q PRICE ELASTICITY OF DEMAND:

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1 q PRICE ELASTICITY OF DEMAND: Definition of Price Elasticity of Demand m Price elasticity of demand is a measure of the effect of a change in price of a good/service in terms of quantity demanded. It measures the responsiveness of demand to a change in price. Definition: Earlier we discussed how changes in demand can occur as a result of a change in price. Looking at the price elasticity of demand involves looking at the degree to which a change in price can result in a change in demand. It is important that the term price elasticity of demand is understood properly, and should be precisely defined. The responsiveness of quantity demanded to price changes is the price elasticity of demand. Mathematically, it is expressed through the percentage change in quantity demanded, divided by the percentage change in price. If a firm raises its prices, revenue will be affected. However, whether total revenue rises or falls depends on the characteristics of the product and the attitudes of buyers. The word to describe the size of the change in price is elasticity. If the product is elastic, then the total revenue (price X quantity) will shift significantly when the price is changed. Just think of an elastic band - large change. However, if the product is inelastic, then the total revenue shift will be small following a change in price. Content: ELASTIC: Definition of Elastic m Elastic goods are those whereby a change in price will have a greater than proportional change in demand price changes have a significant influence on demand. Definition: A good has elastic demand when there is a strong response of the quantity demanded to a change in price. Elastic demand is sometimes written as relatively elastic demand. A good has relatively elastic demand when the increase in quantity demanded is proportionately greater than the fall in price. EXAMPLES: Luxury goods have an elastic demand. The price of airline tickets are considered elastic because price rises generally lead to more than Creative Classroom 151

2 proportionate decreases in demand. This means that an increase in price will result in considerably less of a fall in consumption of the good/ service. If the good being produced has an elastic demand then to increase revenue the business should lower price. This does not mean that profits will be higher. If the price of the good is increased the total revenue will fall. Diagram: For the INELASTIC: Definition of Inelastic m Inelastic goods are those whereby a change in price will have a less than proportional change in demand price changes do not have a considerable impact on demand. Definition: Conversely, a good is relatively inelastic if there is a less than proportionate change in the quantity demanded to a change in price. A good has inelastic demand if there is a weak response in demand to a change in price. If the good being produced has an inelastic demand then to increase revenue the business should increase the price. This means that profits will be higher. If the price of the good is decreased the total revenue will fall. Diagram: For the 152 Creative Classroom

3 EXAMPLES: Most necessities have an inelastic demand curve. Other examples of goods with inelastic demand include alcohol and cigarettes. These are both considered addictive (to differing extents), and thus any price change is unlikely to have a significant impact on the quantity demanded. This is because people who consume these products crave and demand the goods, and are willing to pay almost any reasonable price to do so. Hence, price increases and taxes (such as the recent alcopops and tobacco taxes) have a minimal impact on demand and increase the tax revenue for the government and higher revenue for firms. UNIT ELASTICITY: Definition of Unit elasticity m Unit elasticity refers to a particular impact of a change in price on demand. m Unit elastic goods are those whereby a change in price will have an equally proportional effect on demand. Definition: A good is unit elastic if there is a proportional change in demand to a change in price. For example, a price increase of 10% will mean demand will fall by 10%. If the price of the good is decreased or increased then the total revenue will remain the same. Unit/unitary elasticity is a theoretical point. Diagram: For the Creative Classroom 153

4 CALCULATIONS FOR ELASTICITY: There are three main methods used to calculate price elasticity, these are the total outlay, point, and arc methods. USING TOTAL OUTLAY METHOD: The total outlay method is the easiest way to calculate elasticity. Total outlay, or total expenditure, is calculated by multiplying the price by the quantity demanded at that price and then comparing revenues at different price levels. Relatively inelastic demand occurs when total outlay moves in the same direction as a price change. (Price up, TR up: Price down, TR down.) Relatively elastic demand occurs when total outlay moves the opposite direction to the price change. (Price up, TR down: Price down, TR up.) If total outlay remains the same despite a price change, then the good is unit elastic. (Price up, TR the same: Price down, TR the same.) Tip: Only the total revenue is identified in the syllabus. Price Quantity Total outlay/ expenditure $20 8 $160 - Elasticity $30 6 $180 Inelastic $40 5 $200 Inelastic $50 4 $200 Unit elasticity $60 3 $180 Elastic Example: A story to remember a specfic issue: ELASTICITY Meet the Price family: Story: there are three brothers, their surnames are Price (standing for prices), One brother is called Indiana Price The second brother is called Edward Price The second brother is called Unicorn Price (a half brother) There is a dance with girls, they symbolise, total price revenue. Meaning: Price standing up or down = price changes - up or down. Indiana Price = Inelastic demand Edward Price = Elastic demand Unicorn Price = Unit demand Girls = total revenue (price x quantity) 154 Creative Classroom

