The behaviour of the firm which seems to be efficient in the short-run may found to be inefficient in the long-run. Do you agree? Explain using appropriate diagram.
Expert Answer
Short-Run Efficiency vs. Long-Run Inefficiency in Firm Behavior
The efficiency of a firm's behavior can vary significantly between the short run and the long run due to various factors such as market conditions, technological changes, and consumer preferences. In the short run, certain strategies may seem beneficial, but they may not be sustainable or advantageous in the long run.
1. Short-Run Efficiency: Maximizing Current Profits
In the short run, firms often focus on maximizing current profits. This can be achieved through strategies like cost-cutting, increasing prices, or exploiting temporary market opportunities. For instance, a firm may reduce costs by minimizing expenditure on labor or research and development. While this can lead to increased profits in the short term, it may not be a sustainable strategy in the long run.
2. Long-Run Inefficiency: Neglect of Investment and Innovation
The focus on short-term gains can lead to long-term inefficiencies. For example, cutting costs by reducing investment in research and development can harm a firm's ability to innovate and stay competitive. In the long run, this can result in the firm falling behind competitors who invest in new technologies and product development.
3. Market Changes and Consumer Preferences
Market conditions and consumer preferences are dynamic and can change over time. A strategy that is profitable in the short run may not adapt well to these changes. For instance, a firm may capitalize on a current trend to boost sales, but if it fails to anticipate changes in consumer preferences, it may struggle to maintain its market position in the long run.
4. Short-Termism and Organizational Culture
A focus on short-term efficiency can also lead to a culture of short-termism within the organization. This culture can discourage long-term planning and investment, leading to a lack of sustainability in the firm’s operations. Over time, this can erode the firm's competitive advantage and market share.
5. Regulatory and Environmental Changes
Regulatory environments and sustainability issues are increasingly important in business. A firm that ignores long-term environmental sustainability in favor of short-term efficiency, for example, may face regulatory penalties or reputational damage in the future, leading to long-term inefficiencies.
6. Example of Short-Run Efficiency Leading to Long-Run Inefficiency
Consider a firm that achieves short-run efficiency by cutting costs, including employee training and development. While this may increase profits initially, in the long run, the firm may suffer from a lack of skilled labor, leading to decreased productivity and an inability to adapt to market changes. This illustrates how short-term efficiency can lead to long-term inefficiency.
Conclusion
While certain strategies may appear efficient in the short run by maximizing immediate profits or capitalizing on current market conditions, they may not be sustainable in the long run. Long-term inefficiencies can arise from a lack of investment in innovation, failure to adapt to market and consumer changes, a culture of short-termism, and ignoring regulatory and environmental considerations. Therefore, it is crucial for firms to balance short-term efficiency with long-term strategic planning to ensure sustainable success.
Discuss the reasons behind a typical U-shaped long-run average cost curve (LAC) that a firm may face over its range of output in the long run.
Expert Answer
Understanding the U-Shaped Long-Run Average Cost Curve
The Long-Run Average Cost (LAC) curve in economics is typically U-shaped, reflecting various economies and diseconomies of scale a firm experiences as it increases production in the long run. This curve is crucial for understanding how a firm's costs evolve as it adjusts all its inputs to achieve different levels of output.
1. Economies of Scale: The Downward Sloping Part of the Curve
The initial downward slope of the LAC curve represents economies of scale. As a firm increases its output, it can spread its fixed costs over a larger number of units, reducing the average cost per unit. This section of the curve can be broken down into several factors:
a. Increased Specialization: Larger production allows for more specialized workers and machinery, which increases efficiency and productivity.
b. Managerial Economies: Larger firms can afford to hire specialized managers, leading to more efficient management and lower costs.
c. Financial Economies: Bigger firms often have better access to financial markets and can borrow at lower interest rates.
d. Marketing and Distribution Economies: As output increases, firms can spread their marketing and distribution costs over more units, reducing the per-unit cost.
2. Constant Returns to Scale: The Flat Part of the Curve
At some point, the firm experiences constant returns to scale, where increasing output does not significantly affect the average cost. This phase is characterized by a flat section of the LAC curve. During this phase, the benefits of increased production are balanced by the rising costs of managing a larger operation.
