AS Economics Revision – Income Elasticity of Demand graph

Here are some revision notes on YED which might be useful for the CIE AS Economics exam next week. Quite a few of the class had never come across this graph which is popular in multiple-choice questions. It is important that you read the axis.

Usefulness of Income Elasticity of Demand

Knowledge of income elasticity of demand for different products helps firms predict the effect of a business cycle on sales. All countries experience a business cycle where actual GDP moves up and down in a regular pattern causing booms and slowdowns or perhaps a recession. The business cycle means incomes rise and fall.

Luxury products with high income elasticity see greater sales volatility over the business cycle than necessities where demand from consumers is less sensitive to changes in the economic cycle

The NZ economy has enjoyed a period of economic growth over the last few years. So average real incomes have increased, but because of differences in income elasticity of demand, consumer demand for products will have varied greatly over this period.

Over time we expect to see our real incomes rise. And as we become better off, we can afford to increase our spending on different goods and services. Clearly what is happening to the relative prices of these products will play a key role in shaping our consumption decisions. But the income elasticity of demand will also affect the pattern of demand over time. For normal luxury goods, whose income elasticity of demand exceeds +1, as incomes rise, the proportion of a consumer’s income spent on that product will go up. For normal necessities (income elasticity of demand is positive but less than 1) and for inferior goods (where the income elasticity of demand is negative) – then as income rises, the share or proportion of their budget on these products will fall. See table below for a summary of values.

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AS & A2 Revision – How PED varies along a demand curve

Been doing some more revision sessions 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). A particularly popular question at A2 level is ‘where on the demand curve will a profit maximising firm produce at?’. As MC = MR above zero the imperfect firm always produces on the elastic part of the demand curve.

AS Economics Revision – PED YED XPED

Ludicrous regulations of the US Airline Industry and Contestable Markets

With Auckland now at COVID-19 Alert Level 3 and schools operating online we continued going through the A2 syllabus and discussed Contestable Markets using Webex. I used 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.

In the A2 course contestable markets is a popular essay question and is usually combined with another market structure.

What is a contestable market?

• One in which there is one firm (or a small number of firms)
• Because of freedom of entry and exit, the firm faces competition and might operate in a way similar to a perfectly competitive firm
• The threat of “hit and run entry” from new firms may be sufficient to keep the industry operating at a competitive price and output
• The key requirement for a contestable market is the absence of sunk costs – i.e. costs that cannot be recovered if a business decides to leave a market
• When sunk costs are high, a market is more likely to produce an price and output similar to monopoly (with the risk of allocative inefficiency and loss of economic welfare)
• A perfectly contestable market occurs only when entry and exit into and out of a market is perfectly costless
• Contestable markets are different from perfect competitive markets
• It is possible for one incumbent firm to dominate the industry
• Each existing firm in the market produces a differentiated product (i.e. goods and services are not perfect substitutes for each other)

There are 3 conditions for market contestability:

• Perfect information and the ability and or legal right to use the best available technology
• Freedom to market / advertise and enter a market
• The absence of sunk costs

Example
• Liberalisation of the US Airline Industry in the 1970’s and the European Airline Market in late 1990s
• Traditional “flag-flying” airlines faced new competition
• Barriers to entry in the industry were lowered (including greater use of leased aircraft)
• New Entrants – easyJet- Ryanair

Ludicrous regulations of the US Airline Industry and Contestable Markets

We discussed Contestable Markets in my A2 class today and I used 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.

 

 

 

 

 

 

 

 

In the A2 course contestable markets is a popular essay question and is usually combined with another market structure.

What is a contestable market?

• One in which there is one firm (or a small number of firms)
• Because of freedom of entry and exit, the firm faces competition and might operate in a way similar to a perfectly competitive firm
• The threat of “hit and run entry” from new firms may be sufficient to keep the industry operating at a competitive price and output
• The key requirement for a contestable market is the absence of sunk costs – i.e. costs that cannot be recovered if a business decides to leave a market
• When sunk costs are high, a market is more likely to produce an price and output similar to monopoly (with the risk of allocative inefficiency and loss of economic welfare)
• A perfectly contestable market occurs only when entry and exit into and out of a market is perfectly costless
• Contestable markets are different from perfect competitive markets
• It is possible for one incumbent firm to dominate the industry
• Each existing firm in the market produces a differentiated product (i.e. goods and services are not perfect substitutes for each other)

