Economics Model Essay 3

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

Findings from a variety of studies show that routine consumption of artificial sweeteners such as aspartame, saccharin and sucralose may lead to higher likelihood of heart disease, stroke, diabetes and high blood pressure. Some countries such as the United States and France have imposed a tax on non-diet soft drinks to fight obesity. A rise in the price of sugar has led to an increase in the demand for artificial sweeteners and this has pushed up the prices.

Discuss how the above events would affect consumer expenditure on diet soft drinks and non-diet soft drinks. [25]

Answer

Introduction

Consumer expenditure on a good is the amount of money that consumers spend on the good which is the product of the price and the quantity. The effects of the above events on consumer expenditure on diet soft drinks (DSDs) and non-diet soft drinks (NDSDs) can be discussed with reference to the concepts of demand, supply, price elasticity of demand, cross elasticity of demand and price elasticity of supply.

Demand and Price Elasticity of Supply (DSDs)

The above events are likely to lead to a decrease in the demand for DSDs. 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. The potential link between routine consumption of artificial sweeteners and higher likelihood of health problems will lead to a change in tastes and preferences against DSDs and this will lead to a decrease in the demand. A rise in the price of sugar and a tax on NDSDs 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. 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 DSDs and NDSDs is positive, the rise in the price of NDSDs due to the decrease in the supply will lead to an increase in the demand for DSDs. Given that DSDs do not contain sugar and hence taste quite differently from NDSDs, consumers are unlikely to consider DSDs a close substitute for NDSDs and hence the cross elasticity of demand for DSDs with respect to NDSDs due to a rise in the price of NDSDs is likely to be small. Therefore, the demand for DSDs is likely to fall. If this happens, the price and the quantity will fall which will lead to a fall in the consumer expenditure. When the demand for DSDs falls, whether the price effect or the quantity effect on the consumer expenditure will be greater 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 soft drinks, both DSDs and NDSDs, 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 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 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.

In the above diagram, due to the elastic supply which gives rise to the relatively flat supply curve (S0), a decrease in the demand (D) from D0 to D1 leads to a large fall in the quantity (Q) from Q0 to Q1 and a small fall in the price (P) from P0 to P1 resulting in a decrease in the consumer expenditure from the sum of area A and area B to area A. Given the demand (D0) and the supply (S0), the price and the quantity are P0 and Q0. When the demand decreases from D0 to D1, although the quantity demanded falls at the same price (P0), the quantity supplied remains at Q0 and this results in a surplus. When firms cannot sell all the output that they produce, their stocks will build up. Therefore, they will lower the price to reduce their stocks. As the price falls, the quantity demanded rises and the quantity supplied falls and this process continues until the price falls to P1 where the quantity demanded and the quantity supplied are equal at Q1.

Supply and Price Elasticity of Demand (DSDs)

The above events will lead to a decrease in the supply of DSDs. 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. A rise in the prices of artificial sweeteners will lead to a rise in the cost of production of DSDs. When this happens, the supply will fall which will lead to a rise in the price and a fall in the quantity. Although the rise in the price will increase the consumer expenditure, the fall in the quantity will decrease the consumer expenditure. When the supply of DSDs falls, whether the consumer expenditure will rise or fall 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 DSDs is likely to be price inelastic due to lack of close substitutes as other beverages differ quite substantially from DSDs in taste and the small proportion of income spent on the good as DSDs are generally cheap. Therefore, the price is likely to rise by a larger proportion than the fall in the quantity and hence the consumer expenditure is likely to rise.

In the above diagram, due to the inelastic demand which gives rise to the relatively steep demand curve (D0), a decrease in the supply (S) from S0 to S1 leads to a large rise in the price (P) from P0 to P1 and a small fall in the quantity (Q) from Q0 to Q1 resulting in an increase in the consumer expenditure from the sum of area B and area C to the sum of area A and area B.

Combined Effects (DSDs)

The effect of the above events on consumer expenditure on DSDs will be indeterminate. The decrease in the demand for DSDs will lead to a decrease in the consumer expenditure. However, the decrease in the supply is likely to lead to an increase in the consumer expenditure as the demand is likely to be price inelastic. Therefore, the consumer expenditure will be indeterminate without considering the effects on the price and 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. Due to insufficient information provided in the question and the preamble, it is uncertain whether the decrease in the demand or the decrease in the supply is likely to be greater. If the decrease in the demand is greater than the decrease in the supply, the price will fall. In this case, the fall in the price and the fall in the quantity will both lead to a decrease in the consumer expenditure. Therefore, the consumer expenditure will 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 resulting in a decrease in the consumer expenditure from the sum of area A and area B to area A. However, if the decrease in the supply is greater than the decrease in the demand, the price will rise. In this case, although the rise in the price will increase the consumer expenditure, the fall in the quantity will decrease the consumer expenditure. Therefore, the consumer expenditure will be indeterminate.

