Water Wars 1 : Scarcity,Privatization

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Price Elasticity of Supply (PES)

 

PES defined: it measures the extent to which quantity supplied changes in response to a change in the price of the commodity.

How does one find/measure the price elasticity of supply for a good?

1. Formula: Price Elasticity of Supply – ∆QS/ ∆P . P/QS i.e. the change in quantity supplied/ the change in price of the commodity (times) original price/original quantity supplied.

2. Illustration: Should the original quantities supplied (Q1) = 100 units, original price of the commodity (P1) = 25, the new quantity supplied (Q2) = 60 units, the new price of the commodity (P2) = 20, then PES is ∆QS/ ∆P . P/QS = 40/5 . 25/100 = 2

2 which represent the measurement of PES reads that for every 1% change in price, quantity supplied will change by 2%, which makes PES elastic.

What are the various measurements of price elasticity of supply?

As is the case of price elasticity of demand, there are five measurements of price elasticity of supply (see below).

1. Perfectly Elastic – where elasticity is infinity and the supply curve is horizontal. It means therefore that any shifts in the demand curve will bring no changes to the equilibrium price.

2. Perfectly Inelastic – where elasticity is zero and the supply curve is vertical. This means that, despite an increase or decrease in price quantity supplied will not change.

3. Unitary Elastic – where elasticity is one and the supply curve is a straight line through the origin (this is the sole difference between price elasticity of demand and supply). In the case of unitary, whatever the change in price is, the change in quantity supplied will be the same.

4. Relative Elastic – 1< Elasticity < infinity and the supply curve is very flat (relative to being horizontal). In this case, it is expected that the change in quantity supplied will be greater than the initial change in price.

5. Relative In elastic – 0 < Elasticity < 1 and the supply curve is very steep (relative to being vertical). In this case, it is expected that the change in quantity supplied will be less than the initial change in price.

Graphical Illustration of Price Elasticity of Supply

1. PES is Perfectly Elastic 2. PES is Relatively Elastic

What determines whether a given commodity has a PES that is Elastic or Inelastic?

There are a number of typical factors that will determine whether the price elasticity of supply for a given commodity is elastic or inelastic (see below).

Time Period: When the price of a commodity increases or when the demand for a commodity increases, firms are not able to respond immediate by increasing the quantity supplied on the market. Therefore in the short run PES is likely to be inelastic. However, as time passes by, firms are able to respond better to the changing market condition as they obtain more inputs to increase output, thus, it is likely that in the long run after all adjustments are made that PES will be elastic.

Level of Excess Capacity: When the price of a commodity increases or when the demand for a commodity increases, firms with a high level of excess capacity i.e. with available resources will be able to respond immediate by increasing the quantity supplied on the market. Therefore, the PES is likely to be elastic when firms have high levels of excess capacity. However, if excess capacity is low then firms will be unable to respond as they will not have the inputs necessary to increase output, thus, it is likely that PES will be inelastic when excess capacity is low.

Suitability of Factors of Production: When the price of a given commodity increases or when the demand for such a commodity increases, firms will be better able to switch to producing such a commodity if the factors of production (inputs) used in the production of the previous commodity is very suitable in producing this other commodity. Eg. If the firm was producing vehicle tires and the price of car windows increases, then the firm will respond by attempting to produce more windows and less tires. The extent to which the firm will produce more windows will depend on whether the resources used to produce tires can be easily switched to produce windows. If it can be easily switched to produce car windows then PES is likely to be elastic. If it is not easily switched or if these resources are not very suitable then PES is likely to be inelastic.

Brief Work Sheet: Price Elasticity of Supply (PES)

1. The market for tractors is supplied by two firms, X and Y, each initially having 50 % of the market.

A 10 % increase in the price of tractors leads to an increase in output from firm X of 10 % and from firm Y of 20 %.

What is the price elasticity of supply of tractors in this market?

A 1 B 1.5 C 2 D 3

2. When demand for a good increases, equilibrium price stays the same. What is its elasticity of supply?

A –1

B zero

C +1

D infinite

3. A manufacturer’s ability to increase supply in the short run will be greater

A if labour is immobile.

B if the product is perishable.

C if there is spare capacity. D if unemployment is low.

4. What would increase the price elasticity of supply of a firm’s products?

A a decrease in the period of time that stocks can be kept

B a decrease in the time that it takes to produce the products

C an increase in the cost of capital goods employed by the firm

D an increase in the level of employment in the area

Elasticity

 

Introduction:

‘It is not that more people are going to concerts. Rather, they are paying more to get in. In 1996 a ticket to one of America’s top 100 concert tours cost $25.81, according to Pollstar, a research firm that tracks the market. If prices had increased in line with inflation, the average ticket would have cost $35.30 last year. In fact it cost $62.57. Well-known acts charge much more. The worldwide average ticket price to see Madonna last year was $114. For Simon & Garfunkel it was an eye-watering $169’.

