Here is some revision material that explains the values for each of the above.
Price Elasticity of Demand
Income Elasticity of Demand
Cross Price Elasticity of Demand
Another very good video from Phil Holden in which he explains a buffer stock scheme. A buffer stock scheme (commonly implemented as intervention storage, the “ever-normal granary”) is an attempt to use commodity storage for the purposes of stabilising prices in an entire economy or, more commonly, an individual (commodity) market. Specifically, commodities are bought when there is a surplus in the economy, stored, and are then sold from these stores when there are economic shortages in the economy.
Here is a short clip from the movie Samsara which is enlightening. Overconsumption is a situation where resource use has outpaced the sustainable capacity of the ecosystem. A prolonged pattern of overconsumption leads to inevitable environmental degradation and the eventual loss of resource bases. This six minute video will open your eyes to a world normally hidden from cameras. A hard hitting dose of perspective of what unsustainable demand looks like. To get more information on the movie go to their website – Samsara.
This week James Surowiecki in The New Yorker addressed the issue of the bumper lobster harvests but the high prices of lobster in restaurants. In the state of Maine, on the east coast of the US, lobsters off the boat were selling for US$6 / pound in 2005 in contrast to today where the wholesale price is as low as US$2.20. Therefore why have the prices in restaurants stayed high when you consider the wholesale price?
One logical reason is that ff there is a bad harvest and prices rise, restaurants might find it hard to sell expensive lobster to customers who have got used to it being cheaper.
Lobster is more like a luxury good than a commodity and therefore has a range of psychological factors:
1. High lobster prices became an important image on the menu – studies have shown that people enjoy cheaper wine when they do blind taste tests. If lobster was priced like chicken people wouldn’t enjoy it as much.
2. Customers often correlate price with quality. As the majority are not aware of what is happening on the lobster wholesale market they could presume that the quality of your lobster is not as good as your competitors – low price creates suspicion.
3. By making lobster expensive it make other items on the menu look more reasonably priced. A classic experiment described by Itamar Simonson and Amos Tversky showed that if you asked people to choose between a mid-priced microwave oven and a lower-priced one sales of the products were roughly split. But adding a higher-priced oven to the mix increased sales of the mid-priced product by forty per cent—the mere presence of a more expensive option made the moderate one look like a better buy. So any restaurant that cuts lobster prices significantly runs the risk of making that sesame-crusted tuna look too pricey.
4. Finally. although there is a lot of competition amongst restaurants very few customers would pick restaurants on the price of lobster.
A move by the European Union to slash subsidies to farmers isn’t as big a deal as it sounds. The EU has announced cut to the subsidies it pays industrial scale farmers of up to 30% – this is part of the Common Agricultural Policy (CAP) which costs the EU tax payers 50bn a year and is 40% of the whole EU budget. This will be of little benefit to NZ farmers as they will still be denied access through tariffs and quotas on sheep, butter, cheese etc.
Objectives of CAP
At the outset of the EU, one of the main objectives was the system of intervention in agricultural markets and protection of the farming sector has been known as the common agricultural policy – CAP. The CAP was established under Article Thirty Nine of the Treaty of Rome, and its objectives – the justification for the CAP – are as follows:
1. Raise and maintain farm incomes, through the establishment of high prices for food. Such prices are often in excess of the free market equilibrium. This necessarily means support buying of surpluses and raising tariffs on cheaper imported food to give domestic preference.
2. To reduce the wide flutuations that often occur in the price of agriculutural products due to uncertain supplies.
3. To increase the mobility of resources in farming and to increase the efficiency of all units. To reduce the number of farms and farmers especially in monoculturalistic agriculture.
4. To stimulate increased production to achieve European self sufficiency to satisfy the consumption of food from our own resources.