There are 3 conditions for market contestability:

• Perfect information and the ability and or legal right to use the best available technology
• Freedom to market / advertise and enter a market
• The absence of sunk costs

Example
• Liberalisation of the US Airline Industry in the 1970’s and the European Airline Market in late 1990s
• Traditional “flag-flying” airlines faced new competition
• Barriers to entry in the industry were lowered (including greater use of leased aircraft)
• New Entrants – easyJet- Ryanair

War on drugs: Supply or Demand – that is the question

Michael Cameron – Waikato University Economics Dept – wrote an interesting piece on his blog about Economics and the war on drugs. He refers to an article by Tom Wainwright in the Wall Street Journal on “How economists would wage the war on drugs”. Essentially, the war on drugs is being lost. Badly. As Wainwright notes:

The number of people using cannabis and cocaine has risen by half since 1998, while the number taking heroin and other opiates has tripled. Illegal drugs are now a $300 billion world-wide business, and the diplomats of the U.N. aren’t any closer to finding a way to stamp them out.

This failure has a simple reason: Governments continue to treat the drug problem as a battle to be fought, not a market to be tamed. The cartels that run the narcotics business are monstrous, but they face the same dilemmas as ordinary firms-and have the same weaknesses.

El Salvador – a leader of one of the country’s two gangs has a human resource issue with high turnover of employees.

Mexico – the Zetas cartel franchises its brand like McDonalds which in turn has led to arguments over territory.

Rich countries – street corner dealers are struggle to compete on price and quality with the ‘dark web’. It is a similar scenario with Amazon.

To combat the drug trade governments have focussed on restricting the supply. Each year acres of coca plants and manufacturing activities are destroyed but the price has remains around $150-$200 per pure gram for the past 20 years. How have the cartels managed to keep this price?

However, supply of drugs might not even be appreciably reduced when drug crops are targeted. Wainwright points out that:

1. Drug cartels are a monopsony – they are a single buyer of Andean coca leaves, so they have market power over the price of leaves (i.e. the cartels have the ability to strongly influence the market price of coca leaves). So if some crops are wiped out, the price is unlikely to rise because of the cartels’ market power.
2. The price of cocaine is so much higher than the crop input costs that even a large increase in crop prices would have little effect on the market price of cocaine (i.e. even a big increase in the price of coca leaves would lead to only a small shift in the supply curve for cocaine).

Also because of its addictive nature demand for drugs is relatively inelastic – the decrease in quantity demanded is less than the percentage increase in price. Therefore reduced supply and a higher price doesn’t change demand that much.

Demand-Side interventions seem to be a better option and they are also a lot cheaper. Weighing up reducing supply by destroying coca crops in remote areas against drug education in schools and you find the latter is a much more plausible option.

A dollar spent on drug education in U.S. schools cuts cocaine consumption by twice as much as spending that dollar on reducing supply in South America

Bigger loses have be inflicted on cartels with some US states making marijuana legal.

Tom Wainwright also has written about this in his new book “Narconomics: How to Run a Drug Cartel”

AS Revision – PED, YED and CPED

With the Cambridge AS Level exams nearly upon us 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

Elasticity of Demand for Air Travel

At the most basic level, demand for air travel is stimulated by economic activity and economic and social linkages between countries and cities. Travel is also stimulated by economic linkages (i.e. international trade) and social linkages (i.e. international migration). In general, there will be greater demand for travel between countries that have larger economies and populations. In addition, destination attractiveness is a key driver of demand for leisure travel.
There are many other factors that affect demand for air travel. When the economy grows, greater economic activity stimulates business travel and leisure travel increases as people’s income increases.

• Demand is stimulated by lower prices, both airfares and the price of tourism expenditure (e.g. accommodation and food) ‘on the ground’ at a destination.
• Demand for travel to any particular destination also depends on the price of travel to alternative destinations. Other factors that affect demand include distance, safety, and other one-off events such as health and terrorism scares.