5 Scene 1: Inelastic demand Indiana Price goes to the dance and he stands up. then girls stand up to talk to Indiana. Indiana then sits down, the girls sit down. (total revenue down). Characteristics of Indiana, he is very small guy. Indiana is a chemist. Story: Meaning: Remembering the issues of inelastic demand Indiana Price stands up = The price of a good rises, then the Girls stand up = total revenue (price x quantity) Indiana Price sits down Girls sit down = The price of a good falls, then the = Total revenue falls He is a small guy = The figure for elasticity - less than 1 He is a chemist = Goods that have an inelastic demand are necessities. Indiana, you are a short guy, and all the girls love to be with you. Can we sit down now? Creative Classroom 155

6 Scene 2: Elastic demand Indiana goes home to tell his brother Edward that he should go to the dance. Edward Price then goes to the dance and stands up, sadly, the girls sit down. Edward is a big guy. Edward loves luxury items- he has sports cars and gold chains. Meaning: Remembering the issues of elastic demand Edward Price stands up = The price of a good rises, then the Girls sits down = total revenue falls Edward sits down Girls stand up = The price of a good falls, then the = Total revenue rises. He is a big guy = The figure for elasticity- greater than 1. He loves luxury items = Goods that have an elastic demand are luxuries. Why are the girls sitting down? I am on the dance floor. Eddie, you are a big guy, but the girls would prefer not to be with you. Please sit down so we can stand up. BIG EDDIE IS A LUXURY 156 Creative Classroom

7 Scene 2: Unit elasticity Edward goes home really sad, he tells his half-brother the unicorn that he should go to the dance. Unicorn Price enters the dance room, all the girls are petrified by the pet unicorn. Unicorn Price can stands up or fall to the ground, the girls do not move (Price up or price down, total revenue will remain the same). Unicorn Price yells out that he is Number 1. Tip: Only the total revenue is identified in the syllabus. Meaning: Remembering the issues of unit elasticity demand Unit Price stands up = The price of a good rises (demand is unit elasticity), then the Girls are petrified = total revenue stays the same Unit Price sits down = The price of a good falls, then Girls are petrified = Total revenue stays the same He is Number 1 = The figure for elasticity is equal to 1 The girls don t move even when I stand up or sit down. Girls, don t move, the unicorn is here! Creative Classroom 157

8 g Information overload: Additional details to enhance your extended response answers. USING POINT METHOD: The point method, specifically the midpoint method, uses three rules to determine elasticity. If elasticity of demand is greater than 1, then demand is price elastic. If elasticity is equal to 1, then demand is unit elastic. If elasticity is less than 1, then demand is price inelastic. Value of Elasticity of Demand Elasticity > 1 Elastic 1 Unit Elastic < 1 Inelastic The value of elasticity of demand is calculated by using the following formula: Elasticity = Q /Q P /P Elasticity = (Change in Quantity demanded Quantity demanded) All divided by (Change in Price Price) EXAMPLE: The price of chocolate rose from $3 a block to $5 a block, Consumption fell from 10,000 blocks to 5,000. The price elasticity of chocolate is: Quantity demanded = 10,000; Change in quantity demanded = 5,000; Price = $3; Change in price = $2 Using the formula, and substituting the above figures: Elasticity = (5,000 10,000) (2 3) = Tip: u Only the total revenue is identified in the syllabus. u Tip: Quantity is always on the top of the equation. Story: Remember Queensland is geographically on the top. Q Queensland is always on the top! As this value is less than 1, = 0.75 In this example, chocolate is price inelastic. Remember, Indiana Price is a small guy. g Information overload! If the answer was greater than 1, chocolate would be price elastic. Remember, Edward Price is a big guy. If the answer was equal to 1, chocolate would be price elastic. Remember, Edward Price is a big guy. Ignore this section if you are still coming to grips with the basics. 158 Creative Classroom

9 g Information overload: Additional details to enhance your extended response answers. USING ARC METHOD: Another method of calculating price elasticity is the arc method. The arc method follows the same rules as the point method Elasticity of demand greater than one is price elastic; Elasticity of demand less than one is price inelastic and Elasticity of demand is equal to 1 it is unit elastic. The arc method is more accurate than the point method. The arc method makes use of the following formula: Elasticity = [(Q2 Q1) (Q averaged)] ALL [(P2 P1) (averaged)] Q1 Q2 Q ave P1 P2 P ave = Initial Quantity Demanded = New Quantity Demanded = Average Quantity Demanded = Initial Price = New Price = Average Price EXAMPLE: The price of petrol rose from $1 a litre to $2 a litre and Consumption fell from 100,000 litres to 80,000 litres. Quantity figures: (The figures on the top of the equation) Change in Quantity = 20,000 Q1 = 100,000 Q2 = 80,000 Average Quantity Demanded = 90,000 Price figures: (The figures on the bottom of the equation) Change in Price = $1 P1 = $1 P2 = $2 Average Price = $1.50 Tip: u Only the total revenue is identified in the syllabus. u Tip: Quantity is always on the top of the equation. Story: Remember Queensland is geographically on the top. Q Queensland is always on the top! Using the formula, and substituting the above figures: 20,000 90,000 ALL Divided by ) = -1/3 = 1/3 (absolute values) As this value is less than 1, it can be seen that petrol is price inelastic. Remember, Indiana Price is a small guy. Creative Classroom 159

