2012 Essay Question 1

Question

Most brands of cars are available in different models. A large rise in the cost of car manufacture and a rise in incomes are likely to affect the sales of various models of car in different ways.

(a) Explain how elasticities of demand can assist in understanding the effect of each of these changes on the sales volume of different models of car. [10]
(b) Compare and contrast the likely combined impact of both these changes on the revenue earned from the sales of different models of car. [15]

Answer

(a) Students should distinguish between three models of cars: high-end models (e.g. BMW, Lexus and Mercedes), mid-range models (e.g. Honda City, Toyota Vios and Hyundai Elantra) and low-end models (e.g. Kia Picanto, Tata Nano and Cherry QQ).

The YED for high-end models is likely to be greater than one which means that they are likely to be a luxury. If this happens, a rise in income will lead to an increase in the demand resulting in an increase in the quantity. Students need not discuss the effect on the price as the question explicitly asks about the sales volume.

A rise in the cost of production of cars will lead to a decrease in the supply. When this happens, the quantity will fall.

As an increase in the demand will lead to a rise in the quantity and a decrease in the supply will lead to a fall in the quantity, the quantity will be indeterminate. 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.

The relative price elasticities of demand and supply
High-end models are generally expensive and hence the proportion of income spent on the good is large. Therefore, the demand is likely to be price elastic. As a result, a decrease in the supply is likely to lead to a large decrease in the quantity. As the question explicitly asks to use elasticities of demand, students should not discuss price elasticity of supply. Therefore, the quantity is likely to fall.

The relative changes in the demand and the supply
The YED for high-end models is high. Therefore, the increase in the demand and hence the increase in the quantity is likely to be large. As the rise in the cost of production is large, the supply and hence the quantity is likely to fall substantially. Therefore, the quantity will be indeterminate.

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 fall. Students need to draw a diagram showing a simultaneous shift in the demand and the supply curves.

The YED for mid-range models is likely to be between zero and one which means that they are likely to be a necessity. If this happens, a rise in income will lead to an increase in the demand resulting in an increase in the quantity.

A rise in the cost of production of cars will lead to a decrease in the supply. When this happens, the quantity will fall.

The relative price elasticities of demand and supply
Although mid-range models are not as expensive as high-end models, they are still fairly expensive and hence the proportion of income spent on the good is large. Therefore, the demand is likely to be price elastic. As a result, a decrease in the supply is likely to lead to a large decrease in the quantity. Therefore, the quantity is likely to fall.

The relative changes in the demand and the supply
The YED for mid-range models is low. Therefore, the increase in the demand and hence the increase in the quantity is likely to be small. As the rise in the cost of production is large, the supply and hence the quantity is likely to fall substantially. Therefore, the quantity is likely to fall.

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 fall substantially. Students need to draw a diagram showing a simultaneous shift in the demand and the supply curves.

The YED for low-end models may be less than one which means that they may be an inferior good. If this happens, a rise in income will lead to a decrease in the demand resulting in a decrease in the quantity.

A rise in the cost of production of cars will lead to a decrease in the supply. When this happens, the quantity will fall.

As a decrease in the demand and a decrease in the supply will both lead to a fall in the quantity, the quantity will fall. Students need to draw a diagram showing a simultaneous shift in the demand and the supply curves.

Conclusion

The conclusion can simply be a summary or recommendation as there are no evaluation marks.

Answer

(b) Like Part A, students can distinguish between three models of cars. However, unlike Part A which asks about the effects on the quantity, this part of the question requires students to discuss the effects on the total revenue which is the price times the quantity.

When the demand for high-end models rises due to the increase in income, the price and the quantity will rise which will lead to increase in the total revenue. When the demand for high-end models rises, whether the price effect or the quantity effect on the total revenue will be greater will depend on the price elasticity of supply. Cars are mass produced on assembly line and hence the production time is likely to be short. Therefore, the supply is likely to be price elastic. It follows the proportionate increase in the quantity is likely to be greater than the proportion increase in the price and hence the quantity effect on the total revenue is likely to be greater than the price effect.

When the supply of high-end models falls due to the rise in the cost of production, the price will rise and the quantity will fall. Although the rise in the price will increase the total revenue, the fall in the quantity will decrease the total revenue. When the supply of high-end models falls, whether the total revenue will rise or fall will depend on the price elasticity of demand. As the demand is likely to be price elastic, which has been explained earlier, the proportionate decrease in the quantity is likely to be greater than the proportionate increase in the price. Therefore, the total revenue is likely to fall.

