2010 Essay Question 1

Question

The price of sugar, an ingredient in many canned soft drinks, dropped dramatically by 32% between July 2006 and October 2008. Healthy living campaigns meant consumers became more aware of the possible health dangers of consuming too much sugar and they switched to ‘diet’ drinks that do not contain sugar.

Discuss how the combination of the fall in the price of sugar and the healthy living campaigns might affect expenditure by consumers on non-diet and diet canned soft drinks. [25]

Answer

Diet Canned Soft Drinks

Healthy living campaigns which will increase consumers’ awareness of the possible health dangers of consuming too much sugar will lead to a change in tastes and preferences towards diet canned soft drinks (DCSDs) and this will lead to an increase in the demand. A fall in the price of sugar will lead to a fall in the cost of production of non-diet canned soft drinks (NDCSDs). When this happens, the supply of NDCSDs will rise which will lead to a fall in the price. Since the cross elasticity of demand between DCSDs and NDCSDs is positive, a fall in the price of NDCSDs due to the increase in the supply will lead to a decrease in the demand for DCSDs. Given that NDCSDs contain sugar, consumers of DCSDs who are generally health conscious are unlikely to consider NDCSDs a close substitute and hence the cross elasticity of demand for DCSDs with respect to NDCSDs due to a fall in the price of NDCSDs is likely to be small. Therefore, the demand for DCSDs is likely to rise. If this happens, the price and the quantity will rise which will lead to a rise in the consumer expenditure. When the demand for DCSDs rises, whether the price effect or the quantity effect on the consumer expenditure will be greater will depend on the price elasticity of supply. The supply of canned soft drinks, both DCSDs and NDCSDs, is likely to be price elastic as the production time is likely to be short given that they are mass produced on assembly line and they can be stocked in large quantities given that they are small in size and non-perishable in the short term. Therefore, the quantity is likely to rise by a larger proportion than the price and hence the quantity effect on the consumer expenditure is likely to be greater than the price effect. Students need to draw a diagram showing a rightward shift in the demand curve and shade the area which represent the consumer expenditures before and after the shift.

Non-diet Canned Soft Drinks

Healthy living campaigns which will increase consumers’ awareness of the possible health dangers of consuming too much sugar will lead to a change in tastes and preferences against NDCSDs and this will lead to a decrease in the demand. When this happens, the price and the quantity will fall which will lead to a fall in the consumer expenditure. Since the supply of canned soft drinks is likely to be price elastic, the quantity is likely to fall by a larger proportion than the price and hence the quantity effect on the consumer expenditure is likely to be greater than the price effect.

When the supply of NDCSDs rises due to a fall in the price of sugar which will lead to a fall in the cost of production, the price will fall and the quantity will rise. Although the fall in the price will reduce the consumer expenditure, the rise in the quantity will increase the consumer expenditure. When the supply of NDCSDs rises, whether the consumer expenditure will rise or fall will depend on the price elasticity of demand. The demand for NDCSDs is likely to be price elastic due to the large number of substitutes such as diet packet soft drinks, non-diet packet soft drinks, diet bottle soft drinks and non-diet bottle soft drinks. Therefore, the quantity is likely to rise by a larger proportion than the fall in the price and hence the consumer expenditure is likely to rise.

Combined Effect (Option 1)

Although the decrease in the demand for NDCSDs will lead to a decrease in the consumer expenditure, the increase in the supply is likely to lead to an increase in the consumer expenditure as the demand is likely to be price elastic. The decrease in the demand and the increase in the supply will both lead to a fall in the price. Although the decrease in the demand will lead to a fall in the quantity, the increase in the supply will lead to a rise in the quantity. Students need to consider the relative price elasticities of demand and supply and the relative changes in the demand and the supply to determine the effect on the quantity and hence the effect on the consumer expenditure.

The relative price elasticities of demand and supply
Due to the elastic supply, the decrease in the demand is likely to lead to a large decrease in the quantity, and due to the elastic demand, the increase in the supply is likely to lead to a large increase in the quantity. Therefore, the quantity will be indeterminate.

The relative changes in the demand and the supply
As the price of sugar dropped dramatically by 32%, the fall in the cost of production of NDCSDs is likely to be large which is likely to lead to a substantial increase in the supply. Therefore, the increase in the supply is likely to be greater than the decrease in the demand. If this happens, the quantity is likely to rise.

Combining the effects of the relative price elasticities of demand and supply and the relative changes in the demand and the supply on the quantity, the quantity is likely to rise. Although the rise in the quantity will increase the consumer expenditure, the fall in the price will decrease the consumer expenditure. Therefore, the consumer expenditure will be indeterminate. Students need to draw a diagram showing a simultaneous shift in the demand and the supply curves and shade the areas which represent the consumer expenditures before and after the shifts.

Note: Most schools prefer Option 1.

Combined Effect (Option 2)

Although the decrease in the demand for NDCSDs will lead to a decrease in the consumer expenditure, the increase in the supply is likely to lead to an increase in the consumer expenditure as the demand is likely to be price elastic. The decrease in the consumer expenditure due to the decrease in the demand occurs due to both the fall in the price and the fall in the quantity. Therefore, the decrease in the demand is likely to lead to a relatively large decrease in the consumer expenditure. Although the increase in the supply will decrease the consumer expenditure due to the greater proportionate rise in the quantity, this will be partially offset by the decrease in the consumer expenditure due to the fall in the price. Therefore, the increase in the consumer expenditure due to the increase in the supply is likely to be relatively small. Therefore, unless the increase in the supply is substantially greater than the decrease in the demand, the consumer expenditure is likely to fall. However, as the price of sugar dropped dramatically by 32%, the fall in the cost of production of NDCSDs is likely to be large which is likely to lead to a substantial increase in the supply. To the extent that this leads to an increase in the supply substantially greater than the decrease in the demand, the consumer expenditure may rise. Students need to draw a diagram showing a simultaneous shift in the demand and the supply curves and shade the areas which represent the consumer expenditures before and after the shifts.

Conclusion

The conclusion can simply be a summary as the evaluation marks are awarded to the combined effects which have been discussed.

A more elaborate answer to 2010 Essay Question 1 will be provided in the economics tuition class.

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