3. Diseconomies of Scale: The Upward Sloping Part of the Curve
Beyond a certain point, the LAC curve starts to slope upwards, indicating diseconomies of scale. This happens when the cost per unit starts to increase as the firm expands further. Factors contributing to diseconomies of scale include:
a. Managerial Inefficiencies: As firms become too large, they may face bureaucratic inefficiencies, leading to delayed decision-making and increased costs.
b. Labor Issues: In very large firms, issues such as lack of motivation, poor communication, and coordination problems can arise, reducing productivity.
c. Operational Inefficiencies: Scaling up production might lead to logistical problems and inefficiencies, as the firm may not be able to manage its operations effectively.
d. Resource Limitations: In some cases, a firm may face increasing input costs as it tries to expand, especially if resources are scarce or difficult to acquire.
4. The Optimal Scale of Production
The minimum point of the LAC curve represents the optimal scale of production for the firm, where it achieves the lowest average cost. At this point, the firm has fully exploited economies of scale without encountering significant diseconomies. This scale is ideal for the firm to operate in the long run.
Conclusion
The U-shaped Long-Run Average Cost curve is a fundamental concept in economics, illustrating how a firm’s average costs change with varying levels of output in the long run. Understanding this curve is crucial for firms as they make decisions about scaling their operations. It highlights the balance between economies and diseconomies of scale and helps identify the most efficient scale of production for a firm in the long run.
Explain the concept of an Expansion path? Explain why an expansion path in case of a linear homogeneous production function is a straight line? Discuss.
Expert Answer
Understanding the Concept of an Expansion Path
The expansion path in economics is a graphical representation that shows how a firm’s optimal combination of inputs changes as it scales up production. It is a crucial concept in production theory, helping to understand how firms adjust their input usage to maximize output.
1. Definition and Significance of Expansion Path
An expansion path, also known as a scale line, is a curve on an input-factor graph that connects points of optimal input combinations at different levels of output. It is derived from the firm's production function and indicates the most cost-effective way of increasing production. The expansion path helps in understanding how a firm should allocate its resources as it expands its operations.
2. Characteristics of Expansion Path
The expansion path can take various forms depending on the nature of the production function. It reflects the firm's technology and the substitutability of inputs. In a graph with one input on each axis, the expansion path shows the combination of these inputs that the firm will choose at different levels of production, given the input prices.
3. Expansion Path in Linear Homogeneous Production Function
In the case of a linear homogeneous production function, the expansion path is a straight line. A linear homogeneous production function is one where if all inputs are increased by a certain proportion, output increases by the same proportion. This property leads to constant returns to scale.
4. Reason for Straight-Line Expansion Path
The straight-line expansion path in a linear homogeneous production function can be explained by the following reasons:
a. Constant Returns to Scale: Due to constant returns to scale, doubling both inputs will double the output. This proportionality means that the firm will use inputs in the same ratio regardless of the scale of production.
b. Constant Input Ratios: As the firm expands, it maintains the same ratio of inputs. This constant ratio results in a linear relationship between the inputs, represented by a straight line on the graph.
c. Cost Minimization: The straight-line expansion path also indicates that the firm is minimizing costs at each level of output. The linearity implies that the firm does not need to alter the input mix to achieve cost efficiency as it expands.
5. Implications for Business Decision Making
Understanding the concept of the expansion path, especially in the context of linear homogeneous production functions, is vital for business decision-making. It guides firms in resource allocation and helps in planning the expansion of production. The straight-line expansion path simplifies the decision-making process as it indicates a constant input ratio regardless of the scale of production.
Conclusion
The expansion path is a fundamental concept in production theory, illustrating how a firm should adjust its input combinations as it increases output. In the case of a linear homogeneous production function, the expansion path is a straight line, reflecting constant returns to scale and constant input ratios. This concept is crucial for firms in making informed decisions about resource allocation and scaling up production efficiently. Understanding the nature of the expansion path helps businesses optimize their operations and achieve cost-effective production expansion.
Illustrate isoquants having positively sloped segments. In the same diagram construct ridge lines and explain the concept of Economic Region of Production.
Expert Answer
Understanding Isoquants with Positively Sloped Segments
Isoquants are curves that represent combinations of different inputs that yield the same level of output in production. Typically, isoquants have a negative slope, indicating that an increase in one input can compensate for a decrease in another while maintaining the same output level. However, in certain cases, isoquants can have positively sloped segments, which represent unusual production scenarios.
1. Characteristics of Positively Sloped Isoquants
Positively sloped segments in an isoquant imply that increases in both inputs are required to maintain the same level of output. This situation is atypical as it defies the usual principle of input substitutability. It suggests that the inputs are complements to such an extent that they cannot substitute for each other effectively. In such cases, the production process may involve essential fixed proportions of inputs.