5. To protect consumers from violent price changes and to guarantee a wide choice in the shop, without shortages.
CAP Intervention Price
An intervention price is the price at which the CAP would be ready to come into the market and to buy the surpluses, thus preventing the price from falling below the intervention price. This is illustrated below in Figure 1. Here the European supply of lamb drives the price down to the equilibrium 0Pfm – the free market price, where supply and demand curves intersect and quantity demanded and quantity supplied equal 0Qm. However, the intervention price (0Pint) is located above the equilibrium and it has the following effects:
1. It encourages an increase in European production. Consequently, output is raised to 0Qs1.
2. At intervention price, there is a production surplus equal to the horizontal distance AB which is the excess of supply above demand at the intervention price.
3. In buying the surplus, the intervention agency incurs costs equal to the area ABCD. It will then incur the cost of storing the surplus or of destroying it.
4. There is a contraction in domestic consumption to 0Qd1
Consumers pay a higher price to the extent that the intervention price exceeds the notional free market price.
The increase in farmers’ incomes following intervention is shown also: as has been noted, one of the objectives of price support policy is to raise farmers’ incomes. The shaded area EBCFG indicates the increase in the incomes of the suppliers of lamb.
Throughout most of its four decades of existence, the CAP has had a very poor public relations image. It is extremely unpopular among consumers, and on a number of occasions it has all but bankrupted the EU.
Brian Gaynor in the NZ Herald recently stated why there could be a sustained period of low inflation. He came up with the following reasons. You will notice that most refer to the supply curve shifting to the right. The last one relates to a reduction in demand.
• Labour-saving technologies have reduced costs.
• Union militancy has dissipated, particularly as far as wage increases are concerned.
• There has been a massive increase in the production of goods and services and this has led to some oversupply.
• More competitive marketplaces have made it difficult for suppliers to raise prices.
• The mass production of cheap consumer goods in China and other Asian countries has kept a lid on prices.
• Technological advances have seen the price of some products, particularly telecommunications and electronics, drop sharply.
• A significant reduction in import duties and tariffs has created more import competition and put pressure on high-cost domestic producers.
• Strong currencies, particularly the New Zealand and Australian dollars, have also helped put downwards pressure on prices.
• Better price discovery, mainly through the internet, has enabled consumers to identify the cheapest products.
• High house prices in New Zealand have meant that a high percentage of income is committed to meeting interest payments instead of being available for consumption.
Time magazine ran an interesting article on the tomato market in the Holland and Greece. The Greeks produces twice as many tomatoes than the Dutch but very little of it is sold in export markets. This is a concern in that it is a missed opportunity for the Greeks to earn income. What is more ironic is the fact that in the summer imports of tomatoes come in from Holland because the Greek farmers are still struggling to grow a crop during the hottest time of the year – Holland employs high-tech green houses and is able to produce significantly more during the summer months than Greece.
However, Greece has the potential to produce tomatoes for domestic consumption as well as for export but only has two harvests a year and is at the mercy of the elements – poor weather = poor harvest. The Dutch in contrast have temperature controlled greenhouses helping to create ideal growing conditions and they can produce 70kg of tomatoes in a square metre of his greenhouse whilst the Mediterranean grower gets approximately 7kg. They can also produce all year round.
Single Currency and Productivity
With the introduction of the euro in 2002 Greece could no longer devalue its currency to control the price of its products. With a weaker currency their exports were much more competitive but this had the effect of making the Dutch work even harder to achieve more efficiency and greater economies of scale. Therefore the only way that the Greeks can now compete is by cutting costs and embracing technology.
But it is not just the tomato market that has been hard hit. Greece’s agricultural sector’s productivity levels are 44% below the European average and labour costs have increased by approximately 90% and this is in contrast to Germany where unions agreed to a 3% rise. What is more concerning is that the acreage given over to growing tomatoes in Greece is 10 times that in Holland but they hardly export any of them. The Dutch have seen their exports increase by 30% since 2005. Some economists have laid the blame on the oligopoly market structure that controls the distribution. These middlemen pay farmers low prices and take a big mark-up on tomatoes even as they have failed to put in place a more efficient distribution system, including for exports.
