Price Mechanism and Its Applications (Elasticity) Flashcards
Define PED. How is it calculated? Interpret its sign and magnitude. Explain the factors that affect PED.
Define price elasticity of demand (PED) as the measure of the responsiveness of quantity demanded of a good to a change in its price, ceteris paribus.
PED = %change in quantity demanded / %change in price of good itself
PED value is always negative due to the Law of Demand – when price increases, quantity demanded will fall. PED>1 – price elastic demand. PED<1 – price inelastic in demand.
Determinants of PED:
1) Number and closeness of substitutes
Explanation: Goods with a large number of substitutes would tend to have a more price elastic demand as any increase in price will lead to consumers switching over to the substitutes thus reducing the quantity demanded by a more than proportional amount. (The number of substitutes thus is determined by the way the market is defined – chocolate from Cadbury vs Chocolate) Example: Chocolate from a retailer e.g. Cadbury may have many substitutes e.g. Royce, Hershey’s in the market which consumers can turn towards. However, rice as a diet of Asian communities may be seen as a good with little substitutes and therefore faces a price inelastic demand curve.
2) Proportion of income spent on the good
Explanation: The higher the proportion of income spent on a good, the more people will be forced to reduce their consumption when the price increases. This is because small increases in the price will take up more of the consumer’s available income. Hence demand is more price elastic if the consumers spend a large proportion of his total expenditure on it. However, if only a small proportion of income is spent on the good, consumers tend to be less price sensitive to any price changes. Example: Demand for cars is relatively price elastic as the price of a car constitutes a significant proportion of a household’s income. If the price of a car is $100,000, a 10% rise in price would mean a hefty extra expenditure of $10,000. Compared to a box of staples which cost $1.50; a 10% rise in price would simply mean an insignificant 15 cents increase in cost – thus demand is usually price inelastic.
3) Habitual consumption of the good
Explanation: If a good is purchased or consumed habitually, it is more likely that the consumers will be less sensitive to price changes; and thus demand is price inelastic. However, for goods consumed on a less consistent basis, where consumption is optional; then the demand is likely to be more price elastic. Example: The demand for rice in many Asian societies is relatively price inelastic compared to other Western countries because rice is a staple food in Asian societies and consumed as part of their daily meals.
A special case of habitual consumption relates to a consumer’s addiction to a particular good. The greater the degree of addiction to a substance (alcohol, cigarettes and drugs), the more price inelastic is the demand. However, for chocolates, it is more likely to be consumed on a less consistent basis and therefore likely to be more price elastic in demand.
4) Time horizon
Explanation: When the price of a good rises, consumers will take time to respond to the price change, adjust their consumption pattern and find alternatives. Time is required to develop or discover substitutes. The longer the time period, the more likely consumers can switch to other substitutes and hence demand will be more price elastic. Example: For example, if there is an increase in the price of heating oil, ceteris paribus, consumers can do little to switch to other forms of heating in a short period of time. Thus, demand for heating oil tends to be price inelastic over short time periods. As time goes by, they are able to switch to other heating systems, such as gas, or they can install better insulation, and demand for heating oil becomes more price elastic.
Try to choose examples or provide explanations that are not controversial. If they are controversial, provide a context. For instance, most students argue that rice has no close substitutes but some argue that rice has many close substitutes like noodles, wheat and so on. Examples should be contextualized to minimize controversy, such as rice to the Asian consumers is deemed to have no close substitutes.
Provide details when explaining why a good is price elastic or price inelastic in demand, rather than merely asserting them as statements of facts. Can include details like why are they considered substitutes (e.g. the different brands of chocolates satisfy the same want as the different brands are similar in taste, except that some brands of chocolates have more cocoa and/or sugar than others and they are consumed as a snack for those who want something sweet)
Define YED. How is it calculated? Interpret its sign and magnitude. Explain the factors that affect YED.
Income elasticity of demand (YED) refers to the measure of the responsiveness of quantity demanded of a good to a change in income, ceteris paribus.
