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Price elasticity tells how much of an impact a change in price will have on the
consumers' willingness to buy that item. If the price rises, the law of demand states that
the quantity demanded of that item will decrease. Price elasticity of demand tells you
how much the quantity demanded decreases. Elastic demand means that the
consumers of that good or service are highly sensitive to changes in price. Usually, a
good which is not a necessity or has numerous substitutes has elastic demand. Inelastic
demand means that the consumers of that good are not highly sensitive to price
changes. If the price of an inelastic good, say cigarettes, rises by 10 percent, maybe
sales will only decrease by 1 percent. Consumers will still buy that good, typically
because it is essential or has no substitutes.
When demand is unit elastic, if the price increases by 1%, the quantity demanded
will also decrease by 1%. Total revenue will be unchanged.
MR=MC
Marginal revenue and marginal cost can be used to find the profit-maximizing output
level
Profit rises as output expands for a while, then becomes stand still and then starts to
decline with further increase in output. Profit is maximized where marginal profit is zero.
Any increase or decrease in output from this peak level will cause marginal profit to be
equal to zero. Marginal profit is zero, when marginal revenue equal marginal costs.
Supernormal Profits
When will firms be able to make supernormal profit rather than normal profit?
Normal profit is defined as the minimum level of profit necessary to keep a firm in
that line of business. This level of normal profit enables the firm to pay a reasonable
salary to its workers and managers. The definition of normal profit occurs when Average
Revenue AR=ATC (average total cost)
Supernormal profit is defined as extra profit above that level of normal profit.
Supernormal profit occurs where AR>ATC. Supernormal profit is also known as
abnormal profit. Abnormal profit means there is an incentive for other firms to enter the
industry (if they can)
Perfect Competition.
The theory of perfect competition suggests that supernormal profit can only be earned in
the short term. Perfect Competition involves
Perfect information
Freedom of Entry and exit
Therefore, if a firm is able to make supernormal profits, other firms will be aware of this
fact. Because there is no barriers to entry, firms will be encouraged to enter the market
until price falls. Firms will enter and prices will fall until normal profits are made.
This is why only normal profits will be made in the long run.
However, most markets dont have these features of perfect information and freedom of
entry and exit. Most markets have a degree of barriers to entry and exit. There are sunk
costs which deter entry. Therefore, even if firms are making supernormal profit, new
firms may not be able to enter and compete.