The Greeks could become a thriving exporter of tomatoes once again but will need to embrace the Dutch technology and make use of its natural conditions – sunshine.
The drought in Spain this summer has had a significant impact on the Olive oil market worldwide. Approximately 50% of world production comes from the World Cup and European Champions but The Economist estimate that the lack of rain might cause a drop in global production of around 20% – supply curve to the left. In 2011 the market was awash with around 3 million tonnes of olive oil. Because of this prices hit nine year lows – July 2012 $2,745 but over the last few months they have risen approximately 40% – $3,787 a tonne. Stocks are being put onto the market from last year’s crop (supply curve to the right) have helped to keep the price below $4,000 a tonne – a bit like a buffer stock system. See graph below
Olive Oil – US$ per Tonne
High prices have helped some other economies that border the Mediterranean Sea like Italy and Greece as they are the next biggest producers of olive oil and between them provide 20% of the world market.
Demand on the increase
Demand for olive oil has increased as it becomes more fashionable – maybe from all those cooking shows that they have on TV these days. Germany are using 5 x more olive oil and the British x 10. Demand in the US has been growing 6% for the last 20 years.
Been doing some more revision courses on CIE AS economics and went through how the elasticity of demand varies along a demand curve. Notice in Case A that the fall in price from Pa to Pb causes the the total revenue to increase therefore it is elastic – the blue area (-) is less than the orange area (+). In Case B the opposite applies – as the price decreases from Pa to Pb the total revenue decreases therefore it is inelastic – the blue area (-) is greater than the orange area (+). In Case C the drop in price causes the same proportionate change in quantity demanded, therefore there is no change in total revenue – it is unitary elasticity. Remember where MR = 0 – PED = 1 on the demand curve (AR curve).
There is mention in political circles that the UK is keen to abolish subsidies to its agricultural sector. They have already insinuated that they intend to freeze agricultural spending at 2013 levels until 2020 with the long-term goal of eventually abolishing all assistance to farmers. The EU currently spends €55bn for the farm budget each year and this accounts for 40% of its total budget – more than any other sector.
This action would certainly put New Zealand on a level playing field with the UK and make its produce much competitive than previously. With New Zealand going through the same process of removing subsidies nearly two decades, the UK will agricultural sector will find it difficult to adjust. However it has allowed New Zealand farmers to be far more focused on the essentials of the market rather than being driven by the subsidies from government. Farms became bigger and more efficient as economies of scale became hugely important in maintaining a competitive edge. What the subsidies did in New Zealand was to encourage people to develop land that was not really suitable for any agricultural use. However as they got a subsidy from the government efficiency or quality didn’t feature as a major factor in maintaining competitiveness. Here is what happens when the subsidies are taken away – supply curve to the left.
Although oil producing nations might not like the recent troughs in oil prices, refineries in Europe are experiencing good times even with petrol and diesel prices being relatively high.
According to The Economist refining hasn’t been the most profitable business as overcapacity has dogged the industry. Oil companies had assumed that the world demand for petrol would continue to expand rapidly and built refineries to cope with the this added pressure. However with oil demand peaking this led to an over-supply in the market. Furthermore in the developing world new and more efficient refineries have added to the problem and this had led to some changes in the market players this year.
* Petroplus (Swiss refinery) went out of business
* Shell bought a former Petroplus plant in London and downgraded it to a storage facility.
* Sunoco biggest refinery in north-eastern US is in trouble financially
* Refineries in Pennsylvania and the Virgin Islands have ceased production
Demand for petrol is falling in both the US and Europe as:
* People are driving less
* People are switching to more fuel-efficient cars – especially diesel. This has caused some concerns as Europe’s refineries cannot easily switch to producing more diesel.
Oil Prices 2012
The chart below from the Sustainability Blog shows the oil production has reached an effective cap at around 75 million barrels of regular crude per day. Production over the past six years has increased little despite continued upward oil prices. This they argue has occurred as the oil industry passed a transition point and moved from an elastic supply curve to an inelastic supply curve.
