Indicate whether each of the following statements is true or false and explain why.
1. If consumers expect the price of houses to be significantly higher next year, the current demand for houses will increase.
A shift along the demand curve can occur due to changes in consumer expectations in regard to the price of a commodity. The expectation of the buyers has a relation to the present and future price of the product. The decision to make a purchase today depends on the expectation that the future price of the same commodity might be high because they seek to buy the product at the lowest possible price offered (Sloman & Sutcliffe, 2002). If they expect that the prices of houses will be higher next year, they will be inclined to make the purchase at the moment or buy more at a low price. However, if they expect that the price will decline, they will be tempted not to buy any at the moment or dispose of what they have and buy more when the price declines.
2. The term Price Ceiling refers to that price being the highest permissible price in the market, and above the initial equilibrium price.
A price ceiling is imposed by the government to control the supply and demand of a particular product on the market. This occurs when the government sets a limit to the highest permissible price for the product, and it is usually set below the equilibrium market price to make the commodity cheaper. The government usually imposes the price ceiling measure to protect consumers from a situation that would make certain commodities unaffordable to low-income members of the public.
3. If the demand for products is inelastic, an increase in its price will lead to a decrease in the firm’s total revenue.
Inelastic demand is a situation when the demand for a product changes in a percentage which is less than that of the change in price. For example, if the demand changes by 20%, the price changes by less than 20%. This definition is absolutely wrong because of elasticity measures the responsiveness of the demand for a certain product against its price, and not revenue (Sloman & Sutcliffe, 2002). In addition, an increase in the price of the commodity would lead to a decrease in demand and hence the total number of outputs sold. Therefore, it may not be definite that reduction in demand may lead to a reduction in revenue earned because the increased price may cover the loss in demand.
4. In the long run, firms operating in perfect competition and monopolistic competition will tend to earn normal profits.
In production and supply economics, ‘long run’ is a period, whereby there are no factors that are fixed within the market, and all aspects of production are variable and are adjustable to meet the demand shifts. Just like monopolies, a monopolistic firm is usually a price setter and often behaves as such even in the long run. The firm maximizes its profits by producing goods at the point where the marginal costs and marginal revenue curve are equal. Therefore, in the long run, the demand curve of a supplier in this market will shift to a tangential position, to the firm’s average total cost curve. As a result, it becomes impossible for the firm to earn an economic profit, and it can only break even.
On the other hand, in the perfect competition market, there exist many buyers and sellers with absolute knowledge about the market. The existence of economic profits in the market attracts more firms to the industry, leading to economic losses and equilibrium in the long run. Firms in the perfect competition market earn no economic profit, and the long-run curve of the industry does not even change the input prices.
Part B (40%)
Q1. Consider the following demand and supply functions for certain products:
Qd = 5600 – 20P
Qs = 2800 + 20p
a) What are the equilibrium price and quantity in this market?
The equilibrium price and quantity can be determined where the two curves intersect. The quantity demanded is equal to the quantity supplied as follows.
The price can be determined as follows:
5600 – 20P = 2800 + 20p
40P = 2800
P (eq) = 70
Therefore, the equilibrium price is equal to 70.
The equilibrium quantity can be determined as follows:
Q (eq) = 2800 + 20 x 70
Q (eq) = 4200 units
b) Determine the quantity demanded, the quantity supplied, and the magnitude of the surplus if a price floor of $210 is imposed in this market.
As the form of price control in the market, price floors create a situation of excess supply when the legal price ($210) is above the market price ($70). Suppliers become more willing to provide products to the market at the rate of the price floor than the market is willing to pay for. Therefore, the new price will be $210.
Figure 3: Effect of imposing a price floor in the market (Reisman, 2002).
This surplus leads to inefficiency on the market, thus raising the price of goods for the consumer. This means that consumer demand will decrease significantly as illustrated below.
Quantity demanded Qd = 5600 – 20P = 5600 – 20 x 210 = 5600 – 4200 = 1200
Quantity supplied Qs = 2800 + 20p = 2800 + 20 x 210 = 2800 + 4200= 7000
Therefore, the market will have the excess of 7000-1200 = 5800 units.