YED = %change in quantity demanded / %change in income
Negative YED - inferior good; the demand for the good is negatively related to income and an increase in income decreases the quantity demanded for the good and are often replaced by better quality or more expensive goods as consumers become more affluent. A rise in income will lead to a decrease in demand, ceteris paribus.
Positive YED - normal good including necessities (0 to 1); the demand for the good is positively related to income and an increase in income increases the demand for the good as the purchasing power of consumers increases and they increase the demand for normal goods. A rise in income will lead to a less than proportionate increase in demand for necessities and a more than proportionate increase in demand for luxury goods, ceteris paribus.
Determinants of YED include 1) Nature of the good and 2) Degree of necessity. The more basic an item is in the consumption pattern of households, the lower its YED value. This then depends on the level of income of the consumer base and the different states of economic development.
Define CED. How is it calculated? Interpret its sign and magnitude. Explain the factors that affect CED.
Cross elasticity of demand (CED) refers to the measure of the responsiveness of quantity demanded of a good to a change in the price of a related good, ceteris paribus.
CED = %change in quantity demanded of good A / %change in price of good B
If CED is positive, the two goods are substitutes as an increase in the price of good B will lead to an increase in demand for good A. (Large value = strong substitutes)
If CED is negative, the two goods are complements as an increase in the price of good B will lead to a fall in the demand for good A. (Large value = strong complements)
Determinants of CED between the two goods are the 1) relationship between the two goods that determines the sign of the coefficient and the 2) closeness of the relationship which determines the magnitude of the absolute value of the CED.
CED is useful as it determines non-price strategies the cruise operators can undertake in response to changes in price of substitutes and complements to increase TR. For example, for Carnival if the price of a rival competitor like Royal Caribbean falls, its demand is likely to fall more than proportionately, ceteris paribus since they are strong substitutes (perform similar function of providing cruise services). Hence, it can lower is price to make its services more competitive and reduce the fall in demand, Alternatively, it can also find ways to differentiate itself and reduce substitutability, such as offering novel services (roller coasters) and digital transformation to be less susceptible to price changes by rivals and even help increase its TR and recover from COVID-19.
Define PES. How is it calculated? Interpret its sign and magnitude. Explain the factors that affect PES.
Define price elasticity of supply (PES) as the measure of the responsiveness of the quantity supplied of a good to a change in its price, ceteris paribus. PES is normally positive in value due to the Law of Supply – when price increases, quantity supplied will rise. PES>1 – price elastic supply (responsive sellers to change
in price), 0
Level of stocks/inventories; ease of storing the stocks
Availability of spare capacity (stock of raw materials and physical spare capacity, capacity not saturated, can increase production in response to a rise in price)
Mobility of FOPs (ease and speed at which FOPs can move from one industry to another)
Time horizon (In the momentary period, supply perfectly price inelastic as all FOPs are fixed and it is impossible for the firm to change output immediately)
Length of production (agriculture, long gestation periods, housing and property)
Explain how the concepts of PED can be applied to producer/firm decision and government decision-making
When there are price changes resulting from changes in supply, the extent to which price and quantity change depends on PED.
Price inelastic demand - higher price needed to eliminate shortage as a rise in price leads to a less than proportionate fall in quantity demanded
Price elastic demand - consumers are responsive to price changes and prices do not have to rise by much in order to reduce the quantity demanded
PED is also relevant in examining the impact of changes in price on the total revenue earned by firms
This means that firms can raise prices of goods with price inelastic demand and lower the price of goods with price elastic demand
Price inelastic demand - rise in price will lead to an increase in revenue as rise in price will lead to a less than proportionate decrease in quantity demanded and the gain in revenue due to the rise in price is more than the loss in revenue resulting from the decrease in quantity demanded. Coupled with the fact that TC is likely to fall, the final revenue is greater than the initial revenue. (similar argument for price elastic demand except when Qdd increases, TC will likely increase. Hence, it is uncommon for firms to lower prices for goods with price elastic demand to increase profits as profits will likely fall instead.)
