Elasticity of Demand and Oligopolistic Market Structure

The assignment content discusses various concepts in microeconomics, including elasticity of demand, inferior goods, and oligopolistic markets. It highlights the concept of perfectly inelastic demand for essential commodities like water and vegetables, as well as the concept of negative elasticity (inferior good) for low-quality fats like lard and margarine. The content also discusses the market structure of an oligopoly with price-based collusion, which can lead to kinked demand curves and inefficiencies. Additionally, it touches on barriers to entry, consumer exploitation, and government intervention in such markets.

Micro Economic Analysis September 20
2017
Micro Economic Analysis is very useful in making decision. This paper
gives various examples of micro economic concepts used in business
and government. These tools are useful for managers as well as policy
makers.

Micro Economic Analysis
Contents
Table of Figures..............................................................................................................................2
Part A Case study........................................................................................................................... 4
Case 1......................................................................................................................................... 4
a) Business Cycles................................................................................................................4
b) Causes of Recession........................................................................................................ 6
Case 2......................................................................................................................................... 8
Part B........................................................................................................................................... 11
1. U Shaped Cost Curves.......................................................................................................11
2. Elasticity of Demand......................................................................................................... 15
a) Price Elasticity of Demand..................................................................................................17
b.1) Cross Elasticity of Demand............................................................................................19
b.2) Income elasticity of demand.........................................................................................20
Part C........................................................................................................................................... 23
a) Barriers to Entry................................................................................................................23
b) Consumer Exploitation......................................................................................................23
c) Government Intervention.................................................................................................24
Table of Figures
Diagram 1 Business Cycles...........................................................................................................................6
Diagram 2 Demand Side Illustration of Recession and Expansion ..............................................................8
Diagram 3 Market Indifference Curve.........................................................................................................9
Diagram 4 Marginal Product of Labour.....................................................................................................12
Diagram 5 Several Short Run Average Total Cost Curves are possible in the Long Run 14
Diagram 6 Long Run Average Total Costs for Various Plant Sizes..............................................................15
Diagram 7 Price Elasticity of Demand........................................................................................................19
Diagram 8 : The Kinked Demand curve for Non Collusive Oligopoly.........................................................23
Diagram 9 Demand Curve in a Non Collusive Oligopoly............................................................................24
Diagram 10 Oligopoly and Joint Profit Maximization................................................................................26
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Micro Economic Analysis
Table 1 Pay-off Matrix in case of games........................................................................................9
Table 2 An Illustration of Income Elasticity of Demand with examples.......................................19
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Micro Economic Analysis
Part A Case study
Case 1
a) Business Cycles
a.1) Introduction
Business cycles are economy wide fluctuations in the total national output, income and
employment. Each cycle typically lasts for a duration between 2 to 10 years and is marked by
widespread expansion or contraction of most sectors of the economy.(Samuelson and
Nordhaus 2004)
Typically, a business cycle would have the following phases : recession and expansion and the
changes in the cycles are marked by peaks or troughs.
a2) Recession or Contraction Phase
In this phase, the economic growth slows down. This phase starts after the peak point or the
highest point of the economy has been hit and the economy turns downward.(Chauhan 2009)
 During the first phase where the demand starts to fluctuate and the demand starts to
contract. This contraction could be due to external shocks or the multiplier effects of
higher taxes or tight money policies. This phase is known as a recession or contraction
period in the economy. In this phase, consumer purchases decline sharply while
business inventories increase sharply. This is especially true of consumer durables and
goods like automobiles.
 In such a situation, businesses /firms react by curbing production in the economy and
the real Gross Domestic Product or Real Output falls sharply. The shrinking of demand
has a acceleration effect. Business profits decline sharply as inventories begin to
increase. (Samuelson and Nordhaus 2004)
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Micro Economic Analysis
a3) . Depression
A depression is officially hit when the GDP growth becomes negative i.e the output starts falling
and is no longer just growing slowly. The economy hits a trough.(Chauhan 2009)
 As this period continues, the business investment in plant and equipment also falls
sharply. The demand for labour falls as this trend continues. The demand for raw
material begins to decline and the prices of commodities tumble.