2. Constructing Ridge Lines in the Isoquant Diagram
Ridge lines in an isoquant diagram represent the boundaries beyond which the productivity of one or both inputs decreases. They are drawn on either side of the isoquants, demarcating the region where production is most efficient.
a. The Left Ridge Line: This line indicates the point beyond which the productivity of one input (usually labor) begins to decrease. To the left of this line, adding more of this input while keeping the other constant leads to less than proportionate increases in output.
b. The Right Ridge Line: Conversely, the right ridge line shows the limit to the productivity of the other input (usually capital). Beyond this line, additional units of this input contribute less and less to total output.
3. Economic Region of Production
The area between the two ridge lines is known as the Economic Region of Production. This region represents the range of input combinations where both inputs contribute effectively to production, ensuring efficient utilization of resources.
a. Optimal Input Utilization: Within this region, the firm can achieve the most efficient production, as both inputs are being used in their most productive ranges.
b. Avoiding Inefficiencies: Operating outside this region means that one or both inputs are being used inefficiently, either due to over-utilization or under-utilization, leading to decreased returns.
4. Implications for Production Decisions
Understanding the concept of the Economic Region of Production and the unusual case of positively sloped isoquant segments is crucial for production decision-making.
a. Input Management: It guides firms in managing their input combinations to stay within the efficient production region.
b. Cost Optimization: By operating within the Economic Region of Production, firms can optimize their costs, as both inputs are used in their most productive capacities.
Conclusion
Isoquants with positively sloped segments represent an atypical production scenario where inputs are highly complementary and lack substitutability. The construction of ridge lines and the identification of the Economic Region of Production are essential for understanding the efficient utilization of inputs in the production process. Firms must aim to operate within this region to ensure optimal input utilization and cost-effective production. Understanding these concepts is vital for making informed and strategic production decisions.
Discuss the concept of Utility. How is the cardinal utility approach different from the ordinal utility approach?
Expert Answer
Understanding the Concept of Utility
Utility, in economics, refers to the satisfaction or benefit that a consumer derives from consuming goods or services. It is a central concept in consumer theory, which analyzes how consumers allocate their income to maximize their utility. Utility helps in understanding consumer choices and market demand.
1. Definition and Significance of Utility
Utility is a measure of the relative satisfaction received by consumers from the consumption of goods and services. It is subjective and varies from person to person. The concept of utility is used to explain how consumers make choices among different goods and services to achieve the highest level of satisfaction or utility.
2. Cardinal Utility Approach
The cardinal utility approach, pioneered by economists such as Alfred Marshall, assumes that utility can be measured quantitatively. It suggests that consumers can assign a specific numerical value to their level of satisfaction from consuming a unit of a good or service. For example, a consumer might say that consuming a piece of cake provides them with 10 units of utility.
a. Assumptions: This approach assumes that utility is measurable and that the satisfaction derived from consumption can be expressed in absolute terms.
b. Marginal Utility: Cardinal utility introduces the concept of marginal utility, which is the additional utility gained from consuming an additional unit of a good or service.
3. Ordinal Utility Approach
The ordinal utility approach, developed by economists like Vilfredo Pareto and J.R. Hicks, argues that utility cannot be measured in absolute terms. Instead, it suggests that consumers can rank their preferences in order of the satisfaction they provide. For example, a consumer can say they prefer tea over coffee but cannot specify by how much.
a. Assumptions: This approach assumes that utility is subjective and can only be ordered or ranked, not measured precisely.
b. Indifference Curves: Ordinal utility uses indifference curves to represent combinations of goods between which a consumer is indifferent, reflecting their preferences and the trade-offs they are willing to make.
Conclusion
Utility is a fundamental concept in economics that explains consumer behavior and market dynamics. The cardinal utility approach views utility as a measurable quantity, while the ordinal utility approach considers it as an orderable but not measurable entity. Both approaches provide valuable insights into consumer preferences and decision-making, although the ordinal approach is more widely accepted in modern economics for its realistic representation of consumer behavior.
On what grounds is the law of diminishing marginal utility being criticized by the modern economists?
Expert Answer
Criticism of the Law of Diminishing Marginal Utility by Modern Economists
The Law of Diminishing Marginal Utility is a fundamental principle in economics that states that as a consumer consumes more units of a good or service, the additional satisfaction (marginal utility) derived from each successive unit decreases. While historically significant, this law has faced criticism from modern economists on several grounds.