They can make the demand of its products more price inelastic by engaging in business strategies to reduce the substitutability of their products through advertising to create perceived differences or R&D around product development to improve the quality of their product and reduce its substitutability, allowing them to raise prices and increase profits (explain less than proportionate decrease in Qdd etc)
Explain how the concepts of CED can be applied to producer/firm decision, government decision-making and consumer decisions
Firms use CED to decide on their price and non-price strategies. When a firm’s has a product that has a high positive CED value in relation to its rivals product, a fall in the price of it’s rivals goods will result in a large decrease in the quantity demanded for the firm’s product and the firm will have to respond with price and non-price strategies to reduce its loss in revenue.
Pricing strategies include lowering the price of its good to prevent a huge loss of existing and potential customers. Non-price strategies include reducing the CED between its products and the firm’s products by making its good less substitutable through advertising, adding different features, better customer service and membership schemes to improve brand loyalty among its customers.
However, when the firm has a product has a high negative CED value in relation to its rival product, when the price of its rival’s product falls, there would be a large increase in demand for the firm’s product and the firm can plan for this by increasing production of the good or releasing inventory/stocks. It can also collaborate with the rival firm and package their goods together/do joint promotions.
Explain how the concepts of YED can be applied to producer/firm decision, government policy making and consumer decisions
When the economy experiences economic growth and incomes rise, the firm would stand to benefit from a higher demand for normal goods and more so for luxuries than for necessities. Hence, the firm may channel more resources into developing better quality and highly desirable product with YED>1 to increase total revenue and hence profits, ceteris paribus.
When the economy is going through a recession and incomes fall, the demand for normal goods will fall and the demand for inferior goods will rise. Firms may channel resources from the production of luxury goods to the production of normal goods to minimize the fall in demand for their products and promote their inferior goods to capture a larger share of the rise in demand for inferior goods.
Firms can also use differences in YED across differnt consumer bases to segment the markets and produce the appropriate range of porducts to suit the consumer bases. For instance, supermarkets which cater to different income groups may carry different goods with different degrees of luxury at different locations.
Firms may also do so across different developed and developing countries in the markets for computers and laptops etc.
YED is useful as it helps cruise operators make decisions about patterns of production in the aftermath of COVID-10 to maximize Total Revenue (TR) and hence profits. From Extract 4, the “global economy is projected to grow 5.5 percent in 2021 and 4.27& in 2022” indicating a rise in incomes. Hence, cruise operators can channel resources into the production of luxury services with YED > 1 like “spacious suites” and “sophisticated dining experiences”. Since cruises themselves are luxury goods with YED >1, they can also offer more trips and routes. These increases in income after COVID-19 will lead S0D1D0W1W0WagesQty of jobsQ1Q0 to a more than proportionate increase in demand for such luxuries, leading to an increase in revenue and consequently profits, allowing cruise operators to recover from the pandemic.
Explain the limitations of the various elasticities of demand and supply
Computational issues
Issues with prediction
Cost concerns
Ceteris paribus paribus assumptions
Analyse and evaluate the impact of indirect taxes on the free market. - Incidence of indirect taxes (Tax burden)
Taxes are compulsory payments to the government and are used by the government for various reasons, including to raise government revenue and to resolve market failure.
Specific tax will shift the supply curve vertically upwards by the amount of the tax since the amount of tax is the same at all prices, the supply curve shifts parallel upwards. However, an ad valorem tax or percentage tax is a tax pegged at a certain percentage of the price of the good. As price increases, the amount of tax paid rises and this results in an upward pivotal shift of the supply curve.
Indirect taxes are taxes on goods and services and are paid to the tax authorities indirectly by the suppliers of the goods and services. When an indirect tax is imposed, the COP for firms increases, leading to a leftward and upward shift of the supply curve by the amount of the tax. (If a question does not specify, assume that it is an indirect tax.)
