Price Elasticity of Demand and Supply Assessment Answer

Tutorial Submission

Assessment Question Week4:

 Price Elasticity of demand and supply

Question 3

The price for cigarettes sold by Big Tobacco Co Ltd was 6.00 per packet in March 2018. During the month of March, the consumption of cigarettes was 1000 packets. However, the Board of Directors of Big Tobacco Co Ltd decided to increase the price by 25% during the month of April.  As a manager you noted that price elasticity of demand was 0.8. As a manager Big Tobacco Co Ltd:

1. Advise your management of the strategy that could be adopted by your firm to maintain sales. (5 Marks)

Increase in price = 25%

Hence, price in April = 6*1.25 = 7.5

We also know that, 

Price elasticity of demand = %change in Quantity/%change in Price

-0.8 = ((X-1000)/1000)/0.25

-0.8*0.25*1000 = X-1000

X-1000 = -200

X = 1000-200

X = 800

Hence, at 7.5 price, quantity demanded will reduce to 800 packets.

A price elasticity of 0.8 indicates relatively inelastic demand as seen above. An increase of 25% in price leads to only 20% decline in demand. However, if we see total revenue in either case, it remains same at 6000. 

Hence, the management can benefit due to inelastic demand but it needs to find a price point where total revenue will be higher. For example, at price of 7, total revenue increases from 6000 to 6067.

1. Also, advise your government on recommended interventions in the cigarette market.

Cigarette smoking is injurious to health but people addicted to it will buy even at a higher price as indicated by inelastic demand in above scenario.

Hence, government can intervene by putting higher taxes on cigarette which will in turn, lead to higher prices and may discourage at least some people to stop smoking. This will also lead to higher tax revenue for government.

Assessment Question Week 5:

Production costs

Question 4

John was a high school teacher earning $ 80,000 per year. He quit his job to start his own business in pizza catering. In order to learn how to run the pizza catering business, John enrolled in a TAFE to acquire catering skills. John’s course was for 3 months. John had to pay $2,000 as tuition for the 3 months.

After the training, John withdrew $110,000 from his savings account. He had been earning 5 percent interest per year for this account. He also borrowed $50,000.00 from his friend whom he pays 6 percent interest per year. Further, to start the business John used his own premises. He was receiving $12,000 from rent per year. Finally, to start the business John uses $50,000 he had been given by his father to go on holiday to USA.

John’s first year of business can be summarised as follows:

Based on your calculated accounting profit and economic profit, would you advise John to return to his teaching job?  Show your work(10 marks)

The above information can be presented as follows:

It can be seen that the accounting profit takes into account only explicit costs. Hence, in case of Option 2, accounting profit is $160,000.

However, economic profit takes into account implicit costs and opportunity cost also. In this case, opportunity/implicit cost of Option 2 is:

1. Salary
2. Rent Income
3. Interest Income
4. Holiday
5. The capital is not adjusted as it remains with John in either case. 

When these elements are adjusted in accounting profit for Option 2, the economic profit for Option 2 comes to $4,500.

Hence, it is advised that John should not return to his teaching job as his accounting profit is higher than teaching and economic profit is also positive.

Assessment Question Week6:

Market Structure: Perfect Competition and Monopoly 

Question 5

The above diagram illustrates the short run cost curves for Sarah Mat, a rice farmer in Queensland. Calculate the profit or loss for Sarah Mat and, examine the key characteristics for perfect competition firm with reference to Sarah’s farm. (10 Marks)

A perfect competition is characterized by presence of large number of sellers who sell homogeneous products at exactly same price. Further, there is perfect information available to buyers and sellers. Hence, the firms are price takers rather than price makers. 

This is because of the price is a little higher for one firm, the buyer can go to another firm which is selling exactly the same product at lower price. If a firm sells product at a lower price, then all buyers will come to this firm such that it will not be able to meet the demand and shortage will lead equilibrium price to move up.

In the above case, these conditions are met because:

1. The demand curve is a straight line parallel to x-axis, indicating firms are price takers as price is fixed at AUD40/20KG rice bag. 
2. Further DD=AR=MR which is a condition for perfect competition
3. Rice is a homogeneous product
4. The cost curves of Sarah’s firm can be sued to determine profit for her firm as follows:
   1. A firm will produce at a point where profit is maximized which is at point where MR=MC. This occurs at 500 rice bags/month where equilibrium price is same for all firms at AUD40/20kg rice bag. Hence, total revenue is 500 x 40 = AUD20,000
   2. At level of 500 bags, the Average total cost is approximately AUD32.5/bag. Hence, total cost is ATC x Q = 32.5 x 500 = AUD16,250
   3. Hence, profit for the firm is Total Revenue – Total Cost = AUD20,000 – AUD16,250 = AUD3,750
   4. Hence, the firms cost curves are below the equilibrium price which indicates that the firm will make profit. The firm’s profit will be zero when ATC is AUD40/bag. If the firm’s ATC is more than equilibrium rice, then the firm will start incurring losses.