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## Price Elasticity of Demand

Question 1-Define price elasticity of demand. How you will use to define an "inferior good". Give two examples of an inferior good?

The price elasticity of demand is one of the economic measures for showing the responsiveness of the changes in demanded quantity as a result of the price change. The price elasticity of demand refers to the responsiveness of the quantity demanded as the price changes when all other factors or determinants of demand remains the same (Frank and Cartwright, 2013). It is basically the percentage change in the quantity demanded as a result of a percentage change in the price. Thus the price elasticity of demand is elastic when the percentage change is quantity demanded is higher than the percentage change in price and the price elasticity of demand is inelastic if the percentage change in quantity demanded is lower than the percentage change in price. The price elasticity of demand is usually negative as the quantity demanded falls due to an increase in price and vice versa.

Ed = (Percentage change in quantity demanded / Percentage change in price)

An inferior good can be referred as the good, the demand of which decreases when the income of the consumer increases or vice versa (Perloff, 2012). It is one of the contradictory cases and opposite of normal goods whose demand usually increases as the income increases. For an inferior good the income elasticity of demand is negative as the demand for the good decreases when the income increases.

Here two examples of an inferior good can be given. First example is second hand goods. They are inferior good as, when the income of the consumer increases, the demand for second hand goods fall as they prefer new products. Second example can be given as cheap bus service. When the income of people increases they prefer taxi or new cars over bus.

• Water and sewage service can be categorised in the monopoly market structure. Here it can be said that the public utilities like the water and sewage facilities are often identified as natural monopolies. The main characteristics of the service that resembles the monopolies are single supplier to all the consumers in the market (Perloff, 2012). The water and sewage facilities in a location are usually large enough to supply cost effectively the entire market. There are barriers of entry in the market for new suppliers. The service providers have certain degree of market power and they can influence the price and quantity supplied in the market.
• The breakfast cereals can be categorised in the market structure of monopolistic competition. The main characteristics that resembles the breakfast cereal market with the monopolistic competition is that the suppliers produces and supplies differentiated products in the market and the products are close substitutes of one another. The products are basically differentiated by branding like the Kellogg’s brand is highly valued in the market than other brands like Malt-O-Meal and Post Foods. Like monopolistic competition, there are many firms in the industry supplying the products to many customers (Pindyck and Rubinfeld, 2013). There are no barriers to entry or exit and the producers have certain degree of market power. The companies are involved in non-price competition in terms of establishing the brand value and advertising.

Inflation can be referred as the aggregate rise in the general price level of an economy. The inflation can be demand pull or cost-push.

The demand pull inflation basically occurs when the general price of the economy increases sue to an increase in the aggregate demand of the economy. When the aggregate demand of the economy rises more than the aggregate supply of the economy then it also increases the price level as the suppliers will make the prices higher due to such high demands. The inflation caused by excess demand in the industry leads to demand-pull inflation. In the following diagram the demand pull inflation can be shown (Kim and Lin, 2012). It is seen that, when the aggregate supply remains the same, a shift in the aggregate demand increases the output and the price level in the economy.

The cost-push inflation on the other hand occurs when the general price level of an economy increases due to a rise in the cost of goods and services. Thus the cost-push inflation can be seen in an economy when the cost of production for the firms increases significantly and as a result the supply of the products mat fall. This leads to a leftwards shift of the supply curve where the demand remains the same (Mankiw, 2013). A lower supply in the market also increases the general price level and it is referred as the cost-push inflation. In the following diagram, it can be seen that when the supply curve shifts to the left and the aggregate demand remains the same, it leads to an increase in the price level and a decrease in the output of the economy.

## Inferior Goods

The demand for money or currency can be impacted by various factors like the inflation rate, interest rate, level of income etc. Here the three main motives or factors affecting the demand for currency are speculative, precautionary and transaction (Krugman and Wells, 2013).

It is known that currency is required in order to perform transaction of goods and services with money. Thus the demand for currency increases, when the transaction requirement increases. The transaction demand for currency increases when the GDP or the economy increases (Krugman and Wells, 2013).

The demand for currency can also be affected by the precautionary motive of the people. It is known that people can demand money for taking precautionary measures against uncertain future. There can be repair bills or medical costs that can occur in the future and such factors can affect the demand for currency.

The demand for currency can also be affected by the speculative motive of the people. It is known that money is an asset and the demand for money usually depends on the opportunity cost of holding money and the rate of return in the market. Thus speculative demand for money occurs when it is less risky to hold money in hand than lending or investing.

So these are the main factors affecting the demand for currency.

In this case it is seen that the oil prices has risen temporarily due to the political uncertainty in the middle-east. It is suggested by an advisor that the aggregate supply of oil will be affected due high oil prices. In order to offset the impact, it is important to increase the supply of money in the economy. Then it will not be necessary for the price level to adjust for restoring the equilibrium and a recession can be prevented as well. Here it can be said that a higher supply of money is the market can offset the impact of higher price of oil as people will have more money in hand and the value of money will decrease (Hubbard and O'Brien, 2013). It is known that higher oil prices will reduce the aggregate demand but it will increase the aggregate supply thus in order to avoid recession in the market, measures must be taken to increase the aggregate demand. Increasing the money supply may resolve the issue but it is also evident that increase in the money supply increases the inflation in the economy and thus even higher inflation may worsen the situation and it can lead to recession (Hubbard and O'Brien, 2013). The policy is thus not correct the money supply should be reduced instead of increasing. As a result it will lower the output and increase the real interest rate and thus recession can be avoided.

It is the responsibility of every government to smooth the business cycle. There are various challenges that are faced by every economy and these challenges can emanate the industries from the global market (Hoxley, 2010). Here the measures that are taken by the coalition government of the UK for ensuring the benefits in the economy for every citizen and so that the burden can be reduced. It is known that various measures are taken by the coalition government in order increase in the efficiency in the market. A growth review is launched by the coalition government. The main aim of the policies is to strengthen the growth of the GDP in the country as it was difficult for the country to overcome the recession. They have implemented the fiscal decisions for improving the supply side in the economy. The fiscal policies are implemented for boosting the supply side efficiencies, investments and incentives (Painter, 2012). The government has increased the spending on infrastructure, and they have lowered the corporate tax rate. The coalition policy was also used to cut the deficit in the budget. A fiscal austerity policy was used where the tax rate was increased and the spending of the government was cut for reducing the budget deficit. These measures helped in recovering the economy from the recession.

References

Frank, R. and Cartwright, E. (2013). Microeconomics and behaviour. Maidenhead: McGraw-Hill.

Hoxley, M. (2010). UK coalition government. Structural Survey, 28(4).

Hubbard, R. and O'Brien, A. (2013). Macroeconomics. Boston: Pearson.

Kim, D. and Lin, S. (2012). Inflation and Inflation Volatility Revisited. International Finance, 15(3), pp.327-345.

Krugman, P. and Wells, R. (2013). Macroeconomics. New York, NY: Worth Publishers.

Mankiw, N. (2013). Macroeconomics. New York, NY: Worth.

Painter, C. (2012). The UK Coalition government: Constructing public service reform narratives. Public Policy and Administration, 28(1), pp.3-20.

Perloff, J. (2012). Microeconomics. Boston: Pearson Addison Wesley.

Pindyck, R. and Rubinfeld, D. (2013). Microeconomics. Boston: Pearson.

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