Question

QUESTION TWO [35]

2.1 “Firms must have some knowledge about the elasticity of their products to set pricing strategies. If firms know that the demand for their products is inelastic, they can raise prices without fear of losing sales. On the other hand, if demand for their products is highly elastic, then raising prices could be risky. “ In terms of the above statement, explain the impact of an increase in prices on the following goods:

2.1.1 Motor vehicles (6)

2.1.2 Insulin (6)

2.2 Explain why a consumption good such as petrol is price inelastic in the short-term but price elastic in the long-term. (6)

2.3 Discuss why the long-run average cost curve initially declines over an increasing range of output. (7)

2.4 Explain, with the aid of a diagram, the relationship between average product and marginal product.

Answer 1

2.1.1

Increase in the price of motor vehicle, will make people opt for other substitutes. So, people will either opt for smaller motor vehicle, opt for the public transport system or ride sharing. It is due to the reason that, demand for motor vehicle being price elastic in nature. So, revenue can decrease with increase in price.

2.1.2

Insulin is a necessity. So, rise in price of insulin is not going to decrease the demand. It will cause revenue to increase with increase in price of insulin as demand is relatively inelastic in nature.

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2.2

It is due to the reason that people cannot opt for the substitute in the short run, so demand is inelastic in nature. But, in the long run, people can opt for the vehicles that use alternative energy sources such as electricity or solar energy or public transport system. It makes demand to be elastic in the long run.

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2.3

It is due to the reason that different input factors of production are variable and firms achieve economy of scale in the long run. It makes LRATC to decline when output level increases. It also takes place due to the efficient utilization of resources and production capacity.

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2.4

When AP increases then MP also increases. When MP decreases, then AP also decreases but the decrease is less than the decrease in MP. Further, MP can be negative, but AP cannot be negative.