Economics Model Essay 14

Discuss whether the concepts of elasticity of demand are useful to the government for discouraging the use of private cars. [25]

Introduction

The elasticity of demand for a good is a measure of the degree of responsiveness of the quantity demanded or the demand to a change in a determinant of demand, ceteris paribus. There are three concepts of elasticity of demand each relating to one of the determinants of demand: price elasticity of demand (PED), income elasticity of demand (YED) and cross elasticity of demand (XED). The usefulness of the concepts of elasticity of demand to the government for discouraging the use of private cars can be discussed with reference to PED, XED and YED.

Body

The concept of PED may be useful to the government for discouraging the use of private cars. The PED for a good is a measure of the degree of responsiveness of the quantity demanded to a change in the price, ceteris paribus. PED can be expressed mathematically as

           % Δ Quantity Demanded
PED = ————————————–
% Δ Price

The PED for a good is negative due to the law of demand and the common practice among economists is to drop the negative sign. If the PED for a good is greater than one, such as in the case of luxury watches, the demand is price elastic which means that a change in the price will lead to a larger percentage change in the quantity demanded. If the PED for a good is less than one, such as in the case of food, the demand is price inelastic which means that a change in the price will lead to a smaller percentage change in the quantity demanded. To discourage the use of private cars, the government can impose a tax. A tax on private cars will lead to a rise in the cost of production. When this happens, the supply will fall which will lead to a rise in the price resulting in a fall in the quantity demanded. If the demand for private cars is price elastic, a rise in the price is likely to lead to a large decrease in the quantity demanded. Therefore, a tax on private cars is likely to be effective for discouraging the use. However, if the demand for private cars is price inelastic, a rise in the price is likely to lead to a small decrease in the quantity demanded. Therefore, for a tax on private cars to be effective for discouraging the use, the government needs to ensure that it is sufficiently high.

The concept of XED may be useful to the government for discouraging the use of private cars. The XED for a good with respect to another good is a measure of the degree of responsiveness of the demand for the first good to a change in the price of the second good, ceteris paribus. Suppose that the two goods are good A and good B. Mathematically, it can be expressed as

                % Δ Demand for Good A
XEDAB = ————————————–
% Δ Price of Good B

If XEDAB is positive, good A and good B are substitutes. Substitutes are goods which are consumed in place of one another such as Coke and Pepsi. If the price of good B rises, consumers will buy less of it. Since good A and good B are substitutes, they will buy more good A. If XEDAB is negative, good A and good B are complements. Complements are goods which are consumed in conjunction with one another such as car and petrol. If the price of good B rises, consumers will buy less of it. Since good A and good B are complements, they will buy less good A. To discourage the use of private cars, the government can provide a subsidy for public transport. A subsidy on public transport will lead to a fall in the cost of production. When this happens, the supply will rise which will lead to a fall in the price. As the XED for private cars and public transport is positive, a fall in the price of public transport due to an increase in the supply will lead to a decrease in the demand for private cars. If the XED for private cars with respect to public transport due to a fall in the price of public transport is high, a fall in the price of public transport due to an increase in the supply is likely to lead to a large decrease in the demand for private cars. Therefore, the subsidy on public transport is likely to be effective for discouraging the use of private cars. However, if the XED for private cars with respect to public transport due to a fall in the price of public transport is low, a fall in the price of public transport due to an increase in the supply is likely to lead to a small decrease in the demand for private cars. Therefore, for a subsidy on public transport to be effective for discouraging the use of private cars, the government needs to ensure that it is sufficiently high.

The concept of YED may be useful to the government for discouraging the use of private cars. The YED for a good is a measure of the degree of responsiveness of the demand to a change in income, ceteris paribus. YED can be expressed mathematically as