Demand and Price Elasticity of Supply (NDSDs)

The above events will lead to an increase in the demand for NDSDs. The potential link between routine consumption of artificial sweeteners and higher likelihood of health problems will lead to a change in tastes and preferences towards NDSDs and this will lead to an increase in the demand. A rise in the prices of artificial sweeteners will lead to a rise in the cost of production of DSDs. When this happens, the supply will fall which will lead to a rise in the price. As the cross elasticity of demand for DSDs and NDSDs is positive, the rise in the price of DSDs due to the decrease in the supply will lead to an increase in the demand for NDSDs. Therefore, the demand for NDSDs will rise. When this happens, the price and the quantity will rise which will lead to an increase in the consumer expenditure. Since the supply of soft drinks is likely to be price elastic, 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.

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 resulting in an increase in the consumer expenditure from area A to the sum of area A and area B.

Supply and Price Elasticity of Demand (NDSDs)

The above events will lead to a decrease in the supply of NDSDs. A rise in the price of sugar and a tax on NDSDs 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 and a fall in the quantity. Although the rise in the price will increase the consumer expenditure, the fall in the quantity will decrease the consumer expenditure. The demand for NDSDs is likely to be price inelastic due to lack of close substitutes as other beverages differ quite substantially from NDSDs in taste and the small proportion of income spent on the good as NDSDs are generally cheap. Therefore, the price is likely to rise by a larger proportion than the fall in the quantity and hence the consumer expenditure is likely to rise.

In the above diagram, due to the inelastic demand which gives rise to the relatively steep demand curve (D0), a decrease in the supply (S) from S0 to S1 leads to a large rise in the price (P) from P0 to P1 and a small fall in the quantity (Q) from Q0 to Q1 resulting in an increase in the consumer expenditure from the sum of area B and area C to the sum of area A and area B.

Combined Effects (NDSDs)

The above events are likely to lead to an increase in consumer expenditure on NDSDs. The increase in the demand for NDSDs will lead to an increase in the consumer expenditure. Furthermore, the decrease in the supply is likely to lead to an increase in the consumer expenditure as the demand is likely to be price inelastic. Therefore, the consumer expenditure is likely to rise. The increase in the consumer expenditure will be larger the greater the increase in the demand, the greater the decrease in the supply and the more price inelastic the demand. The increase in the demand will be greater the larger the change in tastes and preferences towards NDSDs and the higher the cross elasticity of demand for NDSDs with respect to DSDs due to a rise in the price of DSDs. The decrease in the supply will be greater the larger the rise in the price of sugar and the higher the tax on the good. The demand will be more price inelastic the more remote the substitutes and the smaller the proportion of income spent on the good.

In the above diagram, an increase in the demand (D) from D0 to D1 and a decrease in the supply (S) from S0 to S1 lead to an increase in the consumer expenditure from area A to the sum of area A and area B.

Evaluation

In the final analysis, although the potential link between routine consumption of artificial sweeteners and higher likelihood of health problems will lead to a decrease in the demand for DSDs, the demand may not stay at the lower level in the long run. Soft drink manufacturers are likely to be able to find artificial sweeteners that are healthier which will lead to a change in tastes and preferences towards DSDs. This is particularly true in view of their substantial financial resources. Similarly, although a rise in the prices of artificial sweeteners will lead to a rise in the cost of production of DSDs, 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, soft drink 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 DSDs. The above analysis is based on the assumption that the soft drink market is perfectly competitive. However, in reality, the soft drink market is oligopolistic. For example, the soft drink market in Singapore is dominated by only a few large firms, namely Coca-Cola, PepsiCo, Yeo Hiap Seng, Pokka, F&N Foods, Malaysia Dairy Industries and Nestle. In such a market, due to the small number of large firms and hence the large market share of each firm, the actions of one firm affect and are affected by the actions of the other firms in the market, and this is known as strategic interdependence. Therefore, if the demand for NDSDs and the cost of production rise, the firms in the market may not increase their prices in fear that they will lose consumers to their rivals.

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

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