Income elasticity of demand is a measure of the responsiveness (sensitivity) of quantity demanded or supplied for a product to a change in income (household or national income). Income elasticity's help us forecast the pattern of consumer demand as the economy grows and people get richer. When we talk about income, we tend to use real income rather than nominal income for this measurement. Income elasticity involves shifts in a demand curve (increase/demand) rather than movements along a demand curve (expansion/contraction). The equation for income elasticity of demand is:
IED= % change in quantity demanded of X
% change in income
As a broad rule of thumb, some people regard income elasticity of demand as useful in classifying products into 'luxury' and 'necessity' groupings. The income elasticity for coal in the U.K is -2.02 showing that coal is income inelastic. This means that even if the average income in the economy rises or falls people would still buy coal because it is considered a 'necessity'. Therefore whatever the percentage change in income there would be minimal change in the quantity demanded. People will never stop needing coal, for example it is essential to generate electricity. Statistics show that 50% of electricity in the US is generated in coal. To conclude, consumers will always buy coal as there are no close substitutes and as electricity is its main use, it will always be essential.
Why are cigarettes and alcohol a good thing to tax? Is increasing the price of alcohol likely to reduce the practice of "binge" drinking by young adults? Explain your answers. (5%)
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Taxation is a major source of government revenue to pay for education, health and defence. Even though the UK rate of VAT is not high by world standards, the UK has very heavy specific taxes on alcohol and tobacco. Tax on smoking and alcohol is called a "sin tax". Alcohol and tobacco have inelastic demand because it is considered to be a necessity as people are dependent on the product.
One reason why cigarettes and alcohol are a good thing to tax is because it discourages the population from carrying out these activities. If the product costs more, less people will buy it and it also prevents others from starting the 'addiction'. In relation to reducing '"binge" drinking of young adults, taxing could reduce this problem as the item becomes less affordable. Having researched more into this topic, the price elasticity's of demand for beer, wine, and distilled spirits are -0.3, -0.1, and -1.5 respectively (Leung and Phelps 1993).
On the other hand, taxing cigarettes and alcohol does not necessarily mean that people would stop buying these products because they can be addictive.
In addition, cigarettes and alcohol is a good thing to tax because they improve efficiency and reduce waste. An example of this is that they lead to health problems such as lung and throat cancer. A case study in France found that smoking is held responsible for 66,000 deaths a year, including 6,000 people who had never smoked. As government revenue pays for health problems, the cost of the NHS would decrease as less people would smoke therefore health problems would be reduced. This can result in the government spending revenue earnt from taxes on other areas such as education instead of spending a large amount on the NHS.
While the main reason governments tax goods such as cigarettes and alcohol, due to the negative externalities caused. Firstly cigarettes, the main externality is to the national health system, where Billions of pounds have to be placed into the system to cover the treatment of lung cancer and many other symptoms of smoking. The main negative externality of alcohol is also of the bill to the NHS, secondly the cost of alcohol related incidence which increases the public sector wage deficit of the police force, with extra police presence needed on the weekend in many Towns and cities to control violence.
However, from the government's point of view, taxing cigarettes and alcohol is good because they can get more revenue. If they stopped taxing these products, would the state of the economy collapse? It might be necessary for the government to tax cigarettes and alcohol to keep the economy running productively.
The price elasticity of demand for translantic air travel is -1.30 whist the income elasticity of demand is +1.40. If the government taxes air travel in an attempt to reduce air travel's carbon footprint is this policy likely to be successful? Explain your answer. (5%)
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Demand for translantic air travel is inelastic in relation to price, therefore demand would still continue even if the price rises or falls. On the other hand, demand for translantic air travel is elastic in relation to income; therefore demand could fall or rise if income changed.
This means that if the government taxed air travel in an attempt to reduce carbon footprint, it could turn out to be extremely successful. If the income of the economy decreased, this could mean that less people would be able to travel abroad, therefore there would be fewer planes running, decreasing carbon footprint. If the price for translantic air travel rises or falls, even though there would be a small increase/decrease, the demand would be mainly dependent upon income. If the peoples real income falls, then whatever the price is at the time, the demand for transatlantic air travel will subsequently decrease, whereas if the economy's income rises, there will be an increase in demand. This would be as travelling abroad is a luxury good as the majority of the population would only go on holiday around 2 times a year.
Therefore, the government's success rate of taxing air travel may only work depending on the 'state' of the economy. For example, during the 'credit crunch' peoples demand for travel would decrease, therefore taxing air travel would be successful because less people would fly, leading to carbon footprint to decrease.
