.2%
nuclear: 3%
other: 0% (2001)
o Electricity - consumption
72.2 billion kWh (2007 est.)
o Electricity - exports
0 kWh (2008 est.)
o Electricity - imports
0 kWh (2008 est.)
o Oil - production
61,870 bbl/day (2008 est.)
o Oil - consumption
383,000 bbl/day (2008 est.)
o Oil - imports
319,500 bbl/day (2007 est.)
o Oil - exports
30,090 bbl/day (2007 est.)
o Oil - proved reserves
339 million bbl (1 January 2009 est.)
o Natural gas - production
37.5 billion cu m (2008 est.)
o Natural gas - consumption
37.5 billion cu m (2008 est.)
o Natural gas - exports
0 cu m (2008 est.)
o Natural gas - imports
0 cu m (2008 est.)
o Natural gas - proved reserves
885.3 billion cu m (1 January 2009 est.)
o Current Account Balance
-$2.42 billion (2009 est.)
-$15.68 billion (2008 est.)
o Agriculture - products
cotton, wheat, rice, sugarcane, fruits, vegetables; milk, beef,
mutton, eggs
o Exports
$17.87 billion (2009 est.)
$21.09 billion (2008 est.)
o Exports - commodities
textiles (garments, bed linen, cotton cloth, yarn), rice, leather
goods, sports goods, chemicals, manufactures, carpets and rugs
o Exports - partners
US 16.1%, UAE 11.7%, Afghanistan 8.6%, UK 4.5%, China 4.2%
(2008)
o Imports
$28.31 billion (2009 est.)
$38.19 billion (2008 est.)
o Imports - commodities
petroleum, petroleum products, machinery, plastics,
transportation equipment, edible oils, paper and paperboard, iron
and steel, tea
o Imports - partners
China 14.3%, Saudi Arabia 12.2%, UAE 11.3%, Kuwait 5.5%, US
4.8%, Malaysia 4.1% (2008)
o Reserves of foreign exchange and gold
$15.68 billion (31 December 2009 est.)
$8.903 billion (31 December 2008 est.)
o Debt - external
$52.12 billion (31 December 2009 est.)
$46.39 billion (31 December 2008 est.)
o Stock of direct foreign investment - at home
$27.95 billion (31 December 2009 est.)
$25.44 billion (31 December 2008 est.)
o Stock of direct foreign investment - abroad
$1.078 billion (31 December 2009 est.)
$1.017 billion (31 December 2008 est.)
o Market value of publicly traded shares
$23.49 billion (31 December 2008)
$70.26 billion (31 December 2007)
$45.52 billion (31 December 2006)
o Currency (code)
Pakistani rupee (PKR)
o Exchange rates
Pakistani rupees (PKR) per US dollar - 81.41 (2009), 70.64 (2008),
60.6295 (2007), 60.35 (2006), 59.515 (2005)
o Fiscal year
1 July - 30 June