Source: The Economist, ‘What’s working in music’, October 7th, 2010.

.

Elasticity (Mr. Troublesome)

It is important to understand:

(a) What is elasticity all about?

(b) What are the many types of Elasticities? (c) How is elasticity measured?

(d) What does the measurement represent?

(e) What are the various types of measurements and how are they illustrated graphically?

(f) What are the implications of elasticity of demand for business decisions and government policy?

(a) What is elasticity all about?

Elasticity is about HOW MUCH does quantity demanded (Elasticity of demand) changes in response to a change in an influential factor.

Re-examined: it measures the extent to which quantity demanded changes in response to a change in an influential factor (such as price, income and price of complements or substitutes).

In order words, while the law of demand says that consumers will buy more when price decreases and less when price increases, ceteris paribus, it does not say by how much more or less. It is the concept of elasticity of demand which will do so.

(b) What are the many types of Elasticities?

Defined: it measures the extent to which quantity demand changes in response to a change in an influential factor (such as price, income and price of complements or substitutes).

There are as many factors influencing elasticity of demand (Ed) as they are factors influencing demand for a commodity.

For the most part, the literature focuses on three important factors; changes in price, income and price of substitutes and complements.

(b) What are the many types of Elasticities (Continue)?

For instance;

1. price elasticity of demand (PED) is the change in quantity demanded for the good in response to a change in the price of the good.

2. income elasticity of demand (YED) is the change in quantity demanded for the good in response to a change in the income of the consumer.

3. cross elasticity of demand (CED) is the change in quantity demanded for good X in response to a change in the price of good Y.

(c) How elasticity is measured?

1. Price Elasticity of Demand (PED) – ∆QD/ ∆P . P/QD i.e. the change in

quantity demanded/ the change in price (times) original price/original quantity demanded.

2. Income Elasticity of Demand (YED) – ∆QD/ ∆Y . Y/QD i.e. the change

in quantity demanded/ the change in the Consumer’s Income (times) previous income/original quantity demanded.

3. Cross Elasticity of Demand (CED) – ∆QDX/ ∆PY . PY/QDX i.e. the

change in quantity demanded of X/ the change in the price of Y (times) previous price of Y/original quantity demanded of X.

(d) What does the measurement represent?

Lets take for instance, the issue of price elasticity of demand (PED). It is ∆QD/ ∆P . P/QD. Should the following quantities and prices exist i.e. Q1= 100, P1 = 25, Q2 = 125, P2 = 20, then PED is 25/5 . 25/100 = 1.25.

1.25 reads that for every 1% change in price, quantity demand will change by 1.25%, which makes PED elastic. (The same could be said if it were income or cross elasticity of demand).

N.B. See relevant tutorial sheet or past paper question.

(e) What are the various measurements and how are they illustrated graphically?

In the previous slide, we argued that a PED of 1.25 represented a case of elasticity. In fact, guided by the formula for elasticity (whether demand/supply), there could be as many as five measurements of price elasticity of demand.

Measurements of Elasticity

1. Perfectly Elastic – where elasticity is infinity and the demand curve is horizontal. At the equilibrium price consumers will demand an infinite amount of the good and zero at a higher price. (This is a typical illustration of a perfectly competitive firm/ second year work).

2. Perfectly Inelastic – where elasticity is zero and the demand curves is vertical. This means that, despite an increase or decrease in price or income quantity demanded will not change.

3. Unitary Elastic – where elasticity is one and the demand curve is a rectangular hyperbola and the supply curve is a straight line through the origin (this is the sole difference between price elasticity of demand and supply). In the case of unitary, whatever the change in price/income is, the change in quantity demanded/supplied will be the same.

4. Relative Elastic – 1< Elasticity < infinity and the demand curve is very flat (relative to being horizontal). In this case, it is expected that the change in quantity demanded will be greater than the initial change in price/income.

5. Relative Inelastic – 0 < Elasticity < 1 and the demand curve is very steep (relative to being vertical). In this case, it is expected that the change in quantity demanded will be less than the initial change in price /income

The importance of the sign

Price Elasticity of Demand – The negative sign only illustrates the negative relationship between quantity demanded and price for a normal good. Generally the negative (-) sign is ignored, thus, PED -4 is the same as PED 4.

Income Elasticity of Demand – The sign is important.

(a) A positive sign (+) suggests that the good is a normal good so that higher incomes bring about higher demand.

(b) A negative sign (-) suggests that the good is an inferior good so that higher incomes bring about lower demand.

