Back to basics Part 3 - Price Elasticity of demand

What is Price elasticity of demand?

• The price elasticity of demand is the measurement of the responsiveness of demand to a change in price.
• The formula for price elasticity of demand (PED) is - 

• The value range of PED:
• PED = 1: Unit elastic, Change in price results in a proportionally equal change in quantity demanded.
• PED = 0: Perfectly inelastic, change in price results in no change in quantity demanded.
• PED = ∞: Perfectly elastic, a change in price results in a infinitely large change in demand.
• 0 < PED < 1: Inelastic demand: A change in price results in a proportionally small change in demand.
• PED > 1: Elastic demand: A change in price results in a proportionally larger change in demand.
• IMPORTANT NOTE: 
• You may have noticed that all values are negative, but assume that for the above PED equations, the value of PED is positive absolute value.
• The case where PED = 0 or ∞, are completely theoretical and cannot exist in the real world. 
• Graphs for the above cases: 

• Factors affecting PED - 
• The number and closeness of substitutes
• The necessity of the product and how widely the product is defined
• Time period considered

Back to Basics Part 2: Supply

What is Supply?

• Supply is the willingness and ability of producers to produce a quantity of goods and services at a given price at a given time period. 
• The law of supply states that, as price increases, the quantity supplied of the product will increase, ceteris paribus. 
• An example could be the market of frozen pizzas. The following graph demonstrates the rule above.

• This happens because at higher prices there will be more potential profits to be made and so the producer will increase output. 

• Factors affecting supply other than price - 
• The costs of factors of production
• The state of technology
• Expectations
• The price of other products which the producer could produce instead of the existing product.
• Amount of Government intervention
• A change in any of these factors (other than price) will shift the supply curve, for example:

Back to Basics Part 1 : DEMAND

What is demand? 

• Demand is the quantity of goods or services that consumers are willing and able to purchace at given prices over a given time period.
• The law of demand states that, as the price of a good falls, the quantity demanded of therpoduct will usually increase, ceteris paribus. (Ceteris paribus is an assumption  that means "all other things being equal")
• An example is the soft drink market. The following graph demonstrates the rule above. 

• As you can see, when the price falls, the demand increases. This is for 2 reasons-
• Income effect- When the price of a product falls, the people will have an increase in their real income, which reflects the amount that their income will buy. 
• Substitution effect- When the price of the product falls, it will be relatively more attractive to people than other goods.
• Factors affecting demand other than price- 
• Income
• Price of other products
• Taste and preferances
• Advertisement
• Population and Age structure
• Other factors such as government policies, etfc.
• A change in any of these factors (other than price), will shift the demand curve, for example:

Supply Side Policy

Supply Side Policies are government attempts to increase productivity and shift Aggregate Supply (AS) to the right.

How do supply side policies work?

Supply side policies aim to increase the long run aggregate supply. This can be done by increasing the quality or quantity of factors of production. Here are a few ways of achieving this - 

1) Increase in training & education - Education is under-provided by the market as it is a merit good. Therefore, governments increase the quality and quantity of training and education by either providing the education themselves or by subsidising companies.

2) Reduction in direct taxes (eg. income tax) - Lower taxes may provide workers with an incentive to work even harder.

3) Improvements in Infrastructure - Improving trasnport and roads will reduce costs of firms which means they invest that in increasing the quality and quantity of their supply.

4) Privatisation - It is argued that private sector firms are more efficient as they have different goals, than the state sector counter parts, which forces them to be more productive. 

5) Reducing the power of Trade Unions - This increases the efficiency of firms and reduce unemployment because trade unions force higher wages. 

6) Deregulation - This invlolves reducing legal barriers to entry (eg. laws) which increase competition as more firms are able to enter the market. Additionally, Monopoly power can be reduced by restricting anti-competitive behaviors.

Advantages of Supply side policices.

1) Lower Unemployment

2) Higher Economic Growth

3) Reduction in the rate of Inflation.

Disadvantages of Inflation.

1) Involves extremely high costs

2) Takes a lot of time to implement.

3) Depends on the initial level of economic activity. 

Monetary Policies

Monetary policy are demand-side policies, which target the aggregate demand of an economy by influencing interest rates and controlling the money supply.  

The central bank is an independant organization, which is responsible for adjusting the base interest rate of an economy. Their primary objective is to hit the target inflation rate (usually 2%).