10 E EXTREME ELASTICITY POINTS: PERFECT ELASTICITY: A horizontal demand curve indicates a perfectly elastic demand. Consumers demand an endless quantity at a certain price, and nothing above this price. This is only theoretical, and very unlikely to occur in the market place. g Information overload! Ignore this section if you are still coming to grips with the basics. PERFECT INELASTICITY: A vertical demand curve indicates a perfectly inelastic demand, where consumers are willing to purchase the product at any price. Diagram: For the Creative approach: ELASTICITY: Key exam points to memorise: There are two extremes with elasticity. One is a vertical line showing perfectly inelasticity (for demand or supply), the other is a horizontal line which represents something that is perfectly elastic. Note: the word perfectly means vertical or horizontal. Under exam conditions you may get them confused. Perfectly inelastic: You must remember this line is vertical, not horizontal or downward sloping. Just remember the I in the word perfectly Inelastic Remember, when drawing perfectly inelasticity curve It looks like the capital letter I! I Perfectly inelastic: Remember, when drawing perfectly elasticity curve It looks like the capital E having a sleep. The word perfectly in front of inelastic or elastic helps you remember it is an extreme situation. Story: 160 Creative Classroom

11 g Information overload: Additional details to enhance your extended response answers. FACTORS AFFECTING ELASTICITY OF DEMAND: 1. TYPE OF PRODUCT - NECESSITIES / LUXURIES: 1. Addictiveness of the good: Goods that can be addictive, such as cigarettes and junk food, can have relatively inelastic demand because most people will purchase the good regardless of price. 2. Need or Want? If the good is a necessity, such as water, then the good will have relatively inelastic demand because people need the good regardless of the price. Conversely, if the good is a luxury, the good will be relatively elastic, because many people will forgo purchasing the good if there is an increase in price. Content: 2. EXISTENCE OF CLOSE SUBSTITUTES: If the good or service has a close substitute then people can easily switch to another good or service if there is an increase in price. Consequently, the good or service will be relatively elastic. 3. PROPORTION OF INCOME SPENT ON THE GOOD: If the good or service takes up a substantial proportion of a person s income, then it will be relatively elastic. For example, a person may forgo purchasing a boat if there is an increase in price, because this increase would take a substantial part of their income. In contrast, an increase in price of a chocolate bar will not lead to a significant decrease in demand, because chocolate bars represent a fairly small proportion of one s income. Content: Content: g Information overload: Additional details to enhance your extended response answers. APPLICATIONS OF CONCEPTS OF ELASTICITY: Price elasticity can have a significant bearing on many different economic decisions, be that of an individual, firm, or government. For example, a business may choose not to raise the price of its products because the demand for the good is relatively elastic, which may result in a considerable loss of revenue. Another example is government taxation. A government may choose to impose a tax on a certain product because it is price inelastic, and thus an increase in price will not cause a significant drop in demand, thus increasing government revenue. g Information overload! Ignore this section if you are still coming to grips with the basics. Creative Classroom 161

12 BUSINESS DECISIONS / PRICE CHANGES: As briefly mentioned earlier, businesses factor price elasticity into the decision-making process, particularly in regards to pricing. A business may decide to raise the price of their good if the demand for that product is inelastic, as such a price rise will not have a significant impact on demand and will result in increased revenue. A firm may also choose to increase the price of its product if the demand is inelastic, as this will cause a less than proportional fall in demand and could positively impact on revenue. In turn, higher revenue is greatly important for firms, as it can lead to expansion, improved profitability, and increased return for investors. Content: BUSINESS DECISIONS / PRICE CHANGES IN OTHER GOODS: Businesses may also account for price changes in other goods. For example, if a competitor increased the price of its products, and demand was elastic, then other businesses may not raise their prices as demand for their goods would rise, while demand would fall for the competitor (which increased its price). Conversely, if a competitor increased the price of an inelastic good, then it is highly likely that other businesses would follow and similarly raise prices because demand would not be significantly affected. Content: GOVERNMENT DECISIONS ABOUT INDIRECT TAXATION: Governments also incorporate elasticity of demand regarding indirect taxation decisions. If used effectively, governments can maximise revenue for select products by implementing a small tax. Common examples of such taxes include alcohol, petrol, and cigarettes. As the demand for these goods is relatively inelastic, a small indirect tax (resulting in a price increase) will not significantly affect demand, and thus lead to considerably higher revenue for the government. Content: ROLE OF MARKET RESEARCH IN DETERMINING ELASTICITY: Market research can help determine elasticity. This is particularly useful for governments and businesses, as this type of research and data can assist these stakeholders in making economic decisions such as taxation and pricing. Market research can be useful if it analyses and evaluates the impact of price changes on demand. Furthermore, it may also incorporate price elasticity of supply on the marketplace, although this is not as critical for some stakeholders such as individuals and governments. Market research is an important tool for businesses and governments in making economic decisions, particularly in regards to finding the optimum price of a good/service. g Information overload! Ignore this section if you are still coming to grips with the basics. 162 Creative Classroom

