Economics Model Essay 2

This question will be discussed in economics tuition in the seventh week of term 1.

After reaching a rate of 8.3 percent in 2010, GDP growth in Asia is projected to average nearly 7 percent in both 2011 and 2012, according to the IMF. Due to the growing unrest in the Middle East sparked by the Egyptian Revolution that began on 25 January 2011, oil prices have started to rise.

Discuss how the market for private cars and its related markets in Asia may be affected by the above events. [25]

Answer

Introduction

The effects of the above events on the market for private cars and its related markets in Asia can be discussed with reference to the concepts of demand, supply, price elasticity of demand, income elasticity of demand, cross elasticity of demand and price elasticity of supply.

Demand and Price Elasticity of Supply

An increase in Gross Domestic Product will lead to an increase in the demand for private cars. The demand for a good is the quantity of the good that consumers are able and willing to buy at each price over a period of time, ceteris paribus. An increase in Gross Domestic Product occurs when firms increase production. When this happens, they will employ more factor inputs from households and hence will pay them more factor income which will lead to an increase in national income. When national income rises, whether the demand for a good will rise or fall will depend on the income elasticity of demand. The income elasticity of demand for a good is a measure of the degree of responsiveness of the demand to a change in income, ceteris paribus. As the income elasticity of demand for private cars is positive, which means that they are a normal good, an increase in national income will lead to an increase in the demand. When this happens, the price and the quantity will rise. When the demand for private cars rises, whether the price or the quantity will rise by a larger proportion will depend on the price elasticity of supply. The price elasticity of supply of a good is a measure of the degree of responsiveness of the quantity supplied to a change in the price, ceteris paribus. The supply of private cars is likely to be price elastic as the production time is likely to be short given that they are mass produced on assembly line which is highly automated. Therefore, the quantity is likely to rise by a larger proportion than the price.

In the above diagram, due to the elastic supply which gives rise to the relatively flat supply curve (S0), an increase in the demand (D) from D0 to D1 leads to a large rise in the quantity (Q) from Q0 to Q1 and a small rise in the price (P) from P0 to P1. Given the demand (D0) and the supply (S0), the price and the quantity are P0 and Q0. When the demand increases from D0 to D1, although the quantity demanded rises at the same price (P0), the quantity supplied remains at Q0 and this results in a shortage. When firms do not produce enough to sell, they can raise the price without losing sales. Therefore, they will do so to increase their profits. As the price rises, the quantity demanded falls and the quantity supplied rises and this process continues until the price rises to P1 where the quantity demanded and the quantity supplied are equal at Q1.

Supply and Price Elasticity of Demand

A rise in oil prices will lead to a decrease in the supply of private cars. The supply of a good is the quantity of the good that firms are able and willing to sell at each price over a period of time, ceteris paribus. When oil prices rise, the cost of production of private cars will rise which will decrease the supply. When this happens, the price will rise and the quantity will fall. When the supply of private cars falls, whether the price or the quantity will change by a larger proportion will depend on the price elasticity of demand. The price elasticity of demand for a good is a measure of the degree of responsiveness of the quantity demanded to a change in the price, ceteris paribus. The demand for private cars is likely to be price elastic due to the large proportion of income spent on the goods as they are generally expensive. Therefore, the quantity is likely to fall by a larger proportion than the rise in the price.

In the above diagram, due to the elastic demand which gives rise to the relatively flat demand curve (D0), a decrease in the supply (S) from S0 to S1 leads to a large fall in the quantity (Q) from Q0 to Q1 and a small rise in the price (P) from P0 to P1.

Combined Effects

The above events will lead to a rise in the price of private cars and is likely to lead to a rise in the quantity. The increase in the demand and the decrease in the supply of private cars will both lead to a rise in the price. Although the increase in the demand will lead to a rise in the quantity, the decrease in the supply will lead to a fall in the quantity. Due to the elastic supply, the increase in the demand is likely to lead to a large increase in the quantity, and due to the elastic demand, the decrease in the supply is likely to lead to a large decrease in the quantity. Therefore, the effect on the quantity will depend to a large extent on the relative changes in the demand and the supply. As the increase in national income is large as evidenced in the preamble and the income elasticity of demand for private cars is high, the increase in the demand is likely to be large. Furthermore, as the increase in oil prices is likely to be small given that they have only started rising, the decrease in the supply likely to be small. Therefore, the increase in the demand is likely to be greater than the decrease in the supply and hence the quantity is likely to rise.

In the above diagram, a larger increase in the demand (D) from D0 to D1 and a smaller decrease in the supply (S) from S0 to S1 lead to a rise in the price (P) from P0 to P1 and a rise in the quantity (Q) from Q0 to Q1.