The concept of elasticity is very useful for understanding demand drivers. Elasticity measures the responsiveness of demand for air travel to changes in some other variable such as prices or income. A price elasticity of -0.5, for example, means that a 10% increase in price leads to a 5% reduction in the level of demand for travel. Or an income elasticity of 1.2, for example, means that a 10% increase in income leads to a 12% increase in the level of demand for travel.

Many studies have attempted to estimate various demand elasticities for air travel. In terms of price and income elasticities, a meta-study by Gillen et al (2008) summarised 254 different estimates from 21 published studies and found an overall median price elasticity of -1.1, indicating that demand for air travel is relatively sensitive to price changes.

As would be expected, the results also indicate that travel for business purposes is less price sensitive than travel for leisure purposes with business short/medium hail elasticities between -0.8 and -0.6 and long haul elasticities between -0.5 and -0.2, compared to -1.5 to -0.9 for short/medium haul and -1.7 to -0.5 for long haul leisure travel. Gillen et al also report a median income elasticity of 1.4, suggesting that demand for air travel is relatively sensitive to changes in income. The table below represents the median for each market segment – Source: Air Travel Demand Elasticities: Concepts, Issues and Measurement.

Given that someone has decided to travel, their choice of airline and airport, when such a choice exists, depends on a number of micro-level factors including purpose of travel, ease of access to the airport, flight frequency, expected delays, and departure/arrival times (Ishii et al, 2009). Thus the demand faced by a particular airline depends on macroeconomic factors as well as other factors more directly under its control.

Source: The New Zealand Aviation Operational Environment: A Guide for the Tourism Sector 2010

Afghan Opium – Relatively Inelastic

America’s war on terror is also on drugs. After its invasion of Afghanistan there has been a focus to eradicate the opium poppy industry. One way approaching this concern was cash incentives – $10bn in total – by American authorities to Afghan peasants to grow wheat instead of poppies. However opium production has actually increased to record levels in 2013 with over 200,000 hectares being planted. Why has this been the case?

The US authorities have concentrated their shut-down of opium production in the least hostile areas of Afghanistan. This is understandable as the drug authorities are more likely to go and investigate areas that are safer. Therefore production has moved to more militant areas – Taliban controlled. As demand for Afghan Opium is inelastic an increase in the price of opium will lead to higher levels of revenue for cultivators. Therefore by the US authorities decreasing production in safer areas the overall supply initially falls (S1 to S2 in the graph below) which increases the price. A significant amount of the extra revenue goes to the Taliban who, according to the UN, earned $100m from opium in 2011-2012. Source: The Economist

AS – Supply and Demand – Oil refineries stumble on hard times

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.

Great Sports Economics Videos

A hat tip to Matthew Ryan from the University of Auckland for these Sports Economics videos. The six short videos (called Some Sports Economics) are produced by Dr Liam Lenten from La Trobe University in Australia explaining basic economic concepts (such as prisoners’ dilemma, absolute/comparative advantage, complementaries, etc.). Well worth a look and notice the kit change for each video. Click on the link below to go to the playlist. Below is the video on “When scoring an own-goal is the only way to win”.

Some Sports Economics

A Level revision – Elasticity – PED

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
100c                                      1000
60c                                        1300
30c                                        2275

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.

Determinants of Elasticity of Demand

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.

The Euro and Export Revenue

Here is a graphic from the Wall Street Journal. It shows a strong correlation between the exchange rate and the revenue from selling exports. Remember the following:

Effects of a declining €
• Imports: Should in theory discourage imports. However if goods are inelastic(necessities) the end result is a much higher import bill.
• Exports: Should lead to an increase in the value of exports sold. But it takes time for exporting firms to adjust their marketing and production schedules to take maximum advantage of falling currency values.
• Inflation: Because of dearer imports this may lead to an increase in domestic inflation.

Effects of a rising €
• Imports: Eurozone imports become cheaper. Will improve the B of P provided demand is inelastic. If demand is elastic, cheaper imports will lead to an increase in the volume of imports and a worsening of B of P position.
• Exports: Eurozone exports become dearer. If demand is inelastic export earnings increase and B of P position improves. If demand is elastic their will be a fall in sales and a consequent worsening of the B of P position.
• Inflation: Eurozone imports are cheaper therefore this helps to reduce inflationary pressures.