13 OTHER EXAMPLES OF ELASTICITY: Elasticity is not limited to demand and supply. Other types of elasticity exist, namely cross-elasticity and income elasticity. Cross-elasticity refers to what are known as related goods (substitute and complementary goods), and the effect of price changes for these products. Income elasticity, however, is refers to the responsiveness of demand when consumer income changes. Both are linked to the demand curve. Q Queensland is always on the top! 1A. INCOME ELASTICITY OF DEMAND - FOR A NORMAL GOOD: Generally, demand for most goods increases (normal good) as consumer income rises. However, the percentage increase in demand is determined by income elasticity. For example, if income rises by 10%, it is highly unlikely that demand for water will rise by more than 10%. It is much more probable that demand for a product such as DVDs will rise by more than 10%. When a rise in income causes a greater percentage rise in demand, then the good is income elastic. However, if a rise in income causes a smaller percentage rise in demand, then the good is income inelastic. For example, if income rose by 10%, but demand for bottled water rose by 1%, then bottled water has income inelastic. The diagram shows demand for two goods. D1 is the original demand for both goods (assume income has increased by 10%). g Information overload! Ignore this section if you are still coming to grips with the basics. Diagram: For the The good represented by D3: It can be seen that demand has increased by more than D2. This indicates that D3 is more likely to be income elastic (large change in demand) compared with the good represented by D2. If D3 is income elastic the demand will increase by more than 10%. The good represented by D2: It can be seen that demand has increased by less than D3. This indicates that D2 is more likely to be income inelastic (small change in demand) compared with the good represented by D3. If D2 is income inelastic the demand will increase by less than 10%. Creative Classroom 163

14 A Creative Story: REMEMERING ISSUE ABOUT INCOME ELASTICITY: When I obtain an increase in income (as if), I will increase my demand for the goods. Look at the following three examples, all of which are based on a ten percent increase in income (as if that s going to happen!) Example 1, salt: It is possible that I will increase my demand for salt, but it is unlikely to be greater than a 10% increase. Therefore my income demand for salt is inelastic. (For Inelastic changes, think Indiana means small change ). The demand curve would move from D1 to D2 Example 2. Movie Tickets: If I receive a 10% increase in income I am likely to increase my expenditure on movie tickets by more than 10%. Note a larger change in demand has occurred as a result of a change in income. Movie tickets are income elastic. (For elastic changes, think Eddie (elastic) is a BIG guy ) BIG EDDIE IS A LUXURY The demand curve would move from D1 to D3. 1B. INCOME ELASTICITY - FOR AN INFERIOR GOOD: As income rises, the demand for a few goods decreases. The consumer views some goods as poor in quality. The consumer would prefer a higher quality good but cannot afford a superior good. Once income rises, the consumer buys the better product and the demand for the inferior good falls. Diagram: For the A Creative Story: REMEMERING ISSUE ABOUT INFERIOR GOODS: Example 3. I am a struggling teacher, so I am buying soup bones to feed my family. If I receive a 10% increase in income then my demand for these bones will decrease because soup bones are an inferior good. I will decrease the demand for soup bones and switch to steak. Steak is a normal good higher increase will cause an increase in demand. The diagram for the inferior good shows that the higher income will cause a decrease in demand, from D1 to D Creative Classroom

15 2. CROSS-ELASTICITY OF DEMAND: (CROSS-ELASTICITY): g Information overload: Additional details to enhance your extended response answers. Cross-elasticity refers to the responsiveness of one good in regards to a change in the price of a different, albeit related, product. Substitute and complement goods are included in this analysis, as these are considered related goods. The following formula is used to calculate cross-elasticity. If the resulting figure is positive, the good is a substitute. If it is negative, then the product is a complementary good. Cross-elasticity of Demand = Percentage change in Quantity demanded for good A Divided by Percentage change in Price of good B. g Information overload! u Tip: Quantity is always on the top of the equation. Story: Remember Queensland is geographically on the top. SUBSTITUTE GOODS: Substitute goods are those which are interchangeable, have the same (or similar) purpose, and can be consumed in place of each other. Examples include butter to margarine and tea to coffee. Generally, if the price of one substitute rises, then the demand for the other good will rise. Applying the example of butter and margarine, this means that if the price of butter rises, then the demand for margarine will also rise. This is shown by the diagram to the right of the text, the demand for margarine will rise because the price of butter has risen. Further, if the price of one substitute falls, then demand for the other good will fall. Again, using the butter and margarine example, if the price of butter falls, then the demand for margarine will decrease. Q Queensland is always on the top! Diagram: For the COMPLEMENTARY GOODS: Complementary goods are those which are consumed together these goods are not used in place of each other. Examples include petrol and cars, and washing machines and washing powder. Generally, if the price for one complement rises, then the demand for both goods falls. For example, if the price of petrol rose, then the demand for large cars would Content: Creative Classroom 165