1. Subjectivity of Utility
One of the primary criticisms is the inherent subjectivity of utility. The law assumes that it is possible to measure utility in quantifiable terms, which modern economists argue is not feasible due to the subjective nature of satisfaction. Different individuals derive varying levels of satisfaction from the same good, and this satisfaction cannot be universally measured or compared.
2. Inconsistent with Indifference Curve Analysis
Modern economic theory, which relies heavily on indifference curve analysis, suggests that utility is ordinal (rankable) rather than cardinal (measurable in units). This approach contradicts the Law of Diminishing Marginal Utility, which is based on the cardinal measurement of utility. Indifference curves demonstrate consumer preference without requiring a quantifiable measure of utility, challenging the law’s applicability.
3. Assumption of Constant Consumption Context
The law assumes a constant consumption context, meaning that the circumstances under which consumption occurs do not change. Modern economists argue that this is unrealistic, as the context of consumption (like mood, environment, and social factors) can significantly affect the utility derived from each additional unit.
4. Neglect of Complementary and Substitute Goods
The law does not adequately account for the effects of complementary and substitute goods on utility. The satisfaction derived from consuming a good can increase if a complementary good is also consumed, or it can change with the availability of substitutes. This interdependence of goods in affecting utility challenges the law’s premise.
Conclusion
While the Law of Diminishing Marginal Utility has been foundational in economic theory, modern economists criticize it for its assumptions about the measurability and constancy of utility, and its lack of consideration for the consumption context and the interdependence of goods. These criticisms have led to the development of more nuanced theories that better reflect the complexities of consumer behavior.
Illustrate the impact of a price support measure imposed by the government on the market of a commodity under the following conditions:
(i) When the price floor is fixed at a price lower than the equilibrium price.
(ii) When the price floor is fixed at a price equal to the equilibrium price.
Expert Answer
Impact of Price Support Measures on Commodity Market
Price support measures, such as price floors, are government interventions to control the prices of commodities. The impact of these measures varies depending on how the price floor is set in relation to the market equilibrium price.
1. Price Floor Lower than Equilibrium Price
When the government sets a price floor that is lower than the equilibrium price, it typically has minimal impact on the market. In this scenario, the market forces are allowed to function normally since the equilibrium price, where the quantity demanded equals the quantity supplied, is above the government-mandated minimum price.
a. Market Equilibrium Maintained: The market continues to operate at the equilibrium price, as it is higher than the price floor. Producers and consumers make their decisions based on market dynamics, not the price floor.
b. No Excess Supply: Since the market price is above the price floor, there is no incentive for producers to increase supply beyond what the market demands. Thus, no surplus is created by the price floor.
2. Price Floor Equal to Equilibrium Price
Setting a price floor equal to the equilibrium price also does not significantly disrupt the market. This is because the price floor is set at a level where the market naturally clears.
a. No Immediate Market Distortion: Initially, the market operates as it would without government intervention, with quantities supplied and demanded remaining at equilibrium levels.
b. Potential for Future Market Imbalance: While there is no immediate effect, the presence of a price floor at this level can lead to future imbalances. If market conditions change (e.g., demand decreases), the price floor can prevent the price from adjusting to a new equilibrium, potentially leading to excess supply.
Conclusion
In both scenarios where the price floor is set below or at the equilibrium price, the immediate impact on the market is minimal. The market continues to function at or near the equilibrium levels of price and quantity. However, setting a price floor at the equilibrium level can lead to future market imbalances if market conditions change. It is when the price floor is set above the equilibrium price that significant market distortions, such as surpluses, typically occur.
What will be the consequences of setting up a price floor above the equilibrium price?
Expert Answer
Consequences of Setting a Price Floor Above the Equilibrium Price
A price floor set above the equilibrium price can lead to several significant market distortions and economic inefficiencies. This intervention typically aims to protect producers by ensuring that prices do not fall below a certain level, but it can have unintended consequences.
1. Creation of Surplus
The most immediate effect of a price floor set above the equilibrium price is the creation of a surplus in the market. At this artificially high price, the quantity supplied by producers exceeds the quantity demanded by consumers. Producers are willing to supply more because the higher price increases potential profits, but consumers are less willing to buy the product at this inflated price, leading to excess supply.
2. Inefficiency in Resource Allocation
The surplus created by the price floor indicates an inefficient allocation of resources. Resources that could be used more efficiently elsewhere in the economy are instead tied up in producing goods that are not in demand. This inefficiency can lead to a deadweight loss in the economy, where the total surplus (consumer and producer surplus) is reduced compared to the equilibrium condition.