While global oil demand remains relatively weak today, with the International Energy Agency predicting global oil demand growth in 2012 of around 1.1 million barrels per day, that inelastic supply curve could yet push oil prices back up to record levels which in turn will increase costs for the refining industry.
Supply side policies have the objective of raising the economy’s supply potential and in conjunction with fiscal policy can improve productivity and boost overall supply. It mainly takes the form of tax incentives, investment opportunities, and training of the labour force. It also focuses on reducing the cost burden on businesses.
The BNZ Markets Outlook produced a very interesting article on supply-side issues in the NZ economy. The graph below shows the gap between the capacity of the NZ economy against the aggregate demand. Where the line is 0 – supply = demand and there is no output gap. Above the line there is excess demand and below excess supply.
Interesting that between 2004-2007 the slowing levels of growth reflected the lack ability to increase supply into the market – approaching the inelastic part of the aggregate supply curve. This was in contrast to the official view which led us to believe that demand was slowing. With the pressure on supply, prices started to rise as did wage inflation.
The RBNZ, around 2005/06, was projecting the economy to open up some spare capacity by 2007/08. The economy actually moved into a state of greater excess demand. The difference was like failing to forecast a 4% pick-up in GDP growth.
You might have read my previous blog post on the Ghost Cities of China where 10 new cities are built each year but are nearly all empty. Reading in the FT, the Chinese property market faces a dilemma it that although property prices in cities are beyond the reach of the majority of the population, in the rural areas where the vast majority of the population still live, property prices have dropped significantly. With the lower prices developers are now less likely to build anymore houses. In the past the government has intervened so as to avoid a US style sub-prime type bubble situation but should it worry more about high prices in big cities or weak construction in the rural areas?
The key questions for Chinese policy makers are as follows:
1. Should it regulate house prices in cities which account for 25% of the market which will have an impact on prices outside cities?
2. Can the Chinese economy afford to have house prices to drop as property construction has accounted for around 15% of GDP in China?
With this potential loss of GDP the government has been making it easier for potential homebuyers to borrow money – see affordability index. Banks have given special offers for first home buyers and there has been pressure on contractors to build more economical houses.
House Price-to-Income Ratio
This ratio gives an indication of the affordability of housing. In China this is 7:1 as compared to most developed countries being 4:1. However in cities the ratio is much higher for example:
Shanghai – 12:1
Beijing – 11:1
Shenzen – 16:1
This makes it very hard for people to take a step on the property ladder. But even in some cities where the house price-to-income ratio is much lower – around 7:1 – house sales have not recovered that much. The main reason for this is the government’s home purchase rule which restricts consumers from buying a second home. Furthermore there is a tendency for potential buyers to now wait for prices to fall.
The Chinese authorities might find that it is just too hard to reduce prices in the cities at same time trying to increase construction in the rural areas.
Last week there was good news for farmers in New Zealand with the Global Dairy Trade (GDT) prices on the up after some concerning months. It is now of the opinion of some analysts that prices have bottomed out and it will be an upward trend from now on.
What caused the price reduction over the last few months has been the bumper season for dairy farmers in New Zealand and the surge in European production. However since then a couple of indicators suggest that prices will be on the rise:
1. US production has slowed
2. EU production has peaked
Below are the GDP results which show an interesting correlation between the amount offered for sale (Supply) and the tonnage sold (Demand), also notice the surplus and the price. Source: Dairy News – June 12 2012
29 cover fuel
20 cover salaries of airlines
16 cover ownership costs
14 cover Government fees taxes
11 cover Maintenance
9 cover other costs – catering etc
1 = Profit
But airline operating costs are off the charts compared with other industries. In a business where much of the work is done outside, routine storms can eat into margins. And there are many moving parts to flying people through the air, and many safety costs required by regulation.