16 fall. This is shown by the diagram below. If the price of petrol is increased, then the demand for large cars will fall. Conversely, if the price of one complement falls, then the demand for both goods will theoretically rise. The key concept regarding all complementary goods is the existence of a relationship between the goods. For example, it is obvious that cars and petrol have a relationship, yet milk and petrol do not have such a relationship. Diagram: For the A Story To Remember A Specfic Issue:s Complementary/ Substitutes 1. Substitute goods: STORY: When the substitute player (Michael Jordan) comes into the basketball game, people hold up positive signs. Meaning: When the price of Good B increases, then the demand for Good increases (a positive sign). N.B - The maths behind this concept: A positive dividing into a positive equals a positive sign. When the price of Good B is lowered, then the demand for Good A will decrease (a positive sign). N.B - The maths behind this concept: A negative dividing into a negative equals a positive sign. Content: 2. Complementary goods: STORY: Two friends are walking down the street, paying each other compliments but crossing their arms horizontally. The two arms are showing a negative sign. Meaning: If the price of Good B goes up, then the demand for Good A will decrease (positive dividing into a negative = negative sign). N.B - The maths behind this concept: A negative dividing into a positive = negative sign. If the price of Good B goes down, then the demand for Good A will increase (negative dividing into a positive = negative sign). N.B - The maths behind this concept: A negative dividing into a positive = negative sign. HSC Importance for the exams Content Markets- Demand No overlap Just know how to draw the Demand and Supply curves Rating 9/10 Short Answer questions Multiple Choice questions Extended Response questions 166 Creative Classroom

17 q PRICE ELASTICITY OF SUPPLY: CONCEPT OF PRICE ELASTICITY OF SUPPLY: Earlier, we discussed how changes in price impact on the quantity demanded. This involved looking at the degree to which a change in price can result in a change in demand. The same set of points relate to the elasticity of supply. The price elasticity of supply involves looking at the degree by which a change in price can result in a change in the quantity supplied. It is important that price elasticity of supply is understood properly. The responsiveness of quantity supply to price changes is known as the price elasticity of supply (PES). Mathematically, it is expressed through the percentage change in quantity supplied divided by the percentage change in price. The value of elasticity of supply is calculated by using the following formula: Elasticity = Q /Q P /P Elasticity = (Change in Quantity supplied Quantity supplied) All divided by (Change in Price Price) ELASTIC: Definition of Elastic Supply m Elastic goods are those goods for which a change in price will have a greater than proportional change in supplies, and for which price changes have a significant influence on the quantity of supply. Q Queensland is always on the top! Definition: If the supply is elastic (relatively elastic), then the quantity supplied will shift significantly when the price is changed. Just think of the elastic band story we looked at for the elasticity of supply- large change. Creative Classroom 167

18 INELASTIC: Definition of Inelastic Supply m Inelastic goods are those whereby a change in price will have a less than proportional change in supply price changes do not have a considerable impact on the quantity supplied. If the product is inelastic (relatively inelastic), then the shift in the quantity supplied will be small following a change in price. Diagram: EXTREME ELASTICITY POINTS: PERFECTLY ELASTIC: At one end of the spectrum, perfectly elastic supply is where an unlimited quantity of goods can be produced, at the current price. This is a theoretical point and not likely to exist in reality. The supply curve in this example is a horizontal line. Content: PERFECTLY INELASTIC: At the other end of the spectrum perfectly inelastic supply, which is where supply does not change regardless of the price offered. The supply curve is a vertical line. The price of this good is determined by the level of demand. Example: A piece of art from one on the great masters, such as a piece by the post-impressionist artist Vincent van Gogh. 168 Creative Classroom

19 FACTORS AFFECTING ELASTICITY OF SUPPLY: There are three main issues impacting on the elasticity of supply. These are: 1. Time / production period 2. Stock Levels 3. Excess Capacity Content: TIME PERIOD: The length of time after a price change impacts significantly on price elasticity of supply. A price rise will cause: 1. Immediately after an increase in price the quantity offered for sale will not change. Price elasticity of supply (PES) will be essentially perfectly inelastic (no increase in the supply of the goods). This is because suppliers are unable to increase supply immediately. This time period is known as the market period. 2. In the short term, suppliers will increase the resources allocated to their existing production capital, in the form of additional workers and raw material, causing a rise in quantity supplied. The producers are using the plant/equipment more efficiently. This time period is known as the short run. 2. In the long term suppliers will add to their existing production capital by increasing the size and number of factories, production lines, and other fixed methods of production. As these processes increase, the ability of suppliers to increase significantly the quantity supplied in response to price increases. Price elasticity of supply will become increasingly elastic. This time period is known as the long run. EXCESS (SPARE) CAPACITY: Excess capacity is a sitution where the resources used by a firm are not being used to the greatest level of efficiency. If this is the case, price elasticity of supply for that firm will be relatively elastic, as any increase in price can be met with increased production by using those resources more efficiently. LEVEL OF INVENTORIES: Some firms have the ability to store excess stock/inventory. The ability to hold this stock significantly affects the price elasticity of supply (PES) for that firm. For example, if the firm has a significant ability to hold over stock, the firm can significantly increase the amount of stock they offer for sale if prices increases. This represents a greatly elastic price elasticity of supply (PES). However, if a firm is unable to hold over stock, they cannot increase the Creative Classroom 169