3. Burden on Consumers
A price floor above equilibrium raises the price of the commodity for consumers. This can be particularly burdensome for lower-income consumers if the commodity is a necessity. The higher price may force consumers to either reduce consumption or reallocate spending from other goods, potentially affecting their overall welfare.
4. Government Intervention to Manage Surplus
Governments may have to intervene to manage the surplus created by the price floor. This can involve purchasing the excess supply or subsidizing producers, which can be costly and lead to increased government expenditure. These costs are ultimately borne by taxpayers.
Conclusion
Setting a price floor above the equilibrium price can lead to market inefficiencies, including surplus creation, inefficient resource allocation, increased consumer prices, and the need for costly government intervention. While intended to benefit producers, such measures can have broader negative implications for the economy and consumers.
For equilibrium, a producer may attempt maximization of output subject to a given cost or alternatively, he may seek to minimize cost subject to a given level of output. Do you agree? Discuss.
Expert Answer
Equilibrium in Production: Output Maximization and Cost Minimization
In economic theory, a producer's equilibrium can be achieved through two primary approaches: maximizing output for a given cost or minimizing cost for a given level of output. Both strategies aim to optimize efficiency and profitability.
1. Maximization of Output Subject to a Given Cost
Producers often seek to maximize their output while keeping their costs constant. This approach is particularly relevant in competitive markets where firms strive to increase their market share and scale of production.
a. Efficient Utilization of Resources: By maximizing output for a given cost, producers ensure that all resources are utilized efficiently. This involves optimizing production processes and eliminating wastage.
b. Economies of Scale: Increasing output while controlling costs can lead to economies of scale, where the average cost of production decreases as the quantity of output increases.
c. Competitive Advantage: Maximizing output can provide a competitive advantage, especially in markets where price competition is intense. Higher output levels can lead to lower per-unit costs and the ability to offer competitive pricing.
2. Minimization of Cost Subject to a Given Level of Output
Alternatively, producers may focus on minimizing costs for a specific level of output. This approach is crucial for maintaining profitability, especially when market prices are fixed or demand is inelastic.
a. Cost Efficiency: Minimizing costs for a given output level involves identifying the most cost-effective combination of inputs. This includes negotiating better terms with suppliers, investing in more efficient technology, and optimizing labor use.
b. Profit Maximization: By reducing the costs of production, firms can maximize their profits, even if the selling price or output level remains unchanged.
c. Flexibility in Pricing: Lower production costs provide more flexibility in pricing strategies. Firms can either reduce prices to increase market share or maintain prices to enjoy higher profit margins.
3. The Role of Production Function
The production function plays a crucial role in both strategies. It defines the relationship between inputs and outputs, helping producers understand how changes in input levels affect output. The production function can guide decisions on whether to focus on output maximization or cost minimization.
Conclusion
In conclusion, for equilibrium, producers can either maximize output for a given cost or minimize cost for a given level of output. Both strategies are aimed at optimizing efficiency and profitability. The choice between these two approaches depends on market conditions, the nature of the product, and the firm's objectives. While maximizing output is beneficial in gaining market share and achieving economies of scale, minimizing costs is crucial for maintaining profitability and competitive pricing. The optimal approach varies based on the specific circumstances and goals of the producer.
Why does the marginal rate of technical substitution (MRTS) decline as we move rightward and downward along a convex-shaped isoquant?
Expert Answer
Declining Marginal Rate of Technical Substitution (MRTS) Along a Convex Isoquant
The Marginal Rate of Technical Substitution (MRTS) is the rate at which one input can be substituted for another while keeping the output constant. In the context of a convex-shaped isoquant, the MRTS declines as we move rightward and downward along the curve.
Diminishing Marginal Productivity: The fundamental reason for the declining MRTS is the law of diminishing marginal productivity. As more of one input (say, labor) is used while reducing the other input (say, capital), the additional output produced by each additional unit of labor begins to decrease.
Substitutability of Inputs: Initially, when a large amount of capital and a small amount of labor are used, a small reduction in capital can be compensated with a small increase in labor with little loss in productivity. However, as we continue to substitute labor for capital, each additional unit of labor becomes less effective because the proportion of capital to labor becomes increasingly smaller.
Convex Shape of Isoquant: The convex shape of the isoquant reflects the decreasing substitutability of inputs. It indicates that as the proportion of one input increases, it becomes increasingly difficult to replace the other input without losing productivity.
