Production Possibility Frontier And Total Revenue Test In Microeconomics

Many movie consumers who used to rent DVDs are now patronising online video rentals and streaming services.

What impact would the introduction of online video rentals and streaming have on the instore movie industry? Use the demand and supply diagram to illustrate your answer. Pay attention to how the equilibrium quantity and price adjust.

Which would be more price elastic, the demand for Optus’ online movie rentals or the demand for online movie rentals in general? Explain.

Would the cross-price elasticity of demand for online movie rentals and in-store movie rentals be positive or negative? What does your answer imply for the equilibrium price and quantity of online movie rentals? Use the demand and supply diagram to illustrate your answer.

Assumptions and Properties of Production Possibility Frontier

Figure 1: Production Possibility Frontier for cars and bicycles

The frontier that indicates feasible combinations of two products or services an economy can produce using all the available resources employed in the most efficient way. The production possibility frontier also known as production possibility curve represent the implication off scarcity and opportunity cost in the economy (Mankiw 2014). The primary assumptions involved in production possibility frontier are stated below.

Two goods: The first primary assumption included in PPF is that in the economy, only two goods are produced. The PPF assumes that utilizing all of its resources the economy can produce alternative combinations of two goods.

Resources are fixed: The construction of PPF is based on the assumption that an economy has fixed resources to use in different production process. This in turn implies the economy is able to produce limited quantities of both goods (Varian 2014). The importance of this assumption lies in the fact that this incorporates the idea of scarcity. Given this assumption, any shift in the PPF captures the effect of a change in economic growth arises from a change in resource stocks.

Fixed technology: Technology is the knowledge used in the production process. PPF assumes that level of technology in the economy is fixed (Gillespie 2014). This assumption is equally important as the assumption of fixed resources.

Technical efficiency: The PPF assumes that the economy employs all the resources in an efficient manner. The assumption of technical efficiency implies that there is no wastage of fixed resources in the production and hence, the resources maximizes level of output.

PPF, constructed based on above assumptions have the following properties

Downward sloping: The assumption of fixed resources implies that the economy cannot produce more of something with producing less of some other (Nicholson and Snyder 2014). This in turn signifies increase in production of one good implies decrease in production of other making PPF downward sloping.

Increasing marginal rate of transformation: The marginal rate of transformation refers to the unit of one good that needs to be sacrificed to obtain additional unit of some other. As resources are not perfect substitutes across the industries, shifting away more and more resources from one industry reduces more and more output in some other industry. The marginal rate of transformation along the PPF thus is increasing in nature.

Bowed out from origin: PPF is concave or bowed out from origin because of the nature of increasing opportunity cost.

Meeting Increased Demand for Cars and Bicycles in Newland

Optimal utilization of resources: Any point on the PPF signifies a technologically efficient point (Leamer and Stern 2017). If the economy is operating on the PPF, then more of something cannot be produced without reducing production of other. Point inside the PPF shows inefficient point of production.

In Newland, demand of 3000 bicycles is associated with demand of 18000 cars. Given the production capacity of Newland, this indicates a point on production possibility curve. Increase in production of any one good needs a decline in production of the other.  The demand for cars in Newland increases to 20,000 while the demand for bicycles increases to 4000. With fixed amount of resources, Newland cannot increase production of both cars and bicycles. The expansion of both output with the given resources is not feasible (Moulin 2014). Some of the possible ways to meet the increased demand for cars and bicycles in Newland are discussed below.

First, the economy should seek to find some new resources. The advent of new resources allow the economy to employ more resources to both the industry. Once more resource is used in both industries, there will be a higher output for both.  

Second, the economy should improve the level of technology. New and innovative technology increases productive capacity of resources. This implies now more output can be produced with the given resources (Cowell 2018). Therefore, in order to meet the increased demand of cars and bicycles one way is to innovate or employ a more productive technology.

Third, limited resources of the economy needs to be employed in line with their specialization. Specialization of resources help to increase output.

At price $400, associated quantity demand is 30. The earned revenue at this price therefore is ($400 * 30) = $12000. When price falls to $350, demand increases to 35. The revenue earned at this price therefore increases to ($350*35) = $12250. When price further drops from $350 to $300, then quantity demanded increases to 40. At this price, output combination, revenue declines from $12250 to ($400*30) = $12000.