20 quantity for sale if the price increases. This represents a greatly inelastic price elasticity of supply (PES). It should be noted that the type of good greatly affects storage for example, cars are often significantly dated, and its model and year greatly affects its selling price, thus firms aim to maintain low stock levels. On the other hand, housing materials do not significantly change, and can be stored for significant lengths of time easily. A STORY -THE FACTORS CAUSING AN ELASTIC SUPPLY: STORY: The elastic band business - Factors causing an elastic supply: I am looking inside a factory that produces elastic bands. There is a long clock (grandfather clock) and its going tick elastic tick. There are workers asleep (idle capacity) and the building is filled to the top with elastic bands (high level of stocks). 1. Elastic Band Company = Elasticity of supply. 2. Long clocks = Long time period. Tick elastic tick = Makes the same point again, that the longer the time period, the more elastic the supply. 3. Workers asleep = Idle or excess capacity including labour and machinery. 4. Room filled with elastic bands = High levels of stocks (inventories). Story: q MARKET STRUCTURES: Overview: There are four main types of market structures. They vary in the degree of market power each firm has, and consequently the level of competition in that market. PURE COMPETITION (PERFECT COMPETITION): NUMBER OF SELLERS: Perfect Competition is a market structure where there are so many firms, and they are all so small, that they are unable to affect the price of the goods or services they provide. In effect, they are price takers, as they would not be able to sell any product above the market price, and must sell all the products at the market price. Going below the market price would simply sacrifice profit needlessly. While perfect competition is a good academic model, it is unlikely to occur in real life, as in almost all markets, firms have some level of market power. Content: 170 Creative Classroom

21 PRODUCT (HOMOGENEOUS / DIFFERENTIATED): In perfect competition, all of the products sold in the market are the same. Buyers and sellers of the product know that the products sold by all the different firms are the same, and know that the price is the same. In perfect competition, the market provides all the competition for the firms. Firms cannot differentiate their products, as they are known to be the same, and they cannot change the price of their goods, as they are price takers. BARRIERS TO ENTRY: There are no barriers to entry. MONOPOLY: NUMBER OF SELLERS: A monopoly market structure is the market structure where there is only one firm selling the product in the market. Therefore, there is no competition in the market at all, and the firm enjoys complete market power. PRODUCT (HOMOGENEOUS / DIFFERENTIATED): To ensure that the firm enjoys this monopoly power, the product being sold must have no close substitutes. Content: BARRIERS TO ENTRY: There are significant barriers to entry into the market, which effectively means that no potential competitors are able to enter the market. REASONS FOR BARRIERS TO ENTRY: 1. In many modern economies, there is a belief that some areas of the economy should not be run for profit, but instead run by the government or government-run institutions. The government legislates that only one producer exists. A good example of this is Australia Post, which is the only company licensed to carry mail in Australia. The industry is not driven by competition and the profit motive, but instead continues to offer good quality of service in this important area. 2. The firm might hold a patent for the production of the good. A good example of this is the pharmaceutical industry. New pharmaceutical medications can take decades, and many hundreds of millions of dollars, to develop, without any guarantee of success. In order to make investments in such a risky venture attractive, the government guarantees that the company will be the only vendor of that product for an extended period of time, by allowing a company to patent their drug. This means that no other company is allowed to produce that drug for a length of time. Creative Classroom 171

22 The patent effectively creating a barrier to entry for other companies, creating a monopoly for the production of that drug. SUPER PROFITS IN THE LONG TERM: As the firm enjoys monopoly power, the firm also has complete market power. This means that the firm is a price setter, or can set the price of the goods at the profit-maximizing level. This means that the firm is able to make abnormal profits. Normally, in a market, if a firm is making abnormal profits in the short term, more firms will enter the market, until firms only make normal profits. However, due to the significant barriers to entry which exist in a monopoly market structure, it is impossible for other firms to enter into the marketplace. The monopolist is able to make abnormal profits in the long term. Oligopoly: NUMBER OF SELLERS: An oligopoly is where there are only a few large firms in the market. An oligopolistic market structure, or one where the firms are in an oligopoly, is a type of imperfect competition. This means that there is some competition, unlike in a monopoly, but there is not as much competition as appears in Perfect Competition. In an oligopolistic market, the few large firms sell a differentiated products. Firms in an oligopoly usually require significant start up costs in order to compete in the market. In this market, they each control a significant market share. A good example of an Australian oligopoly is the supermarket industry, which is dominated by Woolworths and Coles. Content: PRODUCT (HOMOGENEOUS / DIFFERENTIATED): The product is differentiated. There is usually an unspoken agreement in oligopolistic markets to compete on a product basis, rather than price. For this reason, oligopolies usually produce significant amounts of advertising, in an attempt to increase market share by increasing brand loyalty. BARRIERS TO ENTRY: The reasons there are only a few firms in the market due to significant barriers to entry: As there are few firms in an oligopolistic market, each firm closely monitors the behaviour of the other firms in the market. 172 Creative Classroom