However, the eqm price does not rise by the full amount of the per unit tax. The incidence of the tax is shared between producers and consumers. The consumers’ incidence of the tax is reflected by the extent of the increase in price from P0 to P1. The producer’s incidence of the tax is reflected by the amount by which the rise in price is insufficient to cover the tax which is P0 to Ps. This incidence will depend on the relative values of PED to PES of the good.
(Using graphs to explain the following, include the tax incidence, tax amount, total burden on consumers and buyer using the area on the graph)
When demand is relatively more price inelastic than supply, buyers are less responsive to changes in the price of the good compared to sellers. They cannot reduce Qdd readily in response to higher prices, they are less able to avoid paying the higher prices that sellers pass onto them. Therefore, buyers bear a greater burden of the tax.
When demand is relatively more price elastic than supply, sellers are less responsive to changes in the price of the good compared to buyers. They cannot increase Qss readily in response to higher prices, they are less able to avoid paying the higher prices that sellers pass onto them. Therefore, buyers bear a greater burden of the tax.
Analyse and evaluate the impact of indirect subsidies on the free market. - Incidence of indirect subsidies (Subsidy benefit)
Subsidies are cash transfers from the government to the producer or consumer and can be used by the government to resolve market failure or respond to equity.
The specific subsidy will shift the supply curve vertically downwards by the amount of the tax since the amount of subsidy is the same at all prices, the supply curve shifts parallel downwards. However, an ad valorem subsidy is pegged at a certain percentage of the price of the good. As price increases, the subsidy granted rises and this results in a downward pivotal shift of the supply curve.
However, the eqm price does not fall by the full amount of the per unit subsidy. The incidence of a subsidy is the distribution of the share of the subsidy between sellers and buyers and depends on the relative values of PED to PES. When demand is relatively more price inelastic than supply, buyers are less responsive to changes in the price of the good compared to sellers. Therefore, buyers enjoy a greater subsidy incidence. When supply is relatively more price inelastic than demand, sellers are less responsive to changes in the price of the good compared to buyers. Therefore, sellers enjoy a greater subsidy incidence.
Direct subsidies are granted by the tax authorities directly to the economic agent with the income/wealth and can be given in the form of cash grants which increase household’s willingness and ability to consume goods and services and leads to a rightward shift of the demand curve, creating positive welfare effects as it raises their ability to purchase goods and services.
Analyse and evaluate the impact of Price Controls (Price Ceiling and Price Floor) on the free market.
Price controls refer to the setting of minimum or maximum prices by the government so that prices are unable to adjust to their free market eqm determined by market demand and supply and is aimed to achieve price stability and equity. However, an unintended consequence is that price controls result in market disequilibrium and therefore results in shortages and surpluses.
(Pg 66 of notes) Price Floor: Minimum price that is legally established to prevent prices from falling below a certain level and is set above the market eqm price. It is often set to protect producers’ incomes especially when prices are volatile, create a surplus that can be stored in preparation for future shortages, prevent wages from falling below a certain level in the labour market to promote income equality. The setting of a minimum price results in market disequilibrium as it leads to a surplus, impacting the welfare of consumers. producers and society as a whole.
(Pg 67 of notes)Price Ceiling: Maximum price that is legally established to prevent prices from rising above a certain level and is set below the market eqm price. Producers are prohibited from selling above the stipulated price. With the aim of achieving some sort of equity, this has kept prices from rising and ensuring that essential food items can be affordable to the people. The setting of a maximum price results in market disequilibrium as it leads to a shortage, impacting the welfare of consumers, producers and society as a whole. Enforcement must be strict and penalties harsh so that sellers will think twice before flouting the rule and stick to the price set by the government.