 The fall in demand I s first seen by a change in demand for the number of hours put in
by labour and then, in the form of increased unemployment. Wages and prices of
services may stop growing and in some cases, may decline.
 Inflation slows down as there is a fall in the output. In anticipation of low earnings stock
prices begin to decline as investors begin to sniff downturn.
 As the demand for credit falls, interest rates fall drastically.(Samuelson and Nordhaus
2004)
a4) Expansion Phase
An expansion phase officially begins after the economy recovers from the lowest point since
aggregate demand cannot be zero.
 The decline in interest rates may spur investment in plant and equipment. As
investment increases, the demand for labour increases. This is seen by a decrease in
unemployment.
 As unemployment decreases, the aggregate demand in the economy tends to increase,
which in turn increases the inflation in the economy and decreases the build-up of
inventory of goods and services in the economy. This is the multiplier effect.
a5) Boom Phase
 As aggregate demand increases, the investment demand also increases. New spending
has a multiplier effect as there is more spending in the economy.
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Micro Economic Analysis
 Factory output begins to increase due to increased demand and decreased inventories.
This has an acceleration effect and hence, employment as well demand for money
increase. As demand for money increases, the rates of interest also increase.(Samuelson
and Nordhaus 2004) This is a period of high employment, high inflation.(Chauhan 2009)
(Samuelson and Nordhaus 2004)
Diagram 1 Business Cycles Source: (Samuelson and Nordhaus 2004)
b) Causes of Recession
The Aggregate Demand began to decline suddenly in economy ABC. The main causes could
have been exogenous or endogenous.
 Exogenous factors refer to external factors that may have caused the recessions. For
example, an oil shock, a war , gold rush etc.
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Micro Economic Analysis
Endogenous factors refer to the mechanism within the economy that may have caused the
recession.(Samuelson and Nordhaus 2004) Endogenous factors could be related to the supply
side of the economy or the demand side of the economy. However, the given example refers to
a decrease in aggregate demand and not a supply side decrease in output.
Monetary theorists often attribute such decrease in the demand to fluctuations in credit and
money supply. The multiplier effect of A typical case of such a recession begins when there is a
tight money policy or low government or private spending in the economy. (Samuelson and
Nordhaus 2004)
In the given example of country ABC, there is no reference to any external shock .Hence, the
factors in the given example would have been endogenous factors.
This is illustrated in the diagram given below. Let us say, the economy begins at equilibrium B.
Tight money policy causes the Aggregate Demand shift towards the left to AD’ . Tight money
policy or fiscal policies to raise taxes could have effect a This may be due to a variety of reasons
like tight money policy or higher taxes. Until there is shift in the aggregate supply , the economy
remains at equilibrium C. Output declines from Q to Q’. Inflation falls and price level is lower at
point C.
As the demand increase in the boom phase, the AD curve shifts to the right to point D. This may
be due to expansionary policies. For example, the Reserve Bank of the country decided to lower
interest rates so that borrowing. The low interest rates raise demand for housing. The demand
for housing has a multiplier effect and helps generate investment to provide for more housing.
This leads to a cycle of higher- consumption –higher saving-higher investment. (Samuelson and
Nordhaus 2004)
The ceiling of growth is reached when economy approaches to the potential output .
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Micro Economic Analysis
Diagram 2 Demand Side Illustration of Recession and Expansion. Source: (Samuelson and
Nordhaus 2004) Adapted by Author
Case 2
a) In 2001, the consumers have 3 choices: Britannica Book set, Britannica CD, Encarta CD.
In order to answer this question, the following assumptions must be made:
o Consumers definitely choose to buy at least one product.
o Price is the only determinant of choice
o Consumers are indifferent to the three choices, I.e. tastes and preferences are
not counted
 Substitutability between Britannica Book set and Britannica CD. Given a choice in
2001, the consumer could purchase the Encarta CD instead of the Book Set
because the Encarta CD is the second best choice based on price. Hence, the two
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Micro Economic Analysis
goods are not substitutes. However, the two goods would have been close
substitutes in 1992.
