(a) Examine the role of price elasticity of demand in determining the price set by a discriminating monopolist. (10 marks) (b)…

(a) Price elasticity and the pricing of a discriminating monopolist

A monopolist practising third-degree discrimination splits buyers into separate markets and maximises profit by equating marginal revenue in each market with the common marginal cost: MR₁ = MR₂ = MC. Since MR = P(1 − 1/|e|), the rule becomes P₁(1 − 1/|e₁|) = P₂(1 − 1/|e₂|) = MC.

So price is inversely related to elasticity. In the market with less elastic demand, buyers respond little to a higher price, so the monopolist charges more; in the market with more elastic demand, a lower price is set to raise sales. The price is also always set where demand is elastic (|e| > 1), since MC is positive. Elasticity thus decides both whether discrimination is profitable and how prices differ. If the elasticities in the two markets are equal, the prices are equal and discrimination gains nothing. The same responsiveness logic guides peak and off-peak tariffs and group fares.

(b) Backward-bending supply curve of labour

A worker divides a fixed time endowment between work, which earns income, and leisure. A higher wage has two opposite effects on hours worked.

• Substitution effect: leisure becomes costlier, so the worker substitutes work for leisure and supplies more labour.
• Income effect: a higher wage raises real income, and if leisure is a normal good the worker buys more of it, so works less.

At low wages the substitution effect is stronger, so the supply curve slopes upward. At high wages, where income is already comfortable, the income effect dominates, and the worker chooses more leisure, so the supply curve bends backward beyond a critical wage. In indifference-curve terms, the wage line (budget line) pivots, and the tangency with the indifference curve first moves towards more work and then towards more leisure. The shape is seen among highly paid professionals who reduce hours, though it is less common among low-wage workers.

(c) Major differences between classical and Keynesian macroeconomics

• Output and employment: classical economists held that full employment is normal and supply creates its own demand (Say's law); Keynes held that output and employment depend on effective demand, which can fall short of full employment.
• Wages and prices: classical wages and prices are flexible and clear markets; Keynes saw nominal wages as rigid downward, so unemployment persists.
• Saving and investment: the classical interest rate equalises them; Keynes said they are equalised through changes in income, and investment depends on the marginal efficiency of capital and the interest rate.
• Money: the classical view is that money is neutral and only affects the price level; Keynes gave money real effects through the interest rate and liquidity preference.
• Time and policy: the classical view is long run with laissez-faire; Keynes stressed the short run, involuntary unemployment and active fiscal policy.

(d) Internal rate of return in investment theory

The internal rate of return (IRR) is the discount rate that equates the present value of the expected net returns from a project with its cost, that is, the rate at which NPV is zero: Σ Rₜ / (1 + r)ᵗ = C. It is close to Keynes's marginal efficiency of capital.

Importance: a project is accepted if its IRR exceeds the cost of capital or market interest rate, and rejected if it is lower; projects can be ranked by IRR. Summed over projects, it gives the investment demand schedule, showing that investment rises as the interest rate falls.

Limitations: it assumes reinvestment at the IRR, can give multiple values when cash flows change sign, and may rank mutually exclusive projects differently from NPV, particularly when scale or timing differs.

(e) Why open market operations cannot control both availability and cost of credit

Open market operations (OMOs) are the central bank's purchases or sales of government securities. A purchase raises bank reserves, which expands credit availability, and raises bond prices, which lowers yields and the cost of credit.

But the central bank cannot fix both together. If it targets the quantity of reserves, the interest rate must move freely to clear the market and may swing widely. If it targets the interest rate, it must supply whatever reserves the market demands at that rate and gives up control of quantity. So quantity and price targets conflict, as money demand is given.

Other reasons: OMOs change government bond yields but only weakly affect bank lending rates; banks with surplus reserves or low loan demand do not expand credit; and expectations of inflation can offset the fall in interest rates. In a liquidity trap, added reserves do not reduce the rate further.