23 As each firm has significant market power, if one firm decided to undercut its rivals by decreasing its prices, it could start a price war that would significantly lower the profits of the entire market. Oligopolies are usually tolerated by governments, as long as the firms do not abuse their market power. For this reason, any new mergers in oligopoly markets are usually not allowed by the competition watchdog. Any attempt at collusion, such as a synchronised increase in prices, is closely observed by the Australian Competition and Consumer Commission. Monopolistic Competition: NUMBER OF SELLERS: Monopolistic competition is a market structure where there are many firms that all have a small level of market power. A Monopolistic Competition market structure is the other type of imperfect competition. This means that there is some competition, unlike in a monopoly, but there is not as much competition as appears in perfect competition (see later). Firms in monopolistic competition are usually limited in the amount they can expand. A good example of a monopolistic market is the restaurant industry. This means that monopolistic competition usually needs little regulation for it to remain competitive, and as such is usually encouraged by the government. Content: PRODUCT (HOMOGENEOUS / DIFFERENTIATED): While the firms sell similar products, the products are not identical; the products are differentiated. Firms will use significant levels of product differentiation, or branding, to separate their product from other products. Having a degree of separation promotes brand loyalty, which increases the market power of the firm. Firms in monopolistic competition concentrate on product differentiation and brand loyalty. As they must, to a great extent, follow the market price level, their best way to increase profit is to increase the amount of people purchasing their product. As they are able to differentiate their product, they can create a form of brand loyalty which increases their level of sales. This product differentiation, usually based on advertising, becomes one of the key factors of the businesses success. BARRIERS TO ENTRY: There are no barriers to entry. Creative Classroom 173

24 SAMPLE ESSAY q SAMPLE ESSAY: Discuss the workings of the market, including concepts of elasticity, and how governments intervene. In discussing the market economy, the economist must look at both the strengths and weaknesses of the market and its processes, as well the ways in which governments can intervene. The market system involves the interaction of supply and demand to determine price. The responsiveness of quantity demanded and supplied to price changes are, respectively, the price elasticity of demand and price elasticity of supply. Governments intervene in the market through price floors and ceilings, quantity intervention, as well as subsidies and grants. The economic problem arises because of scarcity and finite resources. That is, we do not possess enough resources to satisfy our unlimited wants. The economic problem has generated significant debate amongst economists as to what is the best solution. Solving the economic problem involves acknowledging that finite economic resources must be used efficiently. Different economic models, such as capitalism and socialism, present differing ways to address the economic problem. A solution to the economic problem can lie with producing as many goods and services as possible, and the goods and services needed the most. A laissez faire free market allows the forces of supply and demand to solve the economic problem, ensuring greater allocative efficiency as resources are directed towards highly valued goods and services. A centrally planned economy solves the economic problem through allowing the government to control and prioritise the production of certain goods and services. One of the important components of the price mechanism is demand, the specific amount of a good or service that households are prepared and able to pay for at a specific time. Individual demand is concerned with the demand of each individual person. Market demand is concerned with the collective demand of all consumers, and this is what we are going to look at. Demand interacts with supply, which will be discussed later, to determine the price of a good or service. A demand schedule refers to a table that illustrates the demand for a good or service over a price range, often in constant increments. The law of demand states that an increase in the price of a good or service will result in a decrease in demand, and vice versa. An increase in the price of a good or service means that consumers will purchase less of the product because the product is more expensive compared to alternatives and they cannot afford to purchase as much of the product. Giffen goods represent a challenge to the law of demand, as demand increases when price increases. This is often because higher priced goods are seen as indicative of wealth FOCUS: Introducing the answer. FOCUS: Simple analysis. FOCUS: Key definition. 174 Creative Classroom

25 and prestige, meaning that people want to purchase the good. Price factors play an important role in influencing demand. Price factors only deal with the price of the good or service itself. If the price of a need increases, there will likely not be a significant decrease in demand because such products are required for daily life. However, more luxurious goods will see a decrease in demand when price increases. Ceteris paribus, changes in the price of a good or service, can result in a change in the quantity demanded, most often in the opposing direction of the price change. Only changes in the price of the good or service itself can lead to a contraction or expansion in demand (that is, movements along the demand curve). Several non-price factors can also lead to movements of the demand curve. Social movements, technological developments, and trends can lead to some goods being seen as more fashionable than others, leading to an increase in demand. If there is a rise in level of incomes, perhaps due to economic growth, then there will be a subsequent increase in demand, because consumers will be more willing and able to purchase certain goods and services. If the price of an alternative good or service decreases, and the alternative product is considered a close substitute, then the demand for the alternative product will likely increase whilst the demand for the original good will decrease. If consumers expect that prices will increase in the future, then consumers will increase their current demand. If there is a rise in the proportion of young people, then there will an increase in demand for youth-related products. Similarly, a rise in the proportion of old people will see an increased demand for aged care. The quantity of products demanded will increase if the population increases. The other important component of the price mechanism is supply; the specific amount of a good or service that firms in a specific industry are prepared and able to sell at various price levels at a specific time. Individual supply is concerned with the supply of each individual firm. Market supply is concerned with the cumulative supply of all firms. Supply interacts with demand, which was discussed earlier, to determine the price of a good or service. A supply schedule refers to a table that illustrates the supply of a good or service over a price range, often in constant increments. The following discussion rests under the assumption that there is pure competition and no government intervention in the market. This means that no firm in the market, or the government, has the power to determine prices. The price mechanism involves the interaction of supply and demand to determine the market price of a particular good or service and the quantity FOCUS: Simple examples. FOCUS: Simple analysis. FOCUS: Simple examples. SAMPLE ESSAY Creative Classroom 175

