Basics of Economics

Assignment 2
Part A
Q1. Define what demand means in economics?

Ans. In economics, demand refers to the quantity of a good or service that

consumers are willing and able to purchase at various prices during a specific
period, holding all other factors constant. It represents the desire or willingness of
consumers to buy a particular product or service at different price levels. Demand
is influenced by various factors, including price, income, tastes and preferences,
the prices of related goods, and consumer expectations.

Q2. List the factors that can influence market demand.

Ans. Sure, here are the factors influencing market demand in short form:

1. Price of the good or service

2. Income levels
3. Prices of related goods (substitutes and complements)
4. Tastes and preferences
5. Consumer expectations
6. Population changes
7. Government policies and regulations
8. Seasonal factors
9. Availability of credit
10. Technological advancements

Q3. Name two factor that affects the price elasticity of demand

Ans. Two factors that affect the price elasticity of demand are:

1. Availability of Substitutes: The availability of substitutes for a good or service influences its price
elasticity of demand. If close substitutes are readily available, consumers can easily switch to
alternatives when the price of the good increases, making demand more elastic. On the other hand, if
substitutes are scarce or non-existent, consumers have fewer options to switch to, resulting in a more
inelastic demand.
2. Necessity vs. Luxury: Whether a good is considered a necessity or a luxury affects its price elasticity
of demand. Necessities, such as basic food items or essential medications, tend to have inelastic
demand because consumers are less responsive to changes in price; they will continue to purchase these
items even if prices rise. In contrast, luxury goods, such as designer clothing or high-end electronics,
often have more elastic demand as consumers are more sensitive to changes in price and may reduce
their purchases if prices increase.
 Q4. Discuss what is Total Revenue?

Ans. Total revenue refers to the total amount of money received by a firm from
selling its goods or services over a specific period of time. It is calculated by
multiplying the quantity of goods or services sold by the price at which they are
sold.

Mathematically, total revenue (TR) can be expressed as

TR=Price per unit×Quantity sold

Q5. Explain what you mean by Fixed cost?

Ans. Fixed costs are expenses that do not vary with the level of production or sales
within a certain period. These costs remain constant regardless of changes in
output or sales volume. Fixed costs are incurred by a business to maintain its
operations and are typically associated with the business's capacity to produce
goods or services, rather than the quantity produced.

Part B

Q6. Describe the relationship between price changes and shifts in market demand.

Ans. The relationship between price changes and shifts in market demand is
fundamental to understanding how changes in market conditions impact
consumer behavior and overall market equilibrium. This relationship is governed
by the law of demand, which states that, ceteris paribus (all other factors
remaining constant), as the price of a good or service increases, the quantity
demanded by consumers decreases, and vice versa.

However, it's important to distinguish between movements along a demand curve

and shifts of the entire demand curve:

1. Movements Along the Demand Curve: When there is a change in the price of
a good or service, it leads to a movement along the demand curve. This means
that consumers adjust their quantity demanded in response to the change in price
while all other factors affecting demand remain constant. If the price decreases,
quantity demanded increases, and if the price increases, quantity demanded
decreases, resulting in a movement along the demand curve.
2. Shifts of the Demand Curve: A shift in the demand curve occurs when there is
a change in any factor affecting demand other than price. These factors include
income, prices of related goods (substitutes and complements), tastes and
preferences, consumer expectations, population changes, and government
policies. When any of these factors change, it affects consumers' willingness and
ability to buy a good or service at every price level, leading to a shift in the entire
demand curve.
In summary:

 Price Changes: Cause movements along the demand curve. An increase in

price leads to a decrease in quantity demanded, while a decrease in price
leads to an increase in quantity demanded.
 Factors Other Than Price (Determinants of Demand): Cause shifts in
the demand curve. Changes in income, prices of related goods, tastes and
preferences, consumer expectations, population changes, and government
policies influence consumers' overall demand for a good or service at all
price levels, leading to a shift of the entire demand curve.

Q7. In your own words, explain what "price elasticity of demand" tells us about a Product.

Ans. Price elasticity of demand measures the responsiveness of the quantity

demanded of a product to changes in its price. In other words, it tells us how
sensitive consumers are to changes in price by quantifying the percentage
change in quantity demanded relative to a percentage change in price.

A high price elasticity of demand indicates that consumers are highly responsive
to changes in price, meaning that a small change in price leads to a relatively
large change in quantity demanded. This suggests that the product is more
elastic, and consumers are more sensitive to price changes. Examples of elastic
goods include luxury items, where consumers have more flexibility in their
purchasing decisions and can easily substitute other goods if prices change.

Conversely, a low price elasticity of demand indicates that consumers are less
responsive to changes in price, meaning that a change in price leads to a
proportionally smaller change in quantity demanded. This suggests that the
product is more inelastic, and consumers are less sensitive to price changes.
Examples of inelastic goods include necessities like food, where consumers have
limited flexibility in their purchasing decisions and are less likely to reduce
consumption even if prices increase.