Cross Elasticity of Demand – The sign is important.

(a) A positive sign (+) suggests that the goods are substitutes as the change in the price of good y goes in the same direction with the change in the quantity demand for good x, so if the price of y rises, quantity demand of x rises.

(a) A negative sign (+) suggests that the goods are complements as the change in the price of good y goes in the opposite direction with the change in the quantity demand for good x, so if the price of y rises, quantity demand of x falls.

Implications of elasticity of demand for business decisions

An understanding of the application of elasticity of demand is essential for businesses and government. This is important as;

1. Businesses need to know by how much quantity demanded will change if there is an increase or decrease in the price of a given commodity. The amount by which quantity demanded changes may have implications for its total revenue. E.g. if price elasticity of demand is elastic, a fall in price may raise total revenue while an increase in price might decrease total revenue.

2. On the other hand, if price elasticity of demand is inelastic, then in order to increase total revenue, businesses should increase price.

N.B. In the case of income elasticity, then in a case of rising national income (GDP) businesses will be encouraged to invest, while when income elasticity is inelastic, then businesses are less encouraged to invest despite the rise in national income.

Implications of elasticity of demand for government Policy Making

In the case of government policy, the effective use of government taxes to discourage consumption of certain goods (demerit) could be ineffective depending on the degree of price elasticity for the commodity.

E.g. when price elasticity of demand is perfectly inelastic it means that quantity demand will remain unchanged despite the rise in price which the imposition of a tax will cause (although it will be effective in raising government’s revenues).

References

1. Baumol, William J, and alan S. Blinder. Economics: Principles and Policy. 8th Edition. USA: Dryden Press, 1999.

2. Colander, David C. Economics. 6th Edition. New York: McGraw – Hill/Irwin, 2006.

3. Hardwick, Philip, Bahadur Khan and John langmead. An Introduction to Modern Economics. Essex: Addison Wesley Longman Ltd, 1994.

4. Sloman, John. Economics. 5th Edition. Essex: Pearson Education Ltd, 2003.

 

Summary 1 Basic Concepts in Economics

 

Economics is a social science.

Why?

It studies the behaviour of human beings just as sociology and other social sciences do. (For instance it examines how and why do consumers allocate their resources among competing ends?)

Definition of Economics

 There are numerous definitions of the subject of economics. The following definitions in a nutshell sufficiently captures the job of an economist.

 Economics is defined as a social science which seeks to explain the economic basis of human societies (Hardwick et al, 1994).

 Economics is the study of how human beings coordinate their wants and desires, given the decision making mechanisms, social customs, and political realities of the society (Colander, 2006).

Branches of Economics

1. Microeconomics – a study of economic decisions of economic agents (consumer/household, firms and government) each of which with different objectives. E.g. Consumer – utility maximization, firm – profit maximization and government – social welfare maximization.

2. Macroeconomics – an analysis of the entire economy (how the collective decisions of each individual economic agent affects the economy?) E.g. decisions by firms to produce more or less gives rise to more employment or more unemployment.

The study of economics and scarcity

 Many writings on this study highlight that the economic basis of human society is that of scarcity.

 In fact, many of the world’s pressing problems (such as poverty and unemployment) are economic in nature (Baumol and Blinder, 1999).

 Scarcity is seen as the excess of human wants over what can actually be produced to fulfill these wants (Sloman, 2003).

 It is a case where the Supply of available resources are not equal to the Demands on those resources.

Understanding Scarcity:

Microeconomic Face of Scarcity

1. Individual – need to budget limited income to meet the household’s or individuals needs and wants.

2. Firm – deciding on the employment of factor inputs (FOP) due to limited financial capital.

3. Government – deciding and choosing among public expenditure options (Should government construct a piece of public road or use such resources to construct a school building instead?).

Understanding Scarcity(Cont.): Macroeconomic Face of Scarcity

1. Poverty

2. Unemployment

3. Inflation

4. Debt/GDP Ratio

5. Balance of Payment Problems

6. Government Budget Deficits

7. Crime

Summary of the Economic Problem

Opportunity Cost

Choices

Scarcity

Summary (Cont.)

Opportunity Cost –

 is the value of the next best alternative that the decision forces the decision maker to forgo (Baumol and Blinder, 1999).

 of any activity is the sacrifice made to do it (Sloman, 2003).

 Is the value of the next best alternative forgone (Hardwick et al, 1994).

 N.B. a good whose opportunity cost is zero is called a free good. A good with an opportunity cost is called an economic good.

Illustrating the Summary Concepts

The study of economics uses models in an effort to explain concepts (this is what makes it similar to the natural sciences).

N.B. An Economic Model is a representation of a theory or a part of a theory, often used to gain insight into cause and effect (Baumol and Blinder, 1999).