26 SAMPLE ESSAY of this good or service that is produced. The concept of market equilibrium involves looking at the price mechanism, and occurs when the quantity demanded and quantity supplied of a particular product is equal. As a result, the market clears as there is no excess supply or demand, and there is no tendency for price or quantity change. This concept is similar to the price elasticity of demand. Looking at the price elasticity of demand involves looking at the degree to which a change in price can result in a change in supply. A good has relatively elastic supply when the rise in quantity supplied is proportionately greater than the increase in price. Conversely, a good is relatively inelastic if there is a less than proportionate change in quantity supplied to a change in price. A good is unit elastic if there is a proportional change in supply to a change in price. Looking at the price elasticity of demand involves looking at the degree to which a change in price can result in a change in demand. It is important that price elasticity of demand is understood properly, and should be precisely defined. The responsiveness of quantity demanded to price changes is the price elasticity of demand. Mathematically, it is expressed through the percentage change in quantity demanded divided by the percentage change in price. A good has elastic demand when there is a strong response to a change in price. A good has relatively elastic demand when the increase in quantity demanded is proportionately greater than the fall in price. Conversely, a Key good is relatively inelastic if there is a less than proportionate change in quantity demanded to a change in price. A good is unit elastic if there is a proportional change in demand to a change in price. A good has inelastic demand if there is a weak response in demand to a change in price. Economists have debated endlessly about the level of government intervention that should be allowed in an economy. Often the prices of goods and services can be too high or low, and the quantity produced can be too little or too much. This revolves around how to address the problem of market failure, as the market by itself can lead to undesirable outcomes. Market failure refers to the situation in which the free market and price mechanism only considers private costs and advantages of production, without due consideration of the social costs such as environmental destruction and health problems. For example, the market may fail to take into account the damage caused by carbon emissions, which can worsen the problem of climate change. The market may also fail to take into account factors such as noise pollution caused by aeroplanes and industry. Market failure is a reason for government intervention, and this is why the Australian government intervenes in the market. Governments can intervene FOCUS: Simple analysis. FOCUS: Key definition. FOCUS: Simple examples. 176 Creative Classroom

27 in both price and quantity factors. There can be situations where the market price for a good or service is too high or too low. For example, the cost of public transport or solar panels may be too high, whilst the cost of polluting products may be too low. Consequently, the government may intervene in the price mechanism to address over pricing or under pricing. If a good or service is too expensive, then the government can impose a price ceiling, which is a maximum price that can be charged for a particular good or service. Conversely, if a good or service is too cheap, then the government can apply a price floor, which imposes a minimum price limitation upon a good or service. There are problems associated with the disequilibrium in such price interventions. A price ceiling can lead to under-production of the good, whereas a price floor can lead to over-production of the good. Therefore, price intervention is not a flawless way of addressing market failure. Governments also resort to quantity intervention as a way of addressing market failure. The quantity of certain products may be too high or low because of market failure, and there may be a limited consideration of social costs, such as environmental destruction. The unintended social costs and benefits of production are called externalities, and are not accounted for in the price mechanism. Governments are concerned with negative externalities, such as pollution. Governments intervene through taxes on firms and legislation to decrease the quantity produced of such goods, or to encourage more beneficial, less harmful forms of production. On the other hand, goods and services with positive externalities are often not appreciated fully by the public in terms of social benefits. Examples include parks, the arts and stage productions, as well as the defence force. Such goods are called merit goods and public goods. Merit goods are goods that are not produced enough by firms because consumers do not sufficiently value these goods, and therefore they are largely unprofitable. Public goods are different. Public goods are produced entirely by the government because firms cannot restrict the benefits of such goods to those who have paid for the good. In these cases, the government intervenes, often in the form of subsidies and the direct provision of such goods. As can be seen, the market is a complex system that involves issues of demand, supply, elasticity and government intervention. Imperfections in the market warrant intervention from the government, and appropriate measures need to be taken by decision makers through legislation and government policies. FOCUS: Key definition. FOCUS: Simple analysis. FOCUS: Simple examples. SAMPLE ESSAY Creative Classroom 177