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 in Asia 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 willing and able 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 in Asia 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 lines which are 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 in Asia. The supply of a good is the quantity of the good that firms are willing and able to sell at each price over a period of time, ceteris paribus. When oil prices in Asia 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 good as private cars 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 in Asia. The increase in the demand and the decrease in the supply of private cars in Asia 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 which is stated in the preamble, and the income elasticity of demand for private cars is likely to be greater than one which means that the demand is likely to be income elastic as private cars are likely to be a luxury, 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 in Asia. Private cars and petrol are complements and hence the increase in the demand for private cars in Asia 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, which means that they are complements, 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 in Asia. Private cars and public transport are substitutes and hence the increase in the demand for private cars in Asia 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, which means that they are substitutes, 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 the substitutes 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 the final analysis, although an increase in national income in Asia will lead to an increase in the demand for private cars, the demand may not stay at the higher level in the long run. An increase in the number of private cars on the road will worsen traffic congestion and air pollution. In an attempt to address the problems, the government may improve the public transport system which will induce people to switch from private cars to public transport resulting in a decrease in the demand for private cars. Similarly, although a rise in oil prices will lead to a rise in the cost of production of private cars, the cost of production may not stay at the higher level in the long run. In the face of a rise in the cost of production, car manufacturers will experience a fall in profits. Therefore, they may increase labour productivity through education and training and research and development to reduce costs to maintain profitability which will lead to a fall in the cost of production of private cars. Although a rise in national income will lead to an increase in the demand for private cars, the effects will be different on different types of private cars. A rise in national income is likely to lead to a large increase in the demand for high-end private cars as high-end private cars are likely to be a luxury and hence the demand is likely to be income elastic. Although the demand for mid-range private cars will also rise, the increase will be smaller as mid-range private cars are likely to be a necessity and hence the demand is likely to be income inelastic. In the case of low-end private cars, the demand may fall as low-end private cars may be an inferior good.

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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