While ticket revenue pays the bulk of these costs, “ancillary revenue” supplements the flight by another $18 per person on a 100-passenger flight. That includes fees for checked baggage, seat assignments, ticket penalties and revenue from cargo.
To go to the full article, graphic and video – click link below:
There has been much mention in economic news of a potential housing bubble in the Chinese economy and ultimately a hard landing. This for China would be a GDP figure of around 6%. The worry is that sales of new residential buildings, measured by floor space sold in the chart, have fallen significantly over the last several months, although it may not be going into free fall with March delivering some improvement. Rodney Dickens of Rodney’s Ravings talks about the sheer scale of the numbers is staggering (e.g. at the peak over 150,000,000 sqm of floor area started per month). The charts show how much higher the floor area of building started has been relative to the floor area sold since 2009. On average since January 2009 11,470,000 sqm has started construction each month while 8,569,000 sqm has sold per month. We assume these data are on a comparable basis. This means starts have been running 34% ahead of sales each month on average for over three years, which fits with there being reported to be something like 64m vacant new apartments.
According to Patrick Chovanec (Associate Professor of Practice at Tsinghua University’s School of Economics and Management in Beijing) China’s developers are playing out a kind of prisoner’s dilemma: rush to complete, in hopes of cashing out. But while supply keeps going up, demand is going down. In late March 2012, a central bank (PBOC) survey reported that only 14.1% of Chinese consumers were looking to buy a house in Q2, the lowest level since 1999. Only 17.7% expected home prices to rise in Q2, and 62.9% said they still consider prices to be too high. So all those rushed completions only add to the glut already on the market, driving prices down further and giving buyers — investors and aspiring residents alike — all the more reason to hold off for a better deal.
Doing some last minute revision with students resitting the AS Level exam. Went over elasticity and here are some key points that I covered. Might be useful for those doing AS at the moment.
Price Elasticity of Demand (PED)
This measures the relative amount by which the quantity demanded will change in response to change in the price of a particular good. The equation is:
% change in Quantity ÷ Demanded % change in Price
How is PED calculated?
Consider the following demand schedule for buses in a city centre.
Price (average fare) Quantity of passengers per week
Suppose the current average fare was 100c, what is the PED if fares are cut to 60c?
The percentage change in QD is equal to:
• The change in demand 300 (1300-1000) divided by the original level of demand 1000. To obtain a percentage this must be multiplied by 100. The full calculation is (300 ÷ 1000) x 100 = 30%
The percentage change in price is equal to:
• The change in price 40c (100c – 60c) divided by the original price 100c. To obtain a percentage this must be multiplied by 100. The full calculation is (40 ÷ 100) x 100 = 40%
These two figures can then be inserted into the formula with 30% ÷ 40% = 0.75
Let us now consider the PED when the average fare is cut from 60c to 30c
The percentage change in QD is equal to:
• The change in demand 975 (2275-1300) divided by the original level of demand 1300. To obtain a percentage this must be multiplied by 100. The full calculation is (975 ÷ 1300) x 100 = 75%
The percentage change in price is equal to:
• The change in price 30c (60c – 30c) divided by the original price 60c. To obtain a percentage this must be multiplied by 100. The full calculation is (30 ÷ 60) x 100 = 50%
These two figures can then be inserted into the formula with 75% ÷ 50% = 1.5
Please note that the minus sign is often omitted in PED, as the price elasticity is always negative because demand curves slope downwards. The textbook displays figures as:
PED = (-) 0.2
What price elasticity of demand figures tell us.
The elasticity of a product is influenced by:
• the number of substitutes available
• whether it could be described as a luxury or a basic commodity
• the proportion of the purchaser’s income it represents
• the durability of the product.
Usefulness of Price Elasticity of Demand
The usefulness of price elasticity for producers. Firms can use price elasticity of demand (PED) estimates to predict:
1. The effect of a change in price on the total revenue & expenditure on a product.
The relationship between elasticity and total revenue.