Total revenue test in economics is a measure to identify whether demand is elastic or inelastic. In case revenue increases with increase in price then demand is inelastic. In contrast, if revenue increases with a decline in price then demand is elastic (Azevedo and Leshno 2016). The table below shows revenue earned at different price-output combination.

Total Revenue Test for Elasticity of Demand

Table 1: Total revenue test

At price $300, total revenue equals $12000. As price falls from $300 to $250 revenue decreases from $12000 to $11250. Revenue on the other hand increases from $12000 to $12250 as price rises from $300 to $350. Revenue thus moves in the same direction of price. Change in price thus dominates the effect of change in quantity demanded. This signifies demand is relatively price inelastic in nature.

The demand function for widgets is

The market equilibrium condition is given as

The equilibrium quantity in the market is obtained as

Similarly, from the supply function, the producer surplus is computed as

If government restricted maximum quantity is 25 units and market price is $15, the consumer surplus, producer surplus, and deadweight loss can be computed as

Now if market price reduces to $5, this alters the consumer surplus, producer surplus and deadweight loss as follows

One important factor demand of a good is the associated demand of related goods (substitutes or complements). In case of in-store movie industry, online movie rentals or online video streaming is a substitute good. An increase in preference of movie consumers for online movie rentals or video streaming indicates that demand in the in-store movie industry has declined (Frank and Cartwright 2013). The decline in demand means a shift of demand curve toward origin, which reduce price and quantity in the in-store movie industry at equilibrium.

The demand and supply curve for in-store movie industry is shown as DD and respectively. As consumers shift their demand to online movie rentals or online streaming videos, demand declines in the in-store movie industry. The movement of demand curve to D₁D₁ depicts the demand contraction. Both price and quantity in the in-store movie industry decline.

Price elasticity of demand for Optus’ online movie rentals has a higher elasticity of demand. The number of substitutes for a good determines its elasticity. For Optus’ movie rental, there are rental companies offering this service. Therefore, small change in price if Optus’ movie rental changes the demand for Optus’ movie rental largely (Stiglitz et al. 2013). The demand elasticity of Optus’ movie rental thus is relatively higher compared to the online rental industry in general. 

Online movie rentals and in-store movie rentals are substitutes. Therefore, cross price elasticity of demand between online movie rentals and in-store movie rental is positive (Mahanty 2014). This means an increase in price of online movie rentals reduce the demand of online movie rental while increases the demand for in-store movie rentals.

Change in the price of in-store movie industry brings a consequent change in demand for online movie rental. Accordingly, there will be a change in equilibrium price and quantity. For a given increase in charge of in-store movie rental reduces the demand for in-store movie rentals and encourages people to demand online movie rentals more (Mochrie 2015). The adjustment of equilibrium price and quantity of online movie rentals is shown in the following figure.

The increase in price of in-store movie rental expands the demand for online movie rentals. This shifts the demand curve right to D₁D_1. The resulted effect is to increase the price and quantity of online movie rentals at equilibrium.

References list 

Azevedo, E.M. and Leshno, J.D., 2016. A supply and demand framework for two-sided matching markets. Journal of Political Economy, 124(5), pp.1235-1268.

Cowell, F., 2018. Microeconomics: principles and analysis. Oxford University Press.

Frank, R. and Cartwright, E., 2013. Microeconomics and behaviour. McGraw Hill.

Gillespie, A., 2014. Foundations of economics. Oxford University Press.

Leamer, E.E. and Stern, R.M., 2017. Quantitative international economics. Routledge.

Mahanty, A.K., 2014. Intermediate microeconomics with applications. Academic Press.

Mankiw, N.G., 2014. Principles of macroeconomics. Cengage Learning.

Mochrie, R., 2015. Intermediate microeconomics. Macmillan International Higher Education.

Moulin, H., 2014. Cooperative microeconomics: a game-theoretic introduction (Vol. 313). Princeton University Press.

Nicholson, W. and Snyder, C., 2014. Intermediate microeconomics and its application. Nelson Education.

Stiglitz, J.E., Walsh, C.E., Gow, J., Guest, R., Richmond, W. and Tani, M., 2013. Principles of economics. John Wiley & Sons.

Varian, H.R., 2014. Intermediate Microeconomics: A Modern Approach: Ninth International Student Edition. WW Norton & Company.