Objective Of Maximising Profits

1.As a producer, why is it important to consider the price elasticity of demand of your product when setting the price you are going to charge?

2.Explain the difference between comparative advantage and absolute advantage.

 

1.A rational producer has an objective of maximising profits.  (Elasticity, TR and MR). This objective is the basis of all decisions that involve what to produce, the output level, the inputs and technology to use and the price to sell at. Within this paradigm a knowledge of the elasticity of the good he sells helps to decide how price change will affect revenues and profits.

Profits are the difference between revenues and costs. Demand elasticity is linked to revenues only, while costs remain unaffected.

It can be shown that the relation between revenues and elasticity is as follows:

Marginal change in revenues (MR)/ marginal change in prices = P *(1- e) where e is demand elasticity if negative sign is ignored.  

Ina mathematical sense we have 2 cases:

Elastic demand : e > , which implies (1-e) is negative. This causes an inverse relation between price change and marginal revenue. A price rise will lead to lower revenues.   

In elastic demand: e < 1whicj implies (1-e) >0. This implies a proportional relation between  price change and marginal revenue. It is beneficial to increase prices as revenues are higher. Whether is implies higher profits or not will deepened on effect on costs. (Imperfect Competition )

Hence, a knowledge of demand elasticity helps the producer to decide how a price change will affect his revenues and consequently his profits. He would like to face an inelastic demand so that a price rise can give him higher revenues.

2.Both concepts are used to explain trade between nations. Ricardo introduced comparative advantage concept as an improvement over absolute advantage. (Comparative advantage)Both theories are based on differences in production ability ( expressed in terms of output produced) which is in turn derived from level of resources and available technology.

A nation is said to have an absolute advantage in good X if it can produce more units of X as compared to another nation Y. This can also be reflected in lower production costs in X as compared to Y.

The concept of comparative advantage is explained in terms of opportunity costs.  (Comparative advantage) Opportunity cost is explained in terms of sacrifices required so that 1 unit of a good can be produced. These sacrifices come in terms of the goods that were ‘foregone’ so that 1 unit of this good can be produced. A nation that foregoes less goods will have comparative advantage in production of the good. This concept is better as it considers efficiency in production as the base for determining advantage in relative terms.

Both concepts are old and newer concepts are better as they account for real world situations. The newer theories of trade go beyond efficiency and consider real life differences across nations to explain trade directions. However at a conceptual level these concepts are sound , and are a good starting point for  explaining causes of trade

References

Comparative advantage. (n.d.). Retrieved July 31, 2017, from Econlib.org: https://www.econlib.org/library/Topics/Details/comparativeadvantage.html

Comparative advantage . (n.d.). Retrieved july 31, 2017, from Economicsonline.co.uk: https://www.economicsonline.co.uk/Global_economics/Comparative_advantage.html

Elasticity, TR and MR. (n.d.). Retrieved july 31, 2017, from Economics.utoronto.ca: https://www.economics.utoronto.ca/jfloyd/modules/eltr.html

IMperfect Competition . (n.d.). Retrieved july 31, 2017, from Colarado.edu: https://www.colorado.edu/Economics/courses/Markusen/fall05-4413-001/unotes7.pdf