Q2. Suppose the government regulates the prices of beef and chicken and sets them below their market-clearing levels.
a) Explain why shortages of these goods will develop and what factors will determine the sizes of the shortages.
If the government sets the price of beef and chicken below the market-clearing level, the quantity that the suppliers are able and willing to supply to the market reduces below the price that the consumers are willing and able to pay for. This means that the government influences the market by lowering the prices, making it more affordable to consumers and less profitable to the producers ((Reisman, 2002). The degree of this excess demand implies that the response of the market will depend on the relative elasticity of demand and supply of these commodities. For example, if both the supply and demand for beef and chicken are elastic, the shortage can be bigger than in case both of them have inelastic supply and demand. There are other factors that can determine the degree of elasticity of the products and the size of the excess demand (Sloman & Sutcliffe, 2002). These factors include the consumer’s willingness to eat less meat and the farmers’ ability to change the size of their herds.
b) What will happen to the price of fish? Explain briefly.
The customers whose demands may appear not to be met opt to increase their demand for substitute products, hence raising their demand and prices. If the price of chicken and beef are set below the clearing level of the market, the price of fish as the best available substitute will thus increase.
Part C (30)
Q2. a) What is the rationale for government involvement in the market economy?
In laissez-faire or free economy, there is usually little government intervention because the market is assumed to be self-correcting. The government holds the view that the market is best suited to allocate scarce resources available and allow the market forces of supply and demand to set the market-clearing prices. However, this does not imply that the market operates entirely in the absence of government. The role of government is important in providing an equitable operating environment for all stakeholders providing service or accessing services and products from the market (Reisman, 2002).
The main role of the government is to provide protection of property rights, maintain the value of the currency, and uphold the rule of law in the economy. In the absence of government, the firms would take advantage to exploit the customers through denial of service or various forms of exploitation, overcharging, providing poor quality products, underpayment, poor working conditions, and cases of under- or overvaluation of currency to suit a particular firm (Sloman & Sutcliffe, 2002).
The government also ensures that the firms and the industries operating in a competitive market deliver productively and allocate resources to the dynamic environment effectively. The government ensures that all people, consumers, and stakeholders in the economy are not denied or charged for basic commodities like land, water, or air that are provided free by nature. The government facilitates equal distribution of wealth, income, and resources; improves the efficiency of market performance; and corrects the possibilities and effects of the market failure.
b) What is the role of government in correcting the market failure resulted from a monopoly?
In economics, a situation of market failure may be felt when there is not an efficient allocation of goods and services in the economy. This means that there exists another alternative of resource allocation, Pareto efficiency, that individuals may feel better without, making others worse-off. In the monopoly situation, market failure can be viewed as a situation when the monopoly firm’s pursuit of pure self-interest results in inefficiency in the society’s point of view. The market may fail to operate in an effective manner due to various reasons such as the presence of information asymmetry, externalities, economies of scale and scope, barriers to entry, and indivisibilities.
Externalities are goods that lead to negative social costs; and in the free market, there can be over-consumption of these goods that cause pollution and congestion like smoking, industrial effluent, and many uncontrolled cars on the road (Farmer & National Bureau of Economic Research, 2007). In order to overcome this problem, the government intervenes in the demand for these products by increasing taxes, legal requirements, and imposing quotas. In order to overcome the problem of under-consumption of positive externalities, these goods can be subsidized to make them more affordable to the majority through the use of education and trains for public transport.
Economies of scale are a situation that can also lead to a market failure caused by monopoly power. This situation leads to the overcharging of consumers and the provision of substandard services. Firms get in the position to increase prices and the consumer’s expense, leading to a less efficient market. In order to overcome this market failure, the government can discourage or block the formation of mergers, which can be used to harm the economy, through the competition authority (Sloman & Sutcliffe, 2002).
Information asymmetry is another situation that leads to market inefficiency. If individuals have different information by the time they take action in the market, the market may not perform efficiently even if they seek to take advantage of the trade. When sellers and buyers have incomplete information about the market, the market participants are said to have incomplete information, and the market operates defiantly. Therefore, the government seeks to create a legal requirement to provide market participants with full information about the market, which can influence their decision.