Profit maximisation is when Marginal Cost equals Marginal revenue, hence the profit maximisation output is 5 and profit is 150.
The graph showing the demand curve is shown on a separate piece of paper.
The graph showing the total variable cost, total fixed cost and marginal cost curves is shown on a separate piece of paper.
The marginal cost curve is the relation between marginal cost and the quantity of production. The key feature of the marginal cost curve is the U-shape. This shows that it has a negative slope for small quantities of output, reaches a minimum value, then has a positive slope for larger quantities.
Marginal cost curve is u-shaped; it is directly linked to increasing, then decreasing marginal returns which is the law of diminishing marginal returns. As marginal product and marginal returns increases for relatively small output quantities, marginal cost declines. Then as marginal returns decreases with the law of diminishing marginal returns for relatively larger output quantities, marginal cost increases. Hence diminishing returns dictates the U-shape of the marginal cost curve. Diminishing returns refers to how the marginal production of a factor of production starts to progressively decrease as the factor is increased, whereas an increase would be expected.
There is a clear relationship between total revenue and price elasticity of demand. This clear link is shown if for example a firm was considering changing their price they would have to know what effect the change in price will have on total revenue. However, a change in price will have two effects. Firstly, the price effect occurs meaning that an increase in unit price will tend to increase revenue, while a decrease in price will tend to decrease revenue. Secondly, the quantity effect occurs meaning an increase in unit price will tend to lead to fewer units sold, while a decrease in unit price will tend to lead to more units sold.
Maximising sales revenue is unlikely to be the best policy for the firm to persue because you will have to do without profit maximization, which is the centre point of any business. Profit maximisation is when a firm determines the price and output level that creates the greatest profit. Therefore, this would lead to the opportunity cost to be higher profit at least in the short run. Another problem for the firm maximising sales revenue is that s it may result to share holder dissatisfaction, which could lead to the company being volatile for takeover.
ABC should invest into the project because if the NPV is greater than 0 it means that the investment would add value to the firm, therefore the project can be accepted and undertaken. However, a disadvantage to NPV is it does not account for flexibility/uncertainty after the project decision.
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The rationale for discounting future cash flows is a valuation method used to estimate the attractiveness for an investment opportunity. Flows must be discounted in order to express their present values in order to properly determine the value of a company or project under consideration as a whole. A discounting cash flow takes into account all initial outlays as well as expenses and revenues. It produces the closest thing to an intrinsic stock value.
The company's shareholders will evaluate the project in such a way and will decide whether they feel the project will enhance the company's future profits. Therefore the share price may either dip or increase depending on how the share holders interpret the information. There is also the chance that the share price stays the same given that the major project is consistent with previous company policies. The company will see increase in demand of the share if investors see the major project to give worthwhile high returns without being deemed to be too risky and hence an increase in share price and vice versa. Hence if investors are optimistic about the major project, then share prices will increase, while if they are pessimistic about the major project then the share price will decrease. Supply and demand plays a significant part in the share price, and as explained above, if investors believe the project is worthwhile people will hold on to the share and as demand for the share will be higher and supply being stagnant the share price will increase, while if the project is deemed as risky or not a decent project then investors will sell their shares as they believe the project will lead to a decrease in the value of the company and hence a decrease in price.
I) Price elasticity of demand= (% Change in Quantity Demanded)/(% Change in Price)
âˆ†D/âˆ†P x P/D
2,000,000/-200 x 5000/12,000,000 = -0.416Ì‡Ì‡Ì’
Therefore, the price elasticity of demand assumed by the VGW is -0.4%. This value shows that VGW union assume that the vehicle will be price inelastic; therefore if the price changed the demand would not be affected by a vast amount.
ii) If the price elasticity for cars is -0.5 there would not be a great impact on the automobile industry as this figure shows the product is price inelastic and consumers will pay almost any price. Therefore a low coefficient implies that changes in price have little influence on demand. This would have an impact on the automobile industry in many ways.
Firstly, as two million cars are being sold, this means that the firm would have to produce more of the product. Therefore, if more of the product is being product this would result to a lower cost per unit, reducing the costs of production. Even though profit will remain the same, the company would be able to use the extra revenue saved from the reduced price of production to run the firm on a more efficient level. For example, they may be able to work towards working at full capacity and solving the problem of workers not being employed for a full working week. This could lead to a more enjoyable environment, and workers may feel more involved and attached to their job, resulting in lower absenteeism, turnover and higher levels of production. Therefore, by producing more they are saving costs, and they could use this money to improve the efficiency of the business.
