Principles of Economics: Elasticity, Costs, and Profit Analysis

This economics assignment delves into several core principles. Task 2 examines price elasticity of demand for various goods (milk, jewellery, petrol, oranges, bread, etc.), cross-price elasticity, and the impact of supply shifts on prices and quantities. Task 3 analyzes cost structures, distinguishing between fixed and variable costs, and explores the impact of technological advancements and online retail on costs. Task 4 focuses on profit maximization, the behavior of firms as price takers, the relationship between marginal revenue and marginal cost, and the concept of dominant strategies using a payoff matrix. The assignment provides a comprehensive overview of essential economic concepts and their practical implications.

Running Head: Principles of economics
Principles of Economics

Principles of economics 1
Task 2:
1. Milk is a necessity with high and stable demand; and is consumed by both rich and poor.
There are no close substitutes of milk. While high quality jewellery on the other hand, comes
under luxury. It is affordable mainly by the rich. Necessities have a price inelastic demand,
that is, price does not affect the quantity demanded. People will consume if even if the prices
rise significantly. Also there are no close substitutes of milk. Jewellery is highly price elastic.
A small change in its price will modify the demand significantly. People will not buy
jewellery if it its prices rise sharply. They may switch to artificial jewellery or other
accessories in case of high prices.
High quality jewellery will have higher price elasticity in absolute terms.
2. Petrol has a high demand with not many close substitutes available. The price elasticity of
petrol is inelastic. Even if the prices rise, the demand does not fall significantly. People have
no other good to switch to. Oranges have a relatively elastic demand because in case of price
rise, people can switch to some other fruits which are close n taste to oranges, like tangerine.
Thus, demand for oranges is relatively elastic (Fouquet, 2010).
Price elasticity will be higher in for the oranges’ bag, in absolute terms.
3. If the monetary value of tip top bread rises, people have many choices to switch to. Many
other brands offer similar breads which makes Tip Top bread price elastic. Bread in general
does not have substitutes. Price rise will not affect the consumption of bread as a whole. It is
a necessity. Thus, bread in general is price inelastic.
Price elasticity will be higher for Tip Top.
4. Price elasticity of demand curve, D1 (mid-point formula):
η= ΔQ
ΔP × P
Q
η= (300−200)
(3.00−2.50) × 3.00
200 = 100
0.50 × 3
200 =3
Price elasticity of demand curve D2:

Principles of economics 2
η= ΔQ
ΔP × P
Q
η= (225−200)
(3.00−2.50) × 3.00
200 = 25
0.50 × 3
200 =0.75
Therefore, we can say that the demand curve D2 is more inelastic since its magnitude is 0.75
as compared to D2 which has the magnitude of 3. Also, curve D2 is steeper than D1, making
D2 relatively inelastic.
5. Revenue= Price * Quantity
Demand curve D1:
Revenue if price is $3.00 and demand is 200 units
Revenue= $3.00 * 200 = $600
Revenue if price is $2.50 and demand is 300 units
Revenue= $2.50 * 300 = $750
Here, the increase in revenue from fall in the price is ($750- $600) $150.
Demand curve D2:
Revenue if price is $3.00 and demand is 200 units
Revenue= $3.00 * 200 = $600
Revenue if price is $2.50 and demand is 225 units
Revenue= $2.50 * 225 = $562.5
Here, decrease in revenue due to fall in price is ($600- $562.5) $37.5.
As we can see, the revenue increases in case of D1 demand curve which is relatively elastic.
The demand increases significantly due to fall in prices. In case of D2, the revenue falls by
$37.5. D2 is relatively inelastic. Demand does not increase enough to compensate for the
falling prices.
6. Demand’s cross-price elasticity amongst petrol cars and fuel-efficient small cars may be
regarded as positive. When people buy cars, they take future fuel prices also into

Principles of economics 3
consideration. If they expect the future prices of petrol to be higher, they will tend to buy
fuel-efficient cars. Thus, the demand for fuel-efficient cars will increase in case of increase in
prices of petrol. Less fuel-efficient cars like SUVs will have negative cross price elasticity
with petrol. If the prices of petrol will rise, people will tend to buy fuel-efficient cars and thus
increasing the demand for fuel-efficient cars.
7. Due to the cyclone, the crops were damaged and there was sharp decline the supply of the
bananas, shifting the supply curve backwards. The shift is not up to the extent of the crops
damaged but a little less since some bananas were imported. There will be no change in the
demand. The demand was relatively elastic while the supply was inelastic. Increased prices
were an incentive for the producers to supply more but it will take time. Also, there were
restrictions to trade.
Figure 1: Cyclone changes the supply and its elasticity. The price increases from P to P’ and
quantity decreases from Q to Q’.
Price