AS Revision: Elasticity

With the essay and data response paper on Monday it might be appropriate to go through elasticity. You should know the following for PED, YED, CPED, and PES:

1. Characteristics
2. Equation for calculation
3. Values – what do they mean?
4. Graphs
5. Usefulness to businesses

This topic comes up in a variety of guises:
– Indirect taxes and subsidies
– Market failure
– Trade – J curve
– Macroeconomy

Here is a reminder of some of the main points for PED:

Also a key graph for Income Elasticity of Demand.

Elasticity and climbing Everest

Been doing Elasticity wtih my AS class and came across a good example from the book ‘Into Thin Air” by Jon Krakauer. Remember this theory measures the responsiveness of the quantity demanded to a change in price of the good/service. Licences for climbing Everest are only a small part of the cost of such activities – for most people the largest costs concern the long periods of time they must spend awy from their families and job, not to mention the risk of death and injury. Over the last ten years the volume of people wishing to climb Everest has increased hugely and the Nepalese government realised that this had an environmental impact and created problems in terms of safety, aesthetics etc. The Nepalese government come up with a plan to limit the amount of climbers and also gain some well needed revenue.

1991 – US$2,300 for any size of team
1992 – US$10,000 for a team up to 9 climbers – US$1,900 for each additional climber.

However, climbers continued to show their face at Everest and in 1993 a record number of climbers (294) attempted to scale the peak. Later that year they changed the fee again to climb Everest

1993 – US$50,000 for a team up to 5 climbers and $10,000 for each additional climber.

However at this point demand became more elastic as the Nepalese authorities didn’t consider China only charged US15,000 to allow a team of any size to climb Everest from the Tibet side. Sure enough Everest expeditions now shifted from Nepal to Tibet, leaving hundreds of sherpas out of work. Nepalese authorities, realising this, cancelled the four-expedition limit but still increased the permit fee:

1996 – US$70,000 for up to seven climbers plus and $10,000 for each additional climber.

As 16 out of the 30 expeditions in 1997 climbed via the Nepal side, it seems that the high cost of obtaining a permit doesn’t seem to have been a notable dampner on their desire.

The Elasticity Song

With my AS class I am about to start elasticity and I was reminded of this song on YouTube. My AS class last year found it quite catchy.

Demand↑ and Supply↓ = Food Prices↑

Paul Krugman has simplified the recent increase in global food prices. On his blog he had the following graph which shows the % declines in grain production.

Demand Pressures
With the exceptional growth in China and a change in diet, there is more pressure on imports of food. The US Grains Council, which in October pegged China’s 2011 corn imports at 2m-3m tonnes, said that the figure could reach 3m-9m. However, as Krugman, points out the demand for grain is highly inelastic. For the United States, they put the price elasticity of demand for breads and cereals at 0.04 — that is, it would take a 25 percent rise in price to induce a 1 percent fall in consumption.

Supply Pressures
Most of the decline in world wheat production, and about half of the total decline in grain production, has taken place in the former Soviet Union — mainly Russia, Ukraine, and Kazakhstan. As you may know this was due to unique heatwave that was prevalent in the area. I blogged on this on 5th September last year – Wheat Prices – what’s driving them up? And it’s not just the FSU (Former Soviet Union): extreme weather elsewhere has played a role in bad harvest around the world.

NZ winegrowers want change to excise tax

This morning on Radio New Zealand Morning Report programme there was an interview with New Zealand Wine Growers Chief executive Philip Gregan concerning the Government’s intention to raise the tax from July 2011, which will cost wineries another $1.00 per case.

His worry is that the winegrowers will have to bear the whole tax themselves because they can’t pass it on to the retailers. There are 600 – 700 wineries in New Zealand, but only two major players in the retail sector, which are the supermarkets. Mr Gregan says that gives power to the retailers which are very reluctant to accept price increases so it becomes impossible to pass on the annual tax increases. He says the Government should tax the consumer directly at retail, rather than producer level. Furthermore, despite the excise tax on wine going up more than 60% since 1991, the increase in the cost price index for wine in the past 19 years is only about half the overall CPI increase.

Excise tax: a tax collected by Inland Revenue Department (IRD) which is usually on a specific good within the country. Excises are distinguished from customs duties, which are taxes on importation.