How does interest policy work?

• Expansionary: (decrease in IR)
• Consumption increases - less incentive to save due to lower returns & demand for mortgages increases due to lower interest payments
• Investment increases - more incentive to invest into capital due to lower cost of borrowing

• Contractionary: (increase in IR) 
• Consumption decreases - more incentive to save due to higher returns & demand for mortgages decreases due to higher interest payments
• Investment decreases - less incentive to invest into capital due to higher cost of borrowing

Advantages of using monetary policies:

1. affect consumption & investment ( both large components of AD)
2. Not affected by politics
3. faster than other demand-side policies
4. can affect AS as well as AD
5. easily reversible

Disadvantages :

1. Money supply policy can get out of control leading to stronger/uncontrollable inflation

2. Time lag - need long time to implement (usually 18 months)

3. useful for demand-pull inflation, but ineffective when controlling cost-push inflation

4. Interest rates cannot fall below 0

5. Reaction may not be as expected

Depends on:

• initial level of economic activity
• level of consumer/business confidence - if confidence low than even if interest rates decreases businesses/consumer will not necessarily spend more/save less
• size of multiplyer 
• level of change in interest rates - huge change=huge affect/small change=small affect
• Other factors expansionary monetary policy impaired by contractionary fiscal policy

Real life example :

USA central bank plans to increase interest rates from 0.75% to 1% 

National Income

National Income the total amount of money earned within a country. National income is the total value a country’s final output of all new goods and services produced in one year.

National income accounts The published national income accounts for the UK, called the ‘Blue Book’, measure all the economic activities that ‘add value’ to the economy.

• Adding value - National output, income and expenditure, are generated when there is an exchange involving a transaction. However, for an individual economic transaction to be included in national income it must involve the purchase of newly produced goods or services. It must create an addition to the value of the scarce resources.
• Transactions which do not add value are called transfers, and include second-hand sales, gifts and welfare transfers paid by the government, such as disability allowance and state pensions.
• The Creation of National Income - goods are produced in a number of 'stages', where raw materials are converted by firms at one stage, then sold to firms at the next stage. Value is added at each, intermediate, stage, and, at the final stage, the product is given a retail selling price. The retail price reflects the value added in terms of all the resources used in all the previous stages of production.
• Final output - only the value of the final stage, the retail price, is included, and not the value added in all the intermediate stages - the costs of production, plus profits.  In short, national income is the value of all the final output of goods and services produced in one year.

Example - 

For example, consider the production of a motor car which has a retail price of £25,000. This price includes £21,000 for all the costs of production (£6,000 for components, £10,000 for assembly and £5,000 for marketing) plus £4,000 for profit. To avoid double-counting, the national income accounts only record the value of the final stage, which in this case is the selling price of £25,000.

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When goods are bought second-hand, the transaction does not add new value and will not be included in national output. If second-hand goods are included, double-counting will occur, and this would falsely inflate the value of national income.

For example, if the car in question is sold in two year’s time for £15,000 it would provide the owner with money, but the sale will not add to national income. If it were included in national income, it would make the value of the car £35,000  - the initial £25,000 plus the second hand value of £15,000. This is clearly not the case, so any future second-hand sales are not included when valuing national income. Such second-hand transactions are called transfers.

                        Aggregate Demand and Supply
What is Agregate Demand?
Aggregate demand (AD) is the total demand by domestic and foreign  households and firms for an economy's scarce resources, less the demand by domestic households and firms for resources from abroad.

Aggregate demand consists of the amount households plan to spend on goods (C), plus planned spending on capital investment, (I) + government spending, (G) + exports (X) minus imports (M) from abroad. The standard equation is: 

AD = C + I + G + (X – M)

The aggregate demand curve:

The AD curve shows the relationship between AD and the price level. It is assumed that the AD curve will slope down from left to right. This is because all the components of AD, except imports, are inversely related to the price level.

What is aggregate supply:

Aggregate supply (AS) is defined as the total amount of goods and services (real output) produced and supplied by an economy’s firms over a period of time. It includes the supply of a number of types of goods and services including private consumer goods, capital goods, public and merit goods and goods for overseas markets.

Coponents of AS :

• Consumer goods 
• Capital goods
• Public and merit goods
• Traded goods

The aggregate supply curve: