Inflation and Price Essay

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Evaluation Points:

PED & Revenue
Price cuts are revenue increasing for elastic goods
I Warning 1. To meet the increased demand you must increase production. If marginal cost is increasing then you may end up decreasing profits
I Warning 2. We assume that there is no reaction to your price cut from rival firms

Price Increase Price Decrease
Elastic Demand TR falls TR increases
Inelastic Demand TR increases TR falls
Unitary Demand TR Unchanged TR Unchanged
Income elasticity can be positive or negative
I Positive for normal goods
I Negative for inferior goods
I Luxury goods are income elastic
I Necessities are income inelastic

I Cross price elasticity can be positive or negative
I Positive for substitutes goods
I Negative for complements goods
I Close substitutes will be cross price elastic
I Far substitutes will be cross price inelastic

Mid point method
PED =
(Q2 - Q1)/(Q1 + Q2)/2
(P2 - P1)/(P1 + P2)/2
Marginal cost is key to output decisions
I AC = TC/Q
I MC = 4 TC/4 Q
I Average revenue is P_Q
Q
I Marginal revenue is 4 TR/4 Q

Barriers to entry maintain the monopoly
I Natural monopoly
I Economies of scale
I Product differentiation
I Control of supply chain
I Legal restrictions
I Mergers

Mark Up
The price mark up above MC depends on demand elasticity
P =MC/1+ (1/ed )

P – MC/P = -1/ed
I The more inelastic, the higher mark up
I Monopolist can raise price without losing too many customers I Recall if a competitive firm tries this it loses the whole market! Injections ‘J’ add to national income
I Investment ‘I’
I Government Spending ‘G’
I Exports ‘X’
I J = I + G + X

Withdrawals ‘W’ decrease national income
I Saving ‘S’
I Taxation ‘T’
I Imports ‘M’
I W = S + T + M

Aggregate Demand is sum of all the demand in the economy
I AD is the total amount spend on goods in the economy
I AD = C + J
I AD = C + G + I + [X M]

I Multiplier = 1/MPS = 1/1-MPC

Interest Rates: increase in P, increase Demand, Increase interest rate, increase S, decrease AD

Real Balance: increase P, increase S, Decrease AD

Trade Balance: increase P, decrease X, increase M, decrease AD

A Bank’s balance sheet is driven by trade-off profitability and
Liquidity

I Total Assets (loans) = Total Liabilities (deposits)
I LR = liquid assets/total assets
I Legal requirement to satisfy the liquidity ratio

What causes the money supply to shift?
I Banks reduce liquidity ratio
I Non-bank private sector chooses to hold less cash
I Public-sector deficit
I Inflow of funds from abroad

Equilibrium is achieved through changes in the interest rate
If Ms > Md = increase bonds
Increase in Pbonds decrease in r%
Fall in r% until Ms = Md

An increase in Ms increase in AD
I The Exchange Rate e transmission mechanism
Increase Ms decrease r% decrease e increase X& decrease M RISE IN AD
Increase Ms increase Demand for fixed assets decrease e increase X& decrease M RISE IN AD

Cost push inflation
Rising costs independent of demand
I Contraction of output (and employment) in response to higher costs
I Import price shocks
I Especially oil, cereal and metal shocks
I Uncompetitive labour, unions
I Inflationary Expectations

Aim to boost AS over the long run
I Investment in infrastructure & education
I Incentives for innovation e.g. patents, tax breaks on R&D
I Labour supply growth

Demand pull inflation
The AD-AS framework makes for clearer marginal analysis
I Inflation caused by increases in AD so long as AS is upward sloping
I This may be through monetary expansion (see L13)
I But may also be caused increases in C, I, G or X
I Clear output-inflation trade-off

In the Cournot model of oligopoly…?
B) Firms simultaneously choose output levels according to the output they think their competitor will produce.

The demand for money refers to...?
A) The proportion of your
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