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8. Bananas turned into luxury because the prices rose sharply and not everyone could afford
it. Demand for bananas would have increased with the fall in prices. Luxury goods are
relatively elastic in nature. Supply curve in case of luxury goods is relatively elastic but in
practical, the supply could not be changed instantly with increase in price. Thus, when the
prices increased due to decrease in supply, the demand fell significantly. Demand curve for
luxuries is relatively inelastic in short-run and elastic in the long-run.
Task 3:
1. Cost associated with transistors will be variable cost since its value will change with the
change in output, that is, mobile phones. The cost will be zero at that time of no output.
Hence, there will be a change in variable cost of Samsung.
2. Tax of $1,000,000 is a fixed cost to the firm. It is a direct tax and is not levied on the
commodities. This cost is independent of the output produced. Amount of tax will not change
with the change in output; hence, it will affect the fixed cost of the firm.
3. Investment is done in R&D of Samsung. It will increase the fixed cost of the firm. It will
be the same whether one or several commodities are produced. This cost will exist even at
zero level of output. It is independent of the level of output produced.
4. In case of technological advancement, a new method is devised with either increases the
output with the given resources or produces the same output with lesser resources. In (A), the
firm maintains its level of output with lesser number of workers. IN (B), the firm uses the
same resources to produce the same output as before. Hence, there is technological change
only in case (A).
5. Variable cost refers to the total cost over and above the fixed cost. It can be calculated as:
Variable Cost= Total Cost- Fixed Cost
Variable Cost= $30,000 - $10,000 =$20,000
Average Variable Cost= Variable Cost/ Total Output
Average Fixed Cost= Fixed Cost/ Total Output
When the output is 10,000,
Average Variable Cost= $20,000/ 10,000 = $2

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Average Fixed Cost= $10,000/ 10,000 = $1
Average Variable Cost (AVC) is a U-shaped curve because of law of variable
proportion. AVC decreases at first and then starts to increase with the increase in output
because of law of diminishing returns. It will fall until fixed input, like the capital, is
increased. Average Total Cost (ATC) curve is also U-shaped like AVC curve since the fixed
cost is the same and the deviation come from the variable cost. Initially it declines (not as
sharp as AVC curve) due to the fixed cost which spreads over a larger output (economies of
scale). Eventually it starts to increase because of diminishing returns to the factors (Aurora,
2013).
Initially fixed cost is higher than the variable cost but eventually the variable cost
outgrows the fixed cost. There is increase in both variable cost and total cost. This forces both
the curves to converge with the increase in output. Hence, the difference in AVC and ATC
curves will be greater at output of 10,000 tennis balls.
6. Online booksellers have affected the retail book market by reducing fixed costs like the
distribution cost and storage costs. Cost of storage of the books is a cost to the retails stores
but it is not the case with online stores. Retailers have to keep stock depending on the
demand, which is often difficult to access and may result into loss of sales. There are costs
like rent of the stores and other charges of physical stores. Often the stores keep fewer copies
of books so as to incorporate a large variety of books. This result in higher costs compared to
bulk orders. This is avoided in case of online stores. The books often wear out over the years,
during handling and transportation. Also, there are commissions associated with retails by the
publishers depending on the sales. These costs are also reduced in the online transactions.

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Figure 2: Increase in Fixed Costs
Fixed cost increases the total cost but the slope does not change (no change in the variable
cost).
The fixed costs associated with the physical stores like Bricks and Mortar is high.
They need to keep a lot of stock in a small place. The decision of number of copies to be kept
is tedious. When the demand of certain books is high, the time associated with publishing and
distribution also affects the sales. Estimate of copies to be printed is avoided in online stores
like Amazon. The wearing out of books due to handling and storage does not impact the
online stores.
Task 4:
1. Profits are maximised when Marginal Revenue (MR) is equal to the Marginal Cost (MC).
When there are economic profits in an industry, new firms are attracted. This increases the
level of competition in the industry and reduces the market share of the company and the
economic profits. In this case, a company can maximise its profits by providing what the
customers want at lower prices. It can gain economic profit when there is low level of
competition and with technological improvements. Market research and brand management
helps identify the needs of the customers and implement changes required to capture the
market. It helps the company to gain market share by achieving first-mover advantage.
Technological advancement will help achieve the economies of scale and provide lower
prices to the customers. Due to this, the cost of entry for new firms will increase and the
market share will not change. Thus, the statement given by the sceptic is wrong.
TC’
TC
FC’
FC
Output