 Substitutability between Britannica CD and Encarta CD. Given a choice in 2001,
the consumer could purchase the Encarta CD as it is the second best choice
based on price. Hence , the two goods are substitutes.
The following diagram represents the substitutability between the two goods. If more
consumers buy the Britannica CD, then the equilibrium will be at Point B on the
indifference curve. If for some reasons, the consumers choose the Encarta CD (For
example, if Encarta CD decreases prices or due to low supply of Britannica) , then the
equilibrium will move to a higher point A. (Chauhan 2009)
Diagram 3 Market Indifference Curve . Source: Prepared by Author
b) The given market is a duopoly. A duopoly is a market where two competitors exist.
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Micro Economic Analysis
In such a market, best decisions would be made keeping in mind not just the consumer
demand but also the strategy or the game expected to be played by the competitor.
In order to maximize revenues, it would be best to take the decision based on Game
Theory. (Samuelson and Nordhaus 2004)
Game Theory describes a series of strategy decisions taken by different sellers to maximize
their ‘profit’ or pay-of . These decisions affect all parties and decisions are often met with
retaliatory actions. (Samuelson and Nordhaus 2004)
According to the Theory, pay-offs will be maximized if both parties can collude. Collusion would
lead to both sellers earning monopoly profits by allowing them to act as one seller with a
monopoly price. Hence, the best decisions for the firms would be to collude at $200.
Competitive games would come into play , if Microsoft refuses to collude.
Since a price war would come into play, Microsoft may choose to reduce prices to $49.95.
Micro-soft also has marketing channels. The price of $49.95 should be considered as a low price
since the profit margins will be low. Hence, the firm should engage in non-price competition
and seeking marketing channels like exclusive deals with academic institutions.
The books would still be sold as a premium product since the book set and the CD are not
substitutes. Some non-price competition measures would be
 Providing a Britannica CD free of cost with every Book set
 Seeking to partner with exclusive customers
 Advertising etc.
Assuming that Microsoft does not lower prices , in retaliation. It will lose market share and
hence, must engage in non-price competition mention above. In such a situation, Britannica can
set the price at $74.95
Table 1 Pay-off Matrix in Case of Strategic Games
Source: Prepared by Student
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Micro Economic Analysis
High Price with
collusion
High Price
without
Collusion
Normal Price
With Collusion
Normal Price
Microsoft
Encarta
$200 $74.95 $74.95 (current
price; Britannica
follows price)
$ 49.95
Britannica $200 $74. $74.9595
(Follows
Microsoft Price)
$49.95
Part B
1. U Shaped Cost Curves
a) The relationship between production and costs are represented on the shape of the
curve.
 In the short run, producers are able to adjust variable inputs like materials and
production labour but they are too short to allow inputs to change. Fixed and overhead
factors such as plant and equipment cannot be modified or adjusted in the short run
easily. Therefore, in the Short Run , labour and material costs are typically variable costs
while capital costs are fixed.
 In the long run, all inputs can be adjusted , including labour, materials and capital.
Hence , in the long run, all costs are variable and none are fixed.
 Typically labour costs can be adjusted more easily than Capital costs. Therefore, there
are diminishing returns to the variable factor (labour) because each additional unit of
labour has less capital to work with. As a result the marginal cost of output will rise
because the extra output produced by each extra labour unit is going down. In other
11

Micro Economic Analysis
words, the diminishing returns to the variable factor will imply an increasing short run
marginal cost. Thus, diminishing returns ultimately lead to marginal costs.
Diagram 4 Marginal Product of Labour. Source (Samuelson and Nordhaus 2004)
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Micro Economic Analysis
 The U shaped marginal cost curve in diagram 4 arises from the shape of marginal product
curve in Diagram 3. With Fixed Capital and variable capital costs, the marginal product of
labor in A first rises to the left of B, peaks at B and then falls at D as diminishing returns to
labor set in.
 The Marginal Cost Curve in Diagram 4; the marginal cost falls corresponding to the increase
in marginal product of labor . The Peak marginal product corresponds to the minimum
marginal cost to the right of B, the marginal cost of producing output increases as the
marginal product of labor falls. Overall , the increasing and then diminishing marginal
product to the variable factor gives U shaped marginal cost curve.