Effects on Complements: Petrol

The above events will also affect the market for petrol which is related to private cars. Private cars and petrol are complements and hence the increase in the demand for private cars will lead to an increase in the demand for petrol. The cross elasticity of demand 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. As the cross elasticity of demand for private cars and petrol is negative, the rise in the price of private cars due to the decrease in the supply will lead to a decrease in the demand for petrol. Given that the quantity of private cars is likely to rise, the demand for petrol is likely to rise. If this happens, the price and the quantity will rise. The supply of petrol is price inelastic as the supply of oil is price inelastic due to the long production time as a result of the long construction time of oil rigs, assuming no or little excess capacity in oil production. Therefore, the price is likely to rise by a larger proportion than the quantity. When oil prices rise, the cost of production of petrol will rise which will decrease the supply. When this happens, the price will rise and the quantity will fall. The demand for petrol is likely to be price inelastic due to the high degree of necessity and lack of close substitutes. Therefore, the price is likely to rise by a larger proportion than the fall in the quantity. The increase in the demand and the decrease in the supply will both lead to a rise in the price. Although the increase in the demand will lead to a rise in the quantity, the decrease in the supply will lead to a fall in the quantity. Due to the inelastic supply, the increase in the demand is likely to lead to a small increase in the quantity, and due to the inelastic demand, the decrease in the supply is likely to lead to a small decrease in the quantity. Therefore, the effect on the quantity will depend to a large extent on the relative changes in the demand and the supply. As the increase in oil prices is likely to be small given that they have only started rising, the decrease in the supply is likely to be small. Therefore, the increase in the demand is likely to be greater than the decrease in the supply and hence the quantity is likely to rise.

Effects on Substitutes: Public Transport

The above events will also affect the market for public transport which is related to private cars. Private cars and public transport are substitutes and hence the increase in the demand for private cars will lead to a decrease in the demand for public transport. As the cross elasticity of demand for private cars and public transport is positive, the rise in the price of private cars due to the decrease in the supply will lead to an increase in the demand for public transport. Given that the quantity of private cars is likely to rise, the demand for public transport is likely to fall. If this happens, the price and the quantity will fall. The supply of public transport is likely to be price inelastic as the production time of buses and trains is likely to be long and buses and trains cannot be stocked in large quantities due to their large sizes. Therefore, the price is likely to fall by a larger proportion than the quantity. When oil prices rise, the cost of production of public transport will rise which will decrease the supply. When this happens, the price will rise and the quantity will fall. The demand for public transport is likely to be price inelastic due to the high degree of necessity and lack of close substitutes as private cars are substantially more expensive. Therefore, the price is likely to rise by a larger proportion than the fall in the quantity. The decrease in the demand and the decrease in the supply will both lead to a fall in the quantity. Although the decrease in the demand will lead to a fall in the price, the decrease in the supply will lead to a rise in the price. As the increase in oil prices is likely to be small given that they have only started rising, the decrease in the supply is likely to be small. Therefore, the decrease in the demand is likely to be greater than the decrease in the supply and hence the price is likely to fall.

In the above diagram, a larger decrease in the demand (D) from D0 to D1 and a smaller decrease in the supply (S) from S0 to S1 lead to a fall in the price (P) from P0 to P1 and a fall in the quantity (Q) from Q0 to Q1.

Conclusion

In conclusion, the price of private cars will rise and the quantity is likely to rise, the price and the quantity of petrol are likely to rise, and the price and the quantity of public transport are likely to fall.

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

Author’s comments

Students simply need to explain how the above events would affect the market for private cars, the market for a complement and the market for a substitute with reference to the concepts of demand, supply, price elasticity of demand, income elasticity of demand, cross elasticity of demand and price elasticity of supply.

Students need not discuss the effect on total revenue or consumer expenditure as the focus of the question is on price and quantity.

As the essay is on the long side, students who cannot produce it within the examination time constraint may want to leave out the explanation of the price mechanism.

Students should link a change in demand to PES. A shift in the demand curve will lead to a movement along the supply curve. When this happens, the extent of the effects on price and quantity will depend on the steepness of the supply curve which is determined by PES. Similarly, they should link a change in supply to PED. A shift in the supply curve will lead to a movement along the demand curve. When this happens, the extent of the effects on price and quantity will depend on the steepness of the demand curve which is determined by PED.

Students should understand that the concept of XED can be used to explain the effect of a change in the price of a related good on the demand for a good only when the change in the price of the related good is due to a change in the supply.

Students should understand that consideration of relative price elasticities of demand and supply is necessary only when demand and supply change in opposite directions. When demand and supply change in the same direction, only consideration of relative changes in the demand and supply is necessary.

The Cambridge examiners are fond of diagrams which show the combined shifts in the demand and the supply curves.

Students should understand that a change in demand (or supply) corresponds to a horizontal and not a diagonal shift in the demand curve (or the supply curve). For example, if the increase in demand is greater than the increase in supply, the rightward horizontal shift in the demand curve will be greater than the rightward horizontal shift in the supply curve even though the diagonal distance between the two demand curves may be smaller than the diagonal distance between the two supply curves, especially if the demand curve is flat and the supply curve is steep.

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