Intermediate evaluation: Maximum Price is effective in reducing prices but not desirable* because other problems are created (reducing prices is achieved at the expense of a DWL). It is also allocatively inefficient as it creates a shortage where there is an under-allocation of resources to the production of the good result in deadweight loss. Consumer surplus changes from Area A+B to Area A+C. There is a change in consumer surplusof Area -B+C because the price consumers have to pay fell from P0 to Pmax but the quantity of food consumed decreased from Q0 to Qs (since only Qs will be produced). More intuitively, those consumers who are able to obtain food at Pmax tend to benefit from the price ceiling, but PBM
consumers as a whole tend to suffer because of the fall in quantity of food available from Q0 to Qs. Producer surplus falls from Area C+D+E to Area E. There is a loss in producer surplus of Area C+D because the price producers receive fell, and the quantity of agriculture sold decreased from Q0to Qs. There is a change in society’s welfare = change in consumer surplus (Area -B+C) + change in producer surplus [-(Area C+D)]. There is an overall loss of society’s welfare of Area B+D. This constitutes a deadweight loss to society.
A maximum price should instead be used only as a last resort, with clear systems on how to ration the limited resources to consumers who need them the most. Conclusion: The most effective policy in addressing the issue of affordability depends on the main factors contributing to the issue in the country. These could either supply factors such as rising global prices due to supply shocks, or demand factors such as income levels that are not keeping pace. The effectiveness of a policy is also heavily dependent on the resources that the government has, and its relative priorities. Globally, there are limited policies that individual countries can do to address supply shocks from natural disasters and pandemics such as Covid-19. In the longer run however, agricultural-based countries can focus on research and development to improve the productivity of production and crop efficiency. This can reduce the impact of the growing global population on the prices of necessities such as food. consumers as a whole tend to suffer because of the fall in the quantity of food available from Q0 to Qs. A maximum price should instead be used only as a last resort, with clear systems on how to ration the limited resources to consumers who need them the most.
What is a black market and how does it form?
The effectiveness of maximum price is limited as the enforcement of the price ceiling determines effectiveness. With the implementation of the price ceiling, Qty demanded is now greater than Qty supplied and a shortage will occur within the market. This shortage will create upward pressure on prices. Should enforcement by government be insufficient (officers need to monitor prices set by retailers) or not severe enough (not punitive enough for firms to fear breaking the law), firms may ignore the government’s price ceiling and sell illegally above the price ceiling in the underground/black market at free market prices, resulting an ineffective policy to reduce price.
Underground market (or black market): The prices of good sold in the black market may be as high as PBM (price that consumers are willing and able to pay at the quantity supplied instead of the maximum price). This worsens the issue of affordability, and instead raises the price from P0 to PBM, thus rendering the price ceiling ineffective. The more price inelastic in demand, the higher the black market price will be.
What does the black market price depend on? What does the size of the shortage depend on?
The prices of goods sold in the black market depend on the maximum prices that consumers are willing and able to pay (on the demand curve, above Pmax, at Pbm). The size of the surplus increases as the minimum price/value of PED/PES increases/when demand increases/supply decreases.)
What can governments do to avoid a black market?
Government can encourage increase in supply through drawing on past surpluses or engage in direct production or given subsidies or tax relief to producers to lower their COP and increase supply. It can also reduce demand by controlling income or producing more alternatives of the good in question, helping to eliminate the shortage while maintain the price at Pmax.
While prices may be lowered with a maximum price, the lack of sufficient food for all consumers may mean that some low-income consumers who truly need the lower prices may not be able to acquire the food. Hence, they may be a need for alternative forms of non-price rationing such as the first-come-first-serve basis, or may require the distribution of limited coupons to interested buyers.
The issue is worsened in countries where the government may not have the resources and stockpiles of essential items such as food to distribute and ease the shortage, increasing the pressure on prices.
What can governments do to the surplus? What does the size of the surplus depend on?
Agriculture products that are non-perishable can be resold or redistributed so that the deadweight loss incurred by society will be significantly smaller. In the best-case scenario where all the stored products can be resold, there might not even be a deadweight loss incurred at all.
The size of the surplus increases as the minimum price/value of PED/PES increases/when demand decreases/supply increases.