Elastic Inelastic Unitary
Price ↑ TR↓ TR↑ No Change
Price ↓ TR↑ TR↓ No Change
2. The likely price volatility in a market following unexpected changes in supply.
3. The effect of a change in GST (indirect tax) on price and quantity demanded and also whether the business is able to pass on some or all of the tax onto the consumer.
4. Information on the price elasticity of demand can be used by a business as part of a policy of price discrimination – off-peak and peak travel in major cities. Before 9am – inelastic demand curve – after 9am elastic demand curve.
Recently prices on Fonterra’s global dairy auction fell but analysts feel that this is not going to be long-term. The fall has been mainly caused by:
Supply increasing significantly relative to the demand – March, April and May tend to be very productive for northern hemisphere farmers as that is when they have peak supply figures. Furthermore over the summer in New Zealand we have had excellent growing conditions with soil moisture levels being very high for the time of year. This transfers into an increase in available feed for dairy units and increased milk output.
The graph below shows the Global Dairy Trade Weighted Average Prices and it is believed that this drop in prices is not a re-run of the global financial crisis when prices dropped to below US$2,000 a tonne. This was due to stagnant demand which does not seem prevalent today.
It is estimated that a US$1 difference in the milk price between seasons represents about $1 billion in cash flow for Fonterra’s 10,000 supply farms. When you consider the multiplier effect this can translate to 4 times that for the rural sector as a whole.
An initial change in aggregate expenditure can have a greater final impact on equilibrium national income. This is known as the multiplier effect and it comes about because injections of demand into the circular flow of income stimulate further rounds of spending.
Consider a $300 million increase in business capital investment. This will set off a chain reaction of increases in expenditures. Firms who produce the capital goods that are ultimately purchased will experience an increase in their incomes. If they in turn, collectively spend about 3/5 of that additional income, then $180m will be added to the incomes of others. At this point, total income has grown by ($300m + (0.6 x $300m). The sum will continue to increase as the producers of the additional goods and services realize an increase in their incomes, of which they in turn spend 60% on even more goods and services. The increase in total income will then be ($300m + (0.6 x $300m) + (0.6 x $180m). The process can continue indefinitely. But each time, the additional rise in spending and income is a fraction of the previous addition to the circular flow.
The value of the multiplier can be found by the equation 1 ÷ (1-MPC)
You can also use the following formula which represents a four sector economy
1 ÷ MPS+MRT+MPM
MPS = Marginal propensity to save
MRT = Marginal rate of tax
MPM = Marginal propensity to import
The EU’s Emissions Trading Scheme has displayed an oversupply of carbon permits. In March this year the price of carbon permits plummeted to a record low after data suggested that Europe had produced a smaller amount of polluting emissions last year than had been thought. Below is quite an informative video explaining how the system works.
I use this clip from Commanding Heights to show how regulated the US airline industry was during the 1970’s. Regulations meant that major carriers like Pan Am never had to compete with newcomers. However an Englishman named Freddie Laker was determined to break this tradition and set-up Laker airways to compete on trans-atlantic flights. He offered flights at less than half the price of what Pan Am charged. Alfred Kahn was given the task by the then President Jimmy Carter to breakup the Civil Aeronautics Board (the regulatory body) and he wanted a leaner regulatory environment in which the market was free to dictate price. There is a piece in the clip that shows how ludicrous some of the regulations were:
When I got to the Civil Aeronauts Board, the biggest division under me was the division of enforcement – in effect, FBI agents who would go around and seek out secret discounts and then impose fines. We would discipline them. It was illegal to compete in price. That means it was illegal to compete in the discounts you offer travel agents. So we regulated travel agents’ discounts. Internationally, since they couldn’t cut rates, they competed by having more and more sumptuous meals. We actually regulated the size of sandwiches. Alfred Kahn
When the CAB was closed down competition was the rule and the industry had vastly underestimated the demand for air travel at lower prices – a very elastic demand curve – see graph below.