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Micro Economic Analysis
Diagram 5 Several Short Run Average Total Cost Curves are possible in the Long Run Source
(Chauhan 2009)
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Micro Economic Analysis
Diagram 6 Long Run Average Total Costs for Various Plant Sizes (Chauhan 2009)
 In the long run , the firms can even adjust the plant size or the capacity of production. As
the firm adjusts its capacity, it arrives at several short run Average Total Cost Curves.
(Diagram5). If these curves are traced, the long run average cost curve can be derived. This
curve would indicate different Marginal costs at different levels of production and would
indicate the minimum point or the absolute least cost possible after the firm has made all
adjustments. (diagram 6) this gives it the U shape .
 The law of diminishing returns is not applicable to the long run curve but there are
economies and diseconomies of large scale. Economies result from
 Large Scale production that makes bulk buying possible
 Possibility of increased specialization of labour and machinery
 More efficient use of resources and use of by products.
Diseconomies largely result from problems related to managerial problems. (McConell, Brue
and Flynn 2009)
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Micro Economic Analysis
2. Elasticity of Demand
The Law of Demand states that , ceteris paribus (other things held constant) “the higher the
price of a commodity, the fewer units the consumers are willing to buy. The lower its market
price, the more units are bought” (Samuelson and Nordhaus 2004)
Graph 1: Demand Curve
Source: (Samuelson and Nordhaus 2004)
 Following are 5 types of demand
Types Explanation
Individual Demand versus Market demand  Individual Demand refers t he quantity
demanded by an individual. E.g An
individual’s monthly demand for coffee.
 Market demand is the total demand for the
given market i.e. the individuals as wells as
other entities like firms etc. Market
Demand is an aggregate demand of
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Micro Economic Analysis
individual demand points. The total
demand of all individual entities in the
market for coffee.
Firm (organization) demand versus Industry
Demand
 The demand for the products of a firm /
organization is firm demand. E.g Demand
for latest Mercedes E class car
 The demand for total products supplied by
industry. Example, the total demand for
luxury cars or total demand for cars.
Derived/ composite Demand and Autonomous
demand
 Derived demand is demand that may be
effective demand due to the demand for
another product. E.g demand for
winegrapes is derived demand due to wine.
 All factors of production have derives
demand.
 Autonomous demand is independent
demand . eg. Demand for coffee.
Demand for Durable Goods versus Perishable
Goods
 Demand for durable goods is non-recurring
for of demand where an the product is not
demand every day. Eg demand for capital
goods in an industry or demand for
consumer durables like TV.
 Demand for perishable goods is recurring
demand. For example, demand for food.
Short Term demand Versus Long Term Demand  Short –term demand is demand for goods
in the near term i.e a few months or a few
years.
 Long term demand is demand for goods in
the present as well as future. Long term
demand is an aggregate of short term
demand.
Source: Prepared by Author . Adapted from (Chauhan 2009) (McConell, Brue and Flynn
2009) (Ahuja 2007)
Elasticity of demand is the “degree of responsiveness of demand to a change in a given
factor”. (Samuelson and Nordhaus 2004)These factors could be
 Price of good
 Income of consumer
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Micro Economic Analysis
 Price of a related good such as a substitute or complementary good (cross elasticity)
(Chauhan 2009)
 Responsiveness to marketing or Advertising
a) Price Elasticity of Demand
‘Price elasticity of demand’ is defined as the “degree of responsiveness of a change in demand to
a change in one of its determinants while other determinants remain unchanged (Ceteris
Paribus).”
It is measured as
EP
D = Proportionate change∈ Demand
Proportionate change∈ Prices
= C h ange∈Qty Demanded
C h ange ∈Price
The price of a good may decline proportionately or non-proportionately. Let us assume that
Producer ABC increase the price of Good X by 5% . I
 If the demand does not change at all, then the elasticity of demand is zero.
 If the demand declines by less than 5%, the elasticity of demand is less than one.