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2. Price takers are the firms which are not able to influence the prices of the product in the
market. The firm and its output are too small to affect the prices. It has to take the prices of
the industry. Industry prices are observed by the market forces of demand and supply. This
happens in the perfect competition, where there are a large number of firms with low level of
product differentiation. If the firm increases its prices, it may lose its market share to its
competitors. Hence, only product differentiation can help the firm to influence its product’s
prices without losing the market share.
3. Initially marginal revenue (MR) is higher than marginal cost (MC). As the output is
increased, MR reduces and MC increases. Producer increases its production in this case to
gain more profits. He stops the production when MR is equal to MC; because after that, costs
are higher than the revenues. There are losses after that point. Thus, a firm should produce till
the point where,
MR = MC (Profit Maximisation)
When,
MR > MC : scope for increase in production
MC < MR : need to decrease the production
4. Dominant strategy is the strategy which is best for an individual or firm, irrespective of
what the other firms do. Dominant strategy is the best strategy for the firm under all
circumstances.
In the given pay-off matrix, dominant strategy for Godrickporter will be to increase
the budget of advertising. Once Star Connection decides to increase the budget of advertising,
Godrickporter also chooses to increase its budget of aadvertising. But when Star Connection
chooses to leave the advertising budget unchanged, Godrickporter again, chooses to increase
the advertising budget. Godrickporter is well-off by increasing the advertising budget in both
the cases. Hence, increasing the advertising budget is a dominant strategy n case of
Godrickporter.
5. Since, Godrickporter’s dominant strategy is to increase the budget on advertising; it is
better-off by increasing the budget on advertising. When Godrickporter increases budget on
advertising, profits increase by $10,000 (when Star Connections increases the budget on
advertising). Profits increase by $2,000(when Star Connections does not increase advertising

Principles of economics 8
budget). Star Connections has incentive to increase advertising budget only when
Godrickporter leaves its budget on advertising unchanged.
6. Nash equilibrium is the condition where each firm decides or chooses its best strategy with
the highest pay-offs, given the strategy of the other firm.
Here, the Nash equilibrium is identified where Godrickporter increases its advertising
budget while Star Connections does not increase its advertising budget. It comes with a pay-
off of ($8,000, $10,000). It is the dominant strategy of Godrickporter firm to increase
advertising budget. Given the dominant strategy of Godrickporter, Star Connections is well-
off by not increasing the advertising budget.
Nash Equilibrium: (Increase advertising budget, Leave advertising budget as it is)
7. CSR and Boral are the only organizations in the bricks market. They both charged prices
according to the prices of the other firm. Being an oligopoly market, ththere is
interdependenc. The prices do not vary significantly in the oligopoly market. There is product
differntiation of some level. Due to high demands, they were able to operte as separate firms
and charge high prices, given the competitors’ prices. As the demand fell, their profits and
market also declined. This resulted in higher cost due to decreased demand. They both lost
their economies of scale and had to charge higher for the product. The decision to merge is
beneficial for both the firms to achieve economies of scale with larger scale production. This
can be explained with the help of following diagram:

Principles of economics 9
Figure 3: Economies of Scale achieved by increasing the size of production
As we can see, the cost declines with the increase in output. When the two firms merge, they
now have access to larger market compared to when they operated individually. To meet the
demand, they will increase their production. This will lead to efficient use of resources and
reduced costs. This will enable the firm to charge lower price without cutting down on the
profits. Economy of scale is an important factor initiating mergers.
8. When the two firms merge, the resources can be efficiently used and the prices can be
reduced. Economies of scale plays an important role to reduce the costs and decrease the
market prices. Reduced prices can also increase the demand for the product. The total market
will expand and the profits will start to increase.
Eventually, the market will become a monopoly of the merger firm and it can increase
the prices to gain higher returns. The barriers of entry will also increase due to high
investment and low prices.
Impact:
Prices: fall because of economies of scale
Quantity produced: expand due to monopoly and increased market share
Profits will increase due to lower costs

Principles of economics 10
Costs reduce as the firm merges to form a monopoly, this can be shown with the help of
following graph:
Figure 4: Average costs fall in the long-run and there are economies of scale achieved.
As the firms merge, they gain monopoly over the market. The market has no other
option to resort to. They will be willing to pay higher cost for the same product, since there
are no close substitutes available. The quantity demanded of the product will increase. As the
economies of scale takes place, there is decline in the prices. This increases the profit margin
for the merger firm.
References:
Aurora, B.-B.C., 2013. Cost of Production under Direct Costing and Absorption Costing- A
Comparative Approach. Economy Series, (02).
Fouquet, R., 2010. Trens in Income and Price Elasticities of Transport Demand (1850-2010).
Energy Policy, 50, pp.50-61.