me ass 1 fnl

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Question One

The following equations have been derived from the books of NCPB on demand and supply of

rice: Q=69+2P and Q=90-5P where Q is the quantity and P is price of rice. As the board chief strategist advice the CEO on the following;

a) What function could represent demand curve, supply curve why

The following function would represent the demand curve: Q=90-5P this is because the demand

curve as a negative slope indicating an inverse relationship between price and quantity demanded.

Thus an increase in price would cause a decrease in quantity demanded and vice versa.

b) Compute the equilibrium price and quantity and explain whether equilibrium is

always desirable for both consumers and producers

At equilibrium Qd=Qs Therefore 90-5P=69+2P

-5P-2P=69-90

-7P=-21

Equilibrium Price =3

Substituting for p: Q=90-5(3)

Equilibrium Quantity =75

Q p= 3 Qd=75

Comment

Equilibrium price and quantity is always desirable because the quantity demanded is equal to the

quantity supplied hence there is no deficit or surplus thus at equilibrium both the supplier and the

consumer needs are satisfied

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c) Suppose supply changes to Q=55+2P with no change in demand determine the new

equilibrium price and quantity and explain whether this represents change in

quantity supplied or change in supply

Q=55+2P= Q=90-5P

2P+5P=90-55

7P=35

Equilibrium Price=5

New Equilibrium Quantity; Q=55+2(5)

Equilibrium Quantity =65

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d) Provide four possible reasons for the change in supply indicated in (c) above

The supply change above is as a result of the following factors

Changes in the prices of other goods: Suppliers are frequently able to switch their production

processes from one type of good to another. Farmers, for example, might decide to grow less

wheat and more corn on the same land if the price of corn rises relative to the price of wheat. In

this case, the supply curve for wheat would shift to the left

Changes in the prices of inputs: The prices of the raw materials or inputs used to produce a

good also cause the supply curve to shift. An increase in the prices of a good's inputs will raise

costs to suppliers and cause suppliers to supply less of that good at all prices. Therefore, an

increase in the prices of a good's inputs leads to a leftward shift of the supply curve for that

good, as in Figure 2 (a). A decrease in the prices of a good's inputs reduces costs and allows

suppliers to supply more of that good at all prices. Therefore, a decrease in the prices of a

good's inputs leads to a rightward shift of the supply curve for that good,

Changes in technology: Advances in technology often have the effect of lowering the costs of

production, allowing suppliers to supply more goods at all prices. For example, the

development of pesticides has reduced the amount of damage done to certain crops and

therefore has reduced the cost of farming. The result has been an increase in the supply of these

crops at all prices, which can be represented by a shift to the right in the supply curves for

these crops

The cost of production would cause a change in quantity supplied

Government tax policy may also cause a change in quantity supplied

Climatic and Weather conditions are also another factor causing a change in quantitysupplied

The price for substitute products

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e) Suppose after the supply change the government fixes the price of rice at Ksh 7 per unit.

Explain the economic effects of this policy indicating clearly whether this would result in a

surplus or shortage of rice and advice the CEO on how the board could deal with this

situation

There will be a producers surplus because of the high price ceiling of Ksh 7

The consumers will look for cheaper substitutes this calls for the CEO to advice the

company to invest in substitutes

There will be a surplus this is because suppliers will offer to sale while the demand is not

sufficient to clear the quantity supplied

Revenues will decrease hence the CEO should advice the board to diversify into other

markets

The company should also increase marketing and promotional campaigns for instance

packaging in bigger quantities

Diversifying into other products

The board could also fix the price below the ceiling which represents a price cutting

The board should also consider value addition to the product in order to justify the price

increment

Question 2

A sales manager of a certain company wishes t study the characteristics of revenue received by the

firm. He notices from his study that when the price is Ksh 30 per unit, 100 units of output are sold

while when the price rises to Ksh 50 only 20 units are sold

i) Assuming a linear relationship between these data, determine the Demand, total revenue,

Average revenue and Marginal revenue functions

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Change

Q 100 20 80

P 30 50 -20

Demand Function

q = mp + b

100=m-30b…i

20=m-50b……ii

80= -20b

b= - 4

∆Y/∆X=(100-20)/(30-50)= -4

Substituting for b in above equation

100=m-30*-4=

M=220

Demand Equation=

Q d =

Total Revenue=AR

TR= (220-4b)

TR=

Average Revenue (AR)

=AR=

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=

=

MR= =220b-

=

ii) Compute the price elasticity of demand when total revenue is maximum and comment on the

results

=

= =

= =

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= =

= %

Comment

A small change in price causes will produce a greater change in quantity demanded, thus this

means that for every 1 per cent change in price the quantity demanded will rise by 2.67% per cent.

b) The concept of price elasticity of demand is a versatile tool of economic analysis. Explain this

statement with practical examples

The concept of price elasticity enables a firm to alter its profitability by increasing or decreasing its

price to stimulate demand. However price elasticity enables firms to determine whether to alter

prices of commodities whose demand is elastic and keep commodities whose prices is inelastic

constant. Therefore the concept of price elasticity is a key decision making tool which will enable

firms to alter its price in order to increase or decrease demand for a commodity.

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Question Three

The following data shows the prices of goods X and Y the annual income of the consumer and the

Quantities of X and Y consumed during the last six Years.

Year Price of X ($) Quantity of X Price of Y($) Annual Income ($)

2000 100 80 50 20000

2001 110 90 40 18000

2002 90 100 40 18000

2003 100 100 50 20000

2004 100 90 40 20000

2005 100 110 40 20000

Required

i. What pair of years would you use to calculate the price elasticity of demand for X and why

Years

The above years represents a change both in price and quantities demanded hence price elasticity

of demand can be calculated

ii. Complete the arc price elasticity of demand for X and interpret the coefficient obtained

Arc Elasticity of Demand for X=

= =

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= =

Comment

The above product is

iii. What pair of years would you use to calculate the price elasticity of demand for Y and why

Assumption: All annual income is spent on the two commodities

Thus:

Year 2000 2001 2002 2003 2004 2005

Q 240 202.5 225 200 275 225

Therefore years (2000-2001), (2002-2003) and (2003-2004) can be used to calculate price

elasticity of demand because they exhibit both a change in price as well as quantity demanded

iv. Compute the cross elasticity of demand X and indicate the possible relationship between

goods X and Y

Cross elasticity =

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=

= -

v. Explain whether you would expect the price elasticity of demand for a product to be more

or less elastic in the long run than in the short run

Cross elasticity will be positive for a substitute and negative for a compliment thus goods X

and Y are complements for example Pen and ink

Price elasticity of demand in short run and long run

In the long run elasticity of demand is affected by change in technology, changes in prices of

substitute products, new entrants, income levels, distribution of income

In the long run price will therefore be elastic while in the short run price will be inelastic

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