 If the demand declines by more than 5 %, the elasticity of demand is more than one.
 If the demand decline by 5 % elasticity of demand is 1
 If the demand declines /increases without any change, elasticity = infinity.
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Micro Economic Analysis
Diagram 7 Price Elasticity of Demand. Prepared by Author. Source: (Chauhan 2009)
b.1) Cross Elasticity of Demand
Cross elasticity of Demand measures how sensitive the purchases of one product are to the
change in price of another product. When two products X and Y are related to each other , then
a change in price of Y may affect the change in the quantity demanded for good X. (Eastin and
Arbogast 2011)
It is assumed, ceteris Paribus, that
 the consumer income remains the same
 market prices for other goods do not change.
The cross elasticity of demand measures the change in the price of commodity X given a
change in the prices of commodity Y. For example, the consumption of tea might be affected
due a change in the prices of coffee. (Eastin and Arbogast 2011)
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Micro Economic Analysis
Thus the cross elasticity of demand for tea with respect to a change in the price of coffee is
measured by the cross elasticity of demand co-efficient. Let us measure the demand for Tea by
‘x’ and the demand for coffee by ‘y’
Thus the cross elasticity of demand for tea with respect to a change in the price of coffee is
Exy = percentage change∈theQuantity Demanded of tea
Percentage change∈the Quanity demanded for Coffee (Eastin and Arbogast 2011)
 The percentage changes are calculated by dividing the change in the quantity of X by the
original Quantity of X and the change in the price of Y by the original price of Y.
 If a given percentage change in the price of coffee causes a relatively larger percentage
change in the quantity demanded of tea i.e. the quantity demanded of X is elastic.
 If a given percentage change in the price of coffee results in a relatively small
percentage chage in the quantity demand of tea, then the cross elasticity of demand of
tea to coffee is inelastic.
 The cross elasticity of demand for the two goods would be unity or 1, If a given
percentage change in the price of coffee results in a and equal percentage change in the
quantity demand of tea.
 If the cross elasticity of demand is positive then, the demand for tea varies directly with
the demand for coffee . This implies that X and Y are substitute goods. The quantity
purchased of tea will increase , if the price of coffee goes up and will decrease if the
price of Y goes down
 If the cross elasticity of demand is negative, then the demand for coffee varies directly
with the demand for tea. In such a case, tea would be termed as a complementary good
to Coffee.
 If the cross elasticity of demand is zero, then the two goods are independent goods.
(Eastin and Arbogast 2011)
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Micro Economic Analysis
b.2) Income elasticity of demand
‘Income elasticity of demand’ is defined as the “degree of responsiveness of a change in demand
to a change in one of its determinants while other determinants remain unchanged.” It is
measured (Chauhan 2009)
EI
D = Proportionate change∈ Demand
Proportionate change ∈Income
= C h ange∈Qty Demanded
C h ange∈ Income
Table 2 An Illustration of Income Elasticity of Demand with examples. Source: Prepared by
Author Adapted from (Samuelson and Nordhaus 2004) (Chauhan 2009)
Goo
d
Total
Quantity
Demande
d per
week
before
price
change
Pric
e
Per
K
Qty
Demande
d per
week
after
change in
income by
$10 a
week
(Change in Qty
Demanded)/(Chang
e in Income)
Income
Elasticit
y Co
efficient
Elastic/
Inelastic
Examples
A 20 10 40 20/10 2 Elastic Petroleum,
recreational
spending
B 40 10 50 10/10 1 Unit
Elasticit
y
Any
perfectly
substitutabl
e good like
tea/ coffee
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Micro Economic Analysis
C 70 10 75 5/10 0.5 Less
elastic
Tobacco
D 110 10 110 0/5 0 Perfectl
y
Inelastic
Water,
vegetables
E 160 10 140 -20/10 -20 Negativ
e
Elasticit
y
(inferior
good)
Margaraine
/lard
 There is one kind of elasticity not mentioned in the above table. (Chauhan
2009)Sometimes, the change in income does not have any effect on demand and the
demand may keep increasing. The elasticity of demand in such a case would be infinite.