Understanding the price elasticity of demand helps businesses make informed

decisions about pricing strategies, revenue maximization, and market positioning.
For example, if a product has elastic demand, businesses may need to carefully
consider price changes to avoid losing customers to substitutes. On the other
hand, if a product has inelastic demand, businesses may have more flexibility to
adjust prices without significantly impacting sales volume.

Part C
 Q8. Imagine two companies producing similar products, but Company A has a higher proportion of
fixed costs in its total cost structure compared to Company B. Analyze how this difference might
affect their pricing strategies and responses to changes in market demand

Ans. The difference in the proportion of fixed costs between Company A and
Company B can significantly influence their pricing strategies and responses to
changes in market demand.

1. Impact on Pricing Strategies:

 Company A (Higher Proportion of Fixed Costs):
 Company A, with a higher proportion of fixed costs, faces higher financial
risk if it cannot cover its fixed expenses. As a result, Company A may adopt
a pricing strategy that aims to generate sufficient revenue to cover its fixed
costs.
 To cover their fixed costs, Company A may set higher prices for their
products compared to Company B. This ensures that even if sales volumes
fluctuate, they can still cover their fixed expenses and maintain profitability.
 However, setting higher prices may make Company A's products less
competitive in the market, especially if consumers perceive similar value
from Company B's products, which are priced lower.
 Company B (Lower Proportion of Fixed Costs):
 Company B, with a lower proportion of fixed costs, may have more flexibility
in its pricing strategy. Since its fixed costs are relatively lower, Company B
may be able to afford to set lower prices for its products.
 Lower prices may make Company B's products more attractive to
consumers, potentially leading to increased market share and sales
volumes.
 Additionally, Company B may be able to adjust its prices more readily in
response to changes in market demand, as it has less pressure to cover high
fixed costs.
2. Responses to Changes in Market Demand:
 Company A:
 When faced with changes in market demand, Company A may be less able
to adjust its prices due to the need to cover its higher fixed costs. If demand
decreases, Company A may struggle to reduce prices to stimulate demand
without risking profitability.
 Conversely, if demand increases, Company A may be able to capitalize on
this by maintaining higher prices, as the fixed costs remain constant
regardless of changes in sales volume.
 Company B:
 Company B, with a lower proportion of fixed costs, may be better positioned
to respond to changes in market demand. If demand decreases, Company B
can afford to lower prices to stimulate demand without jeopardizing
profitability, as their fixed costs are relatively low.
 Similarly, if demand increases, Company B can potentially increase prices to
capture additional revenue without significant pressure to cover high fixed
costs.
 Q9. Analyze the impact of a fixed price increase on a firm's total cost, average total cost, total
revenue, and marginal revenue. How might these changes influence the firm's decision-making
regarding production levels and pricing strategy?

Ans. When a firm increases its fixed price, several key factors are affected,
including total cost, average total cost, total revenue, and marginal revenue. Let's
analyze the impact of a fixed price increase on each of these factors and how they
might influence the firm's decision-making regarding production levels and pricing
strategy:

1. Total Cost:
 A fixed price increase does not directly impact total cost because fixed costs
remain constant regardless of changes in output or sales volume. Therefore,
total cost remains unchanged.
2. Average Total Cost (ATC):
 Average total cost is calculated by dividing total cost by the quantity of
output produced. Since total cost does not change with a fixed price
increase, average total cost also remains constant.
3. Total Revenue (TR):
 Total revenue is the product of price per unit and the quantity of output sold.
With a fixed price increase, assuming demand remains constant, the firm
earns more revenue per unit sold. Therefore, total revenue increases
proportionally with the increase in price.
4. Marginal Revenue (MR):
 Marginal revenue is the additional revenue generated from selling one more
unit of output. In a competitive market where the firm faces a horizontal
demand curve, marginal revenue is equal to the price of the product.
Therefore, with a fixed price increase, marginal revenue remains constant
and equal to the price.

These changes in total revenue and marginal revenue can influence the firm's
decision-making regarding production levels and pricing strategy:

 Production Levels:
 If the increase in total revenue resulting from the fixed price increase
exceeds the increase in total cost associated with producing additional units,
the firm may choose to increase production levels to maximize profit.
 However, if the fixed price increase leads to higher marginal costs or if
demand is not responsive to the price increase, the firm may decide to
maintain or reduce production levels to avoid overproduction and potential
inventory buildup.
 Pricing Strategy:
 The firm may consider further price adjustments based on the impact of the
fixed price increase on total revenue and marginal revenue. If the increase
in total revenue resulting from the price increase is significant and
 sustainable, the firm may choose to maintain the higher price to maximize
revenue and profitability.
 Conversely, if the fixed price increase leads to a disproportionate decrease
in demand or if competitors respond with lower prices, the firm may need to
reconsider its pricing strategy to remain competitive in the market.