How the Economist study their subject?

While we are looking at models in economics, we must keep in mind that the Economist uses two approaches in studying how humans allocate scarce resources.

1. Positive Economics (focuses on what is and factual/can be tested such as the real inflation rate is 10%).

2. Normative Economics (focuses on what should be and is based on value judgments/cannot be tested such as government should increase its expenditure on health care to improve on the competitiveness of the economy).

Production Possibility Curve (PPC)

In Economics, the PPC (or PPF or PPB) could also be called transformation curve/frontier/boundary, provides a tool for illustrating the concepts of scarcity, choice, opportunity cost and economic efficiency.

Defined:

it joins together the different combinations of goods and services which a country can produce using all available resources and the most efficient techniques of production (technology).

N.B. Can also be called Transformation Curve/Boundary/Frontier

PPC (cont.)

There are three shapes of the PPC. These indicate the slope of the PPC and the level of suitability of resources.

 

Marginal Rate of Transformation (MRT)

Defined: is the rate at which one product can be transformed or converted into another product by reallocating resources (Hardwick et al, 1994).

The MRT measures the slope of the PPC. In the above example 1.33 represents the amount of good y that are being forgone in order to increase the amount of good X by a small amount (1 unit change). (∆ in the forgone Good y / ∆ in units of the good being increased x).

PPC (Shifts)

The PPC can shift inwards, outwards or pivot at a point.

1. An inward shift will represent negative economic growth (occurs when an economy is LESS able to produce more goods and services for each consumer- Baumol and Blinder, 1999)

2. This could be the result of; lost or depletion of resources, retardation of technology, brain drain etc.

PPC (Shifts)

3. In the case of outward shifts this will represent positive economic growth.

4. Positive economic growth may occur for the opposite reasons which explains why negative economic growth takes place.

5. The PPC can pivot at a point to show the increase or decrease in the potential of the economy to produce more or less of a good, while keeping the potential of the economy to produce the other good unchanged.

PPC (Inward & Outward Shifts)

Allocative Mechanisms (the economy – a mechanism which facilitates the allocation of resources so that the production, exchange and distribution of commodities can take place).

In the previous PPC, the owners and managers of the resources in the economy will decide what combination point, A, B and C the economy will produce at. Essentially, the allocative mechanisms answer the questions of:

1. What to produce?

2. How to produce?

3. And for whom to produce?

These questions addressed the issue of resource allocation.

Allocative Mechanism (Cont.)

N.B. The traditional system was a subsistence system which eventually evolved into a trading system which centered upon the use of Barter.

(Failure of the barter system is a result of the problem of double coincidence of wants)

Modern economic system/allocative mechanism exist along a continuum

Market Economy Mixed Economy Command Economy

Types of Economic Systems

Economic

System

How to Produce?

What to Produce?

For Whom to Produce?

Free Market Individuals who are

Owners of the resources (Land, Labour, Capital (money) and Enterprise). This decision will depend on relative prices of inputs and the need to meet the profit maximizing objective

Individual owners of resources who will seek to allocate resources towards the production of a good which is highly demanded on the market and thus, will better able a firm to meet its profit maximizing level.

As with the two functions, this will be based on the price mechanism.

Those who can afford the equilibrium price will consume the commodity

Mixed Owners of resources

(individual and government will make this decision)

1.Price Mechanism

2. Based on government objective and in response to market failure (externality and public good).

1. Price mechanism

2. Based on government objective.

Command Government ownership

(decisions to be taken by some central authority)

Central Authority (often informed by little market data)

Central Authority (often through some form of rationing)

Appendix: Money

Thus, in a market economic system, the monetary system plays a key role in determining the allocation of resources.

Money can be seen in terms of narrow or broad money (Hardwick et al, 1994), however the most simplistic definition is a commodity which is generally accepted both as a measure of value and a medium of exchange.

Money (Continue)

(A) Functions

1. Medium of Exchange

2. Store of value

3. Unit of Account

4. Standard of Deferred Payment

(Hardwick et al, 1994)

Money (Continued)

(B) Characteristics

1. Durable

2. Portable

3. Divisible

4. Scarce

5. Homogenous

6. Generally acceptable

References

1. Baumol, William J, and alan S. Blinder. Economics: Principles and Policy. 8th Edition. USA: Dryden Press, 1999.

2. Colander, David C. Economics. 6th Edition. New York: McGraw – Hill/Irwin, 2006.

3. Hardwick, Philip, Bahadur Khan and John langmead. An Introduction to Modern Economics. Essex: Addison Wesley Longman Ltd, 1994.

4. Sloman, John. Economics. 5th Edition. Essex: Pearson Education Ltd, 2003.