Combining the demand and the supply effects, the total revenue is likely to rise. Although the decrease in the supply is likely to lead to a decrease in the total revenue as the demand is likely to be price elastic, the increase in the demand will lead to an increase in the total revenue. The increase in the total revenue due to the increase in the demand occurs due to both the rise in the price and the rise in the quantity. Therefore, the increase in the demand is likely to lead to a relatively large increase in the total revenue. Although the decrease in the supply will reduce the total revenue due to the greater proportionate decrease in the quantity, this will be partially offset by the increase in the total revenue due to the rise in the price. Therefore, the decrease in the total revenue due to the decrease in the supply is likely to be relatively small. Therefore, the total revenue is likely to rise, unless the decrease in the supply is substantially greater than the increase in the demand, a scenario not indicated by the information provided in the preamble or the question. Students need to draw a diagram showing a simultaneous shift in the demand and the supply curves.

When the demand for mid-range models rises due to the increase in income, the price and the quantity will rise which will lead to an increase in the total revenue. As the supply is likely to be price elastic, which has been explained earlier, the proportionate increase in the quantity is likely to be greater than the proportionate increase in the price and hence the quantity effect on the total revenue is likely to be greater than the price effect.

When the supply of mid-range models falls due to the rise in the cost of production, the price will rise and the quantity will fall. Although the rise in the price will increase the total revenue, the fall in the quantity will decrease the total revenue. As the demand is likely to be price elastic, which has been explained earlier, the proportionate decrease in the quantity is likely to be greater than the proportionate increase in the price. Therefore, the total revenue is likely to fall.

Combining the demand and the supply effects, the total revenue is indeterminate. Although the decrease in the supply is likely to lead to a decrease in the total revenue as the demand is likely to be price elastic, the increase in the demand will lead to an increase in the total revenue. The increase in the total revenue due to the increase in the demand occurs due to both the rise in the price and the rise in the quantity. Therefore, the increase in the demand is likely to lead to a relatively large increase in the total revenue. Although the decrease in the supply will reduce the total revenue due to the greater proportionate decrease in the quantity, this will be partially offset by the increase in the total revenue due to the rise in the price. Therefore, the decrease in the total revenue due to the decrease in the supply is likely to be relatively small. Therefore, the total revenue is likely to rise, unless the decrease in the supply is substantially greater than the increase in the demand. Students need to draw a diagram showing a simultaneous shift in the demand and the supply curves. However, as the rise in the cost of production is large and the increase in the demand is likely to be small due to the low YED, the decrease in the supply may be substantially greater than the increase in the demand. Therefore, the total revenue may fall.

A decrease in the demand for low-end models due to an increase in income will lead to a fall in the price and the quantity. When this happens, the total revenue will fall. As the supply is likely to be price elastic, which has been explained earlier, the decrease in the demand is likely to lead to a greater proportionate decrease in the quantity than the decrease in the price and hence the quantity effect on the total revenue is likely to be greater than the price effect.

A decrease in the supply of low-end models due to the rise in the cost of production will lead to a rise in the price and a fall in the quantity. Although the rise in the price will increase the total revenue, the fall in the quantity will decrease the total revenue. As the demand is likely to be price inelastic, which has been explained in Part A, the proportionate rise in the price is likely to be greater than the proportionate fall in the quantity. Therefore, the total revenue is likely to rise.

Combining the demand and the supply effects, the total revenue is indeterminate. Although the decrease in the supply is likely to lead to an increase in the total revenue as the demand is likely to be price inelastic, the decrease in the demand will lead to a decrease in the total revenue. The decrease in the total revenue due to the decrease in the demand occurs due to both the fall in the price and the fall in the quantity. Therefore, the increase in the demand is likely to lead to a relatively large increase in the total revenue. Although the decrease in the supply will increase the total revenue due to the greater proportionate rise in the price, this will be partially offset by the decrease in the total revenue due to the fall in the quantity. Therefore, the increase in the total revenue due to the decrease in the supply is likely to be relatively small. Therefore, the total revenue is likely to fall, unless the decrease in the supply is substantially greater than the decrease in the demand. Students need to draw a diagram showing a simultaneous shift in the demand and the supply curves. However, as the rise in the cost of production is large, the decrease in the supply may be substantially greater than the decrease in the demand. Therefore, the total revenue may rise.

Evaluation

Students simply need to explain why the demand for high-end cars and mid-range cars and the cost of production may not stay at the higher level in the long run.

Students simply need to explain why an increase in the demand for high-end cars may not lead to an increase in the price due to strategic interdependence.

Note: The above answer is presented in a way which facilitates my explanation. However, due to the command words in the question, compare and contrast, students need to rearrange the points which shows comparison and contrast.

A more elaborate answer to 2012 Essay Question 1 will be provided in the economics tuition class.

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