Economics Exam Solutions

Essay 1: With the help of examples explain the determinants of price elasticity of supply. Price elasticity of supply (PES) is the measure of the responsiveness of a quantity of a good supplied to changes in its price. Generally, if a large responsiveness is observed, the good is noted as elastic, while a small response with regards to price change corresponds to the product being classified as inelastic. In the market, there are many such factors that can affect the extent to which a good is price elastic to supply. These include: time, mobility of factors of production, unused capacity and the ability to store stocks. In the short run, the value of a goods price elasticity of supply is significantly lower than in the long run. As time progresses, the product becomes price elastic as a firm is allowed to adjust its production levels. Assumingly, in the long run, all factors of production can be utilised to increase supply, whereas in the short run only the labour can be increased, a change that may prove to be quite costly. Especially, in agricultural markets, the momentary supply is immobile and the average production yield is determined in advance due to the climatic conditions. Therefore, for example a cotton farmer, cannot immediately respond to an increase in the price of soybeans because of the extra time it would take to prepared the necessary land. Another determinant of the price elasticity of supply is the productiveness of the factors of production, such as land, labour, capital and enterprise. If these can be shifted from one productive use to another in a firm, then the product will be relatively elastic. This is particularly true if both capital and labour are occupationally mobile. For example, if a machine being utilised to produce orange juice also has the ability to make blueberry juice, when there is an incentive to increase the supply of blueberry juice (i.e. increase in the market price), the orange juice machine can also be additionally used for the production. Conversely, if a business only produces leather sofas, it can be reasonably difficult to switch to making wooden chairs. Having unused capacity also increases the elastic nature of a production because that would imply that the levels of output can be increased with ease. This can be done without a major rise in costs and even during a recession, the product will remain elastic, as variable factors will be readily available. In a scenario where a school teacher is on leave, having substitute teachers coming in as a backup will make the supply of teachers in a school elastic. Similarly, having excess stores of corn kernels in a pop-corn making factory will ensure that when there is a price incentive to increase production, there are extra resources to increase the output being supplied. However, if a company has utilised its factors of production to the full capacity, the good will be inelastic to price as the output wont be significantly different even if the price incentive alters. Lastly, if a firm is able to store high levels of stock of their product and the raw materials constituting it, then the good is relatively elastic. For instance, if a manufacturer can make and store jumpers during the summer, when the price is high during winter, the supply of jumpers can be increased. In conclusion, as discussed above, these listed factors are the determinants of the price elasticity of supply.

Discuss why it may be important for a firm to have knowledge of price elasticity of demand. Price elasticity of demand is a measure of the responsiveness of the quantity of a good demanded to changes in its price. It is of great importance to a firm to have knowledge about the price elasticity of demand because it is a determinant of pricing strategy. When a firm understands the usual market reaction of consumers demand relative to the market price, it can formulate strategies to maximise its profit. Basically, there are three categories of goods, each corresponding to unalike elastic behaviour. These are: inferior, normal and luxury goods. Moreover, concepts of complementary goods and substitution, also conceptualising with price elasticity of demand, assist in firms making suitable economic decisions. If a product is relatively elastic, as its price decreases, the total revenue of the company will increase. This is because changes in the price will result in a considerably large change in demand, as it benefit the consumer to buy a product cheaper.

A strong inverse relationship exists between the price and demand of elastic products: as the price increases, the demand decreases and vice-versa. These goods are generally normal goods, which are not a necessity in the lives of common people, such as Pepsi. They have substitutes, like Coca-Cola, and their demand is easily affected by fluctuations in their prices. All in all, such products are generally manufactured goods. On the other hand, a firm will have contrasting revenues when inelastic goods are being sold. Generally, their revenues will increase when prices rise and vice-versa. This is because goods with relatively low price elasticity of demand will not have a significant change in demand, regardless of the changes in the price of the good.

These goods are normally necessities, like agricultural products, such as wheat, without any strong substitutes. They are an essential part of a common mans lifestyle and regardless of their financial condition; consumers will have a demand for them.

Data Response
1. Define the term rationing as used in the article? Rationing, as used in the article, means to allocate scarce resources in the most efficient manner to avoid opportunity costs. 2. The article refers to how Beijingrigidly caps pump fuel rates to shield users from a 50 percent rally in global oil so far this year. Why does Beijing cap pump fuel rate? Beijing caps fuel prices, or sets a price ceiling for oil prices, to protect the people from the very high prices and prevent the already boosted high inflation from further increasing. 3. Draw a supply and demand diagram to illustrate the situation in the Chinese fuel market in 2007. Assume that demand is constant given the quote China's apparent oil demand nearly stalled in September with only a 0.3 precent rise from a year earlier.

4. Referring to the diagram you have drawn in Q. 3, and referring to the article, explain why enormous queues of trucks have been forming in China. There is a shortage in the Chinese fuel market, accounting for these enormous queues. Given the slight increase in demand, there was expected to be a slight increase in fuel prices and the supply of fuel. However, this isnt the case in this scenario, and the supply is not enough to meet the demand. This is shown by the difference in Qd and Q1 due to the price ceiling. There is a clear shortage and so

resultant the available fuel is being rationed on a first-come, first-serve basis to the consumers, causing the queues. 5. Referring to your diagram in Q. 3, define and identify consumer surplus and producer surplus. Producer Surplus The excess of actual earnings that a producer makes from a given quantity of output, over and above the amount the producer would be prepared to accept for that output Consumer Surplus The highest price the consumers are willing to pay for a good, minus the price actually paid.

6. Does a governments control of prices reduce the total welfare of consumers and producers in a market like petrol? Explain. Yes- the governments control of prices reduces the total welfare of consumers and producers because there is essentially misallocation of resources and disequilibrium. Society is being underprovided with a good that is generally considered inelastic (demand is not responsive to price changes), petrol. Consumers can both benefit and suffer in this scenario. While they get the opportunity to buy the good a lower price, they can be treated unfairly by the market. This is because non-price rationing systems have to be utilised to distribute the scarce resources, like favouritism. The first-come, firstserve principles, the most common side effect of a shortage, results in long waiting lines, which are an unnecessary waste of energy. Traffic can also decrease social welfare. Similarly, producers have a decrease in there total revenue as they sell a smaller quantity of the good at a lower price. There is a loss of producer surplus.

7. State if a government subsidy to petrol producers would provide a more desirable solution to the high oil prices than the solution described in this post? In your answer, sketch a new market diagram for petrol to show the effects on supply, demand, price and quantity of a government subsidy to petrol producers?

Subsidising the producers would increase the welfare of the producers because they would get paid a higher price for the supply. Thus, it would provide a more desirable solution.