           % Δ Demand
YED = ———————–
% Δ Income

If the YED for a good is positive, such as in the case of clothing, the good is a normal good. A normal good is a good whose demand rises when consumers’ income rises. There are two types of normal goods: necessity and luxury. The YED for a necessity is between zero and one which means that the demand is income inelastic. A necessity is a good whose demand rises by a smaller proportion when consumers’ income rises. The YED for a luxury is greater than one which means that the demand is income elastic. A luxury is a good whose demand rises by a larger proportion when consumers’ income rises. If the YED for a good is negative, such as in the case of public transport, the good is an inferior good which means that the demand will fall when consumers’ income rises. An increase in consumers’ income will lead to an increase in the demand for private cars as the YED is positive which means that they are a normal good. When the demand for private cars increases, the quantity will rise which will worsen traffic congestion and air pollution. If this is a matter of concern to the government, it can decrease the supply of private cars by increasing the tax. If the decrease in the supply is equal to the increase in the demand, the quantity will not rise and hence traffic congestion and air pollution will not worsen. If the demand for private cars is income inelastic, an increase in consumers’ income is likely to lead to a small increase in the demand. Therefore, an increase in the tax on private cars is likely to be effective for preventing an increase in the quantity. However, if the demand for private cars is income elastic, an increase in consumers’ income is likely to lead to a large increase in the demand. Therefore, for an increase in the tax on private cars to prevent the quantity from increasing, the government needs to ensure that it is sufficiently large.

The concept of PED may not be useful to the government for discouraging the use of private cars. To discourage the use of private cars, the government can impose a quota at a level lower than the current quantity which will lead to a fall in the supply. As the supply will be perfectly price inelastic at the quota, the quantity will fall to the quota regardless of the PED. In this case, instead of the extent of the fall in the quantity, the PED will only determine the extent of the rise in the price. Therefore, the concept of PED may not be useful to the government for discouraging the use of private cars.

In the above diagram, the imposition of a quota at Q0 leads to a decrease in the supply (S) from S0 to S1 resulting in a fall in the quantity (Q) from Q0 to Q1.

The concept of XED may not be useful to the government for discouraging the use of private cars. As discussed earlier, to discourage the use of private cars, the government can provide a subsidy for public transport which will lead to a fall in the price resulting in decrease in the demand for private cars. If the XED for private cars with respect to public transport due to a fall in the price of public transport is low, a fall in the price of public transport due to an increase in the supply is likely to lead to a small decrease in the demand for private cars. Therefore, for a subsidy on public transport to be effective for discouraging the use of private cars, the government needs to ensure that it is sufficiently high. However, the government may be facing a budget constraint and hence may not be able to provide a high subsidy. This may happen as the government may be incurring a high expenditure on welfare benefits such as the United States. Therefore, the concept of XED may not be useful to the government for discouraging the use of private cars.

The concept of YED may not be useful to the government for discouraging the use of private cars. As discussed earlier, an increase in consumers’ income will lead to an increase in the demand for private cars which will lead to an increase in the quantity resulting in a worsening of traffic congestion and air pollution. However, if the government has already put in place a quota system, an increase in the demand for private cars will not lead to an increase in the quantity. In this case, regardless of the YED and hence the extent of the increase in the demand, traffic congestion and air pollution will not worsen. Therefore, the concept of YED may not be useful to the government for discouraging the use of private cars.

The concepts of elasticity of demand may not be useful to the government for discouraging the use of private cars as they are subject to several other limitations. The data that are used to calculate elasticities of demand may be irrelevant or unreliable. Data from past records may no longer be relevant to calculating elasticities of demand as some of the determinants of demand may have changed. Although data from current market surveys are relevant to calculating elasticities of demand, they may not be reliable as the respondents may not be truthful in their responses. Furthermore, if the sample sizes of the market surveys are small, the results may not be reliable as they may not be reflective of the actual markets for the goods. The assumption of ceteris paribus that is made in calculating elasticities of demand is unlikely to hold in reality. In reality, many factors such as the level of income, the price of the good and the prices of related goods are changing simultaneously.

Evaluation

In the final analysis, there is a need for some governments to discourage the use of private cars to control traffic congestion and air pollution. The Singapore government is a case in point. The demand for private cars is high in Singapore due to the high level of income. According to the International Monetary Fund, Singapore has the third highest GDP per capita in the world, behind Qatar and Luxembourg. However, there is a small of road space in Singapore due to the small size of the country. The land area of Singapore is only about 720 square kilometres. In the absence of government measures to discourage the use of private cars in Singapore, a high demand for private cars coupled with a small amount of road space is likely to lead to severe traffic congestion in the country. Furthermore, to control traffic congestion, the government should not only control the number of cars, it should also control the use of certain roads during certain hours of the day. For example, the major expressways in Singapore such as the Pan Island Expressway and the Central Expressway are congested in the early mornings when many people travel to their workplaces from their residences and in the late afternoons and early evenings when many people travel to their residences from their workplaces. Therefore, the government should control the use of these roads during these hours to reduce the traffic congestion through imposing a toll. For example, the Singapore government imposes a toll known as the ERP charge on the major expressways in the early mornings and in the late afternoons and early evenings.

The question will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

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