In summary, the declining MRTS along a convex-shaped isoquant is a result of the diminishing marginal productivity of inputs and the decreasing ease of substitutability between these inputs as their relative proportions change.
The concept of consumer’s surplus is derived from the law of diminishing marginal utility. Discuss.
Expert Answer
Consumer's Surplus and the Law of Diminishing Marginal Utility
Consumer's surplus is a concept closely related to the law of diminishing marginal utility. This economic principle states that as a consumer consumes more units of a good or service, the additional satisfaction (marginal utility) derived from each successive unit decreases.
Basis in Marginal Utility: Consumer's surplus is the difference between the total amount that consumers are willing and able to pay for a good or service and the total amount they actually pay. It is derived from the law of diminishing marginal utility because it is the diminishing satisfaction that leads consumers to value each additional unit of a good or service less than the previous one.
Willingness to Pay: Initially, a consumer may be willing to pay a high price for a good due to high utility derived from the first units. As consumption increases, their willingness to pay decreases, aligning with the law of diminishing marginal utility.
Calculation of Surplus: The consumer's surplus is represented graphically by the area under the demand curve and above the market price. It quantifies the benefit to consumers in monetary terms, arising because they pay less for each unit than what they would have been willing to pay, based on their initial utility assessment.
In summary, consumer's surplus is inherently linked to the law of diminishing marginal utility, as it is the decreasing marginal utility that underpins a consumer's decreasing willingness to pay for additional units of a good or service.
What is meant by Arbitrage?
Expert Answer
Arbitrage: Definition and Explanation
Arbitrage is a financial strategy that involves simultaneously buying and selling the same asset or closely related assets in different markets to exploit price differences for profit. The core idea of arbitrage is to take advantage of market inefficiencies, where the same asset is priced differently in separate markets.
Price Discrepancies: Arbitrageurs identify assets that are undervalued in one market and overvalued in another. They buy the asset where it is cheaper and sell it where it is more expensive, capitalizing on the price discrepancy.
Risk-Free Profit: Ideally, arbitrage is considered a risk-free operation, as the transactions are made simultaneously. The profit is the difference between the buying and selling prices, minus transaction costs.
Market Efficiency: Arbitrage plays a crucial role in financial markets by promoting market efficiency. As arbitrageurs exploit price discrepancies, their actions help to align prices across different markets, reducing or eliminating the price differentials.
Arbitrage is commonly used in currency exchange, securities, commodities, and other financial markets. Advanced technology and high-speed trading systems have made arbitrage more competitive, often requiring sophisticated algorithms to identify profitable opportunities quickly.
Draw an income consumption curve in case the good marked on the horizontal axis is a necessity good while that marked on the vertical axis is a superior good.
Expert Answer
In a graph where the horizontal axis represents a necessity good and the vertical axis a superior (or luxury) good, the income consumption curve (ICC) would typically slope upwards from left to right, illustrating how consumption patterns change with increasing income.
Necessity Good (Horizontal Axis): As income increases, the quantity of the necessity good consumed increases, but at a decreasing rate. This is because once a sufficient quantity is reached, additional income is less likely to be spent on this good.
Superior Good (Vertical Axis): For the superior good, as income increases, consumption of this good increases at an increasing rate. This is because superior goods are more desirable and consumers spend a larger proportion of their additional income on these goods.
Thus, the ICC would start from a lower left position (low consumption of both goods) and curve upwards to the right, reflecting a higher increase in consumption of the superior good compared to the necessity good with increasing income.
Who does bear the tax burden when the demand is perfectly elastic and supply is of normal shape?
Expert Answer
In a market scenario where demand is perfectly elastic and supply has a normal (upward-sloping) shape, the tax burden falls predominantly, if not entirely, on the suppliers.
Perfectly Elastic Demand: When demand is perfectly elastic, consumers are highly sensitive to price changes. A perfectly elastic demand curve is horizontal, indicating that consumers will only buy a certain quantity at one price and no quantity at any higher price.
Normal Supply Curve: A normal supply curve slopes upward, indicating that suppliers are willing to offer more goods for sale as prices rise.
Tax Burden on Suppliers: In this scenario, if a tax is imposed, suppliers cannot pass any of the tax burden onto consumers in the form of higher prices because consumers would cease to purchase the product altogether (due to the perfectly elastic demand). Therefore, suppliers have to bear the full burden of the tax, absorbing it in the form of reduced profits or increased costs.