The closest example of such a case would be addictive substances.
 Additionally, some goods are preferred less by consumers once their income increases.
(mentioned above) These goods are called inferior goods. Examples are low quality fats
like lard, margarine , low quality grains. (Samuelson and Nordhaus 2004) these are
exception to law of demand.
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Micro Economic Analysis
Part C
The market described in the given paper is an oligopolist industry with price based collusion.
An Oligopolistic market structure is a market wherein there are a more than two producers or
sellers but not many. The products are largely homogenous and there is very little differentiation.
Oligopolistic markets have few firms and hence, the firms may collectively set together the price.
This is known as ‘collusive oligopoly’. (Chauhan 2009)
In such a market, if firms do not collude, they will suffer from kinked demand (i.e ) and there
will be price wars that could be a race to the bottom. Hence, firms decide to collude. Firms
could collude to maintain a level of price or a level of quality. (Chauhan 2009)
Diagram 8 : The Kinked Demand curve for Non Collusive Oligopoly
Prepared by Author. Adapted from (McConell, Brue, & Flynn, 2009)
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Micro Economic Analysis
In a Non Collusive oligopolistic market, a kinked demand curve has been observed. It is
assumed that there is always a ruling price. This is simple because, if a firm raises prices,
it may lose customers. However, a firm also cannot reduce prices to a great extent since
other firms may also follow suit. This may lead to price wars where it would be a race to
the bottom. E-commerce firms are an example of such behaviour.
The nature of a non Collusive oligopolist’s demand would depend on whether his
competitors match D2 D2 and MR2 MR2 in the diagram above.. Any price change that he
may initiate from the current price QP. In all likelihood an oligopolists rivals will ignore
a price increase but follow a price cut. This causes the Oligopolist’s demand to be kinked
i.e D2 P D1 and his Marginal Revenue will have a break at MR2 MR1
Diagram 9 Demand Curve in a Non Collusive Oligopoly
The kinked demand curve DPD and the broken MR Curve MRMR help explain the price
inflexibility which characterizes Oligopoly. Any shift in Marginal costs between MC1
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Micro Economic Analysis
and MC2 will cut the vertical (short dashed segment of the marginal revenue curve, no
change in either price QP or Output Q will occur.
a) Barriers to Entry
.The mobile phone market requires sophisticated technology. Any firm looking to enter
the market must acquire the same technology. Additionally, the product in the mobile
phone market is homogenous . Any firm looking to enter the market, must be able to
provide services at par with the existing service providers. Moreover, these providers
provide services all over the European Union at cheap rates. In order to be competitive,
any provider must be a large scale provider right from the outset which is a significant
barrier for small firms.
b) Consumer Exploitation
The given market is an Oligopoly with large entry barriers. In such a situation, a new
firms that wish to enter the market must be able to invest large scale capital right in the
beginning. In order to recover the costs of large scale entry, firms could be willing to
collude and keep roaming prices artificially high, instead of allowing the demand and
supply mechanism to work. An Oligopoly is an inefficient market. Hence, the consumer
welfare is not maximized and consumer can be exploited.
The prices will be a lot above the Average Cost or Marginal Cost as shown in the diagram
below.
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Micro Economic Analysis
Diagram 10 Oligopoly and Joint Profit Maximization Source: (Samuelson and Nordhaus 2004)
c) Government Intervention
A Collusive Oligopoly acts like a monopoly. If the government does not intervene, then
the firms can together charge monopolistic prices. There is a serious problem of
inefficient allocation of resources and loss of consumer welfare due to the existence of
such a market.
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Micro Economic Analysis
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EASTIN, Richard V. and ARBOGAST, Gary L. (2011). Demand and Supply Analysis: Introduction.
[online].
MCCONELL, Campbell R, BRUE, Stanley L and FLYNN, Sean Masaki (2009). Economics. Irwin,
McGraw Hill.
SAMUELSON, Paul and NORDHAUS, William (2004). Economics: Seventeenth edition. 17th ed.,
New Delhi, Tata McGraw Hill. ISBN 0-07-231-488,
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