However, VGW should not expect a large increase in demand because even if the price of the product does decrease the product is price inelastic. Consequently, they should not expect an increase in profit. Price inelasticity would not affect the demand sold by a vast amount, because consumers are willing to pay for the product whether the price stayed the same or went down. There are many reasons why the product is price inelastic. The automotive industry designs, develops, manufactures, markets, and sells the world's motor vehicles. In 2008, more than 70 million motor vehicles, including cars and commercial vehicles were produced worldwide. This shows the extent to how necessary the automobile industry is. The nature of the need satisfied of the product is an extremely important concept. The product is needed to sell motor vehicles which are necessary products for everyday life. The more basic and necessary the need, the less price sensitive consumers tend to be and less elastic the demand.
Therefore, for the automobile industry to reduce the price of cars by £200 per car could lead to a small difference to the number of sales as the product is a 'necessity' and consumers are willing to spend money whether the price decreased or increased. There could be slight improvements to the efficiency of the firms; however, there would be no major changes.
Breakeven output= fixed costs/contribution per unit (selling price pet unit-variable cost per unit)
= 500/ (350-250)
Therefore the breakeven output is=£5
Therefore the breakeven output is=£5000
i) The severe frost which occurred in Spain and Florida resulted in 30% of lemon crops being destroyed. As shown in the demand and supply diagram below, due to adverse weather conditions there will be a decrease in supply from S1 to S2, and a new equilibrium point at e2 from e1. The effect upon the equilibrium price and quantity is as follows, there will be an increase in price (P1 to P2), and a drop in quantity of lemons (Q1-Q2).
ii) Due to an increase in price of lemons resulting from a drop in supply due to adverse weather conditions, products which use lemons as an ingredient would subsequently have to increase the price of the good. The two diagrams represent goods with elastic and inelastic demand curves respectively. Diagram A (the good is demand elastic towards price) shows that an increase in price would lead to a large drop in the quantity demanded for the good. While diagram B (the good is demand inelastic towards price) shows that an increase in the price would lead to a very small decrease in quantity demand, due to the goods inelastic nature.
Q9) The following paragraphs and diagrams will illustrate the following statement: 'according to traditional economic theory, price is determined at the level of output at which marginal revenue equals marginal cost' Firstly I will explain perfect competition and then Monopoly.
Perfect competition is a market structure in which there are large numbers of fully informed buyers and sellers of a homogeneous product and there are no obstacles to entry or exit of firms into the market. There are 5 main assumptions of a perfectly competitive market:
There are many buyers and sellers.
There is perfect information so buyers know what products are on offer and at what price.
The product is homogenous so firms cannot differentiate their product.
There are no barriers to entry so firms can enter and leave the industry in the long run.
Producers have similar technology and there are perfectly mobile resources, hence one firm cannot maintain an advantage over another.
Each firm in perfect competition is a price taker. This means that changes in output by one firm do not shift the industry supply curve sufficiently to alter the price. If the whole industry make more or less output the supply will shift and the price will change, but not if one firm increases or decreases output. This means each firm can sell all it wants at the given market price. This also means that marginal revenue equals price. In the short run firms in perfectly competitive markets can make abnormal profits or losses. If firms make abnormal profits, firms will enter the market due to there being no barriers to entry, shifting supply to the right hence a fall in price will occur. This will continue until firms are only making normal profits, which occurs in the long run.
The diagram below shows the long run equilibrium in perfect competition.
A monopoly exists where there is a single seller in a market, hence a monopolist is a price taker. There are three main assumptions:
There is only one firm in the industry - the monopolist.
Barriers to entry prevent new firms from entering the market.
The monopolist is a short run profit maximiser.
The monopolist faces a downward sloping demand and can set the price or the output but not both. If the monopolist sets the price it must accept the quantity which is demanded at this price, alternatively if it sets output it must accept the price it can get for this quantity.
As many people believe monopolist can charge any price they want, this is wrong. It is correct that a firm with monopoly has price-setting power and will look to earn high levels of profit. However the firm is constrained due to the position of the demand curve, hence a monopoly cannot charge a price that the consumers in the market will not bear. A pure monopolist is the sole supplier in an industry and, as a result, the monopolist can take the market demand curve as its own.
A monopolist therefore faces a downward sloping AR curve with a MR curve twice the gradient of AR. Hence as shown on the diagram below the output is decided where Marginal cost equals marginal revenue and therefore sets the price at P1. The area highlighted yellow shows the monopolist making supernormal profits.
The diagrams of monopoly and perfect competition shows the price is determined at the level of output where Marginal cost equals marginal revenue.