The Essay Explores The Relationship Between Price Elasticity Of Demand, Price Controls, And Aggregate Demand And Supply Analysis.

As a sales director of a big manufacturing firm that produces both an elastic good and an inelastic good, illustrate to the board of the organisation the relationship between price elasticity of demand and total revenue, and how the elasticity concept can be used to maximise revenues of both commodities? Illustrate your answer using relevant diagrams of elastic and inelastic goods.

(a) Market systems may not allocate resources efficiently for many reasons. This is known as market failure. Governments intervene in order to correct such market failures. Imposition of price controls is one such intervention. Using relevant diagrams, discuss the use of (i) maximum prices, and (ii) minimum price controls in the markets and the consequences of each approach to the market and the society.

As an adviser to a new finance minister of a developing country, you have been tasked to produce a policy brief on how to stimulate the growth of the economy. Using the AD-AS (aggregate demand and aggregate supply) model, discuss using the relevant diagrams and at least two examples of supply-side measures and two demand-side measures, how the government can expand the economy.

Using the aggregate demand and supply analysis, explain with the aid of diagrams the concept of (i) cost-push inflation and (ii) demand push inflation by assessing how the two impact on the price level, real GDP and employment

Price Elasticity of Demand

Price elasticity of demand demonstrates the responsiveness of the quantity demanded to variations in prices (Arnold 2013, p. 21). The law of demand informs us that an increase in the price of a good or a service results in a decrease in the quantity of the product demanded. The price elasticity of demand supplements this knowledge by showing us how much the quantity demanded will decline following a price hike.

If the price elasticity of demand for a product is elastic, then a small alteration in the price will lead to a substantial change in the quantity bought by the clients (Mankiw & Cosgrove 2014, p. 24). In this scenario, the consumers are exceedingly responsive to the variations in the prices. A variety of reasons can be used to explain this phenomenon. For example, it could be easier for the purchasers to find a substitute and hence they have little tolerance to the price hike. Also, if the commodity is not a necessity, the buyers tend to highly responsive to price variation (Sloman, Wride & Garratt 2015, p. 21). Therefore, for this type of good, the management can only maximize the revenue by decreasing the price.

On the graph one below, if the firm reduces the price of the elastic product from 1 to 0.75 U.S Dollars, then the quantity demanded increases from 3 units to 12 units. More units are sold at a relatively low price and hence more revenue for the company. The area shaded green shows a growth in revenue that results from selling more at a lower price. On the contrary, the portion shaded red depicts a loss of income arising out of selling at a lower price.

Graph 1: Elastic Demand

If the price elasticity of demand for a product is inelastic, then a significant change in the price leads to a small shift in the product purchased by the consumers. For such commodities, the consumers are unresponsive to fluctuations in the price level. Those goods that are essential or lack substitute fall under this category. The buyers will continue to procure the same amount of product regardless of the changes in the prices (McTaggart, Findlay & Parkin 2015, p. 26). The management of the company can increase the revenues by increasing the prices of inelastic good as the clients will continue to buy even at a higher price.

On the graph two below, a hike in the price of the good from 0.50 to 2.50 U.S Dollars results in a small reduction in the units demanded, that is by one unit. At a price of 2.50 U.S dollars, the firm gets more revenue compared to a price of 0.50. The area shaded green depicts a growth in revenue arising from selling at a higher price. On the other hand, the area marked red exhibits a loss in revenue resulting from a reduction in quantity sold.

Elastic Good

Graph 2: Inelastic Demand

Price controls involve government sanctioned legal maximum or minimum price for a given commodity or a service. Price controls are often implemented as a form of direct government involvement in the economy to make sure that particular service or product is affordable to the citizens (Case, Fair & Oster 2014, p. 31). Price controls are categorized as price ceilings and price floors.

Price Ceilings

Price cap specifies a maximum price the merchants are legally allowed to charge for a good or service. The ceiling price is often set below the equilibrium and aims at protecting the consumers from price hike resulting from the free market (Frank 2015, p. 36). A good example of price ceiling that is often implemented by the governments is the rent cap. Many states especially the New York are have used have used rent control policy to protect the renters from high rates charged by the landlords.

Graph 3: Maximum Price

The government often has good intentions of protecting the consumers through the use of maximum price policy. However, the final outcomes of such plan are undesirable as the purchasers end up suffering more even before the imposition of the price ceiling. On the graph three above, the equilibrium in the free market is attained at point h where the equilibrium price is Pe whereas as the equilibrium quantity is Qe. On the imposition of a maximum rate, that is, P3, both the quantity supplied and demanded changes. The product the suppliers are willing to supply to the market declines to Q2 while the amount required increases to Q3. The variation between Q3 and Q2 represents a shortage of goods in the market due to maximum price.

Moreover, the price ceiling results in loss of consumer and producer surplus. The primary consumer surplus on the graph above is demonstrated by portion fkPe which declines to the area marked j on the introduction of the price cap. On the other hand, the primary producer surplus is denoted by area mhPe which shrinks to portion labeled l. The deadweight loss, area marked D, results. The deadweight loss occurs because the consumers are unable to find sufficient amount of goods and also the revenues of suppliers decline. The black market will emerge where the consumers will have to pay higher prices to secure the commodities.

Price Floors

The price floors stipulate the lowest price the customers are required to incur on a particular product or a service. Unlike the maximum rate which is meant to protect the consumers, the minimum price regulation is intended to protect the producers. This control is mostly applied by the governments to give the farmers higher incomes. Increased tariffs and higher prices are some of the negative impacts associated with the minimum price policy (Mankiw 2014, p. 43). Additionally, the price floor leads to an oversupply of goods and hence wastage and inefficiencies.

Inelastic Good

Graph 4: Minimum Price

The law of supply holds that the goods supplied to the market increase with an increase in the price. Thus, when the government imposes a price floor which is always above the equilibrium point, the producers will increase their supplies. At higher prices, consumers demand fewer goods. On the graph four above, the quantity supplied is Q3 while the amount demanded is Q2 and hence oversupply.

The minimum price control increases the welfare of suppliers and consumers suffer significantly due to a price hike. On the graph above, the producer surplus is denoted by area C and G while that of the consumer is H. the deadweight loss results, that is, area W. in the long run, the suppliers will incur losses due to weak demand and oversupply.

Enhancing Education and Training

Education is an essential factor that is known to have a significant impact on the aggregate supply of any nation. Government expenditure on training and education leads to the improvement and development if human capital (Gillespie 2014, p. 65). This approach generates a qualified pool of workers. With improved employee productivity, the aggregate supply will also increase resulting in a lower level of inflation and increase in the products produced by an economy. Moreover, the retraining of formerly manual employees is crucial. There is a need to enhance training, especially for the redundant workers as a way of improving the occupational mobility of employees in the economy.

Equitable and Sufficient Development of Infrastructure

Improving the core infrastructure of the country is essential in providing a favorable environment for the functioning of the businesses (Goodwin 2014, p. 52). Therefore, the government should strive to develop roads, railways, airports, energy, water and sewerage. Better transport is known to boost the movement of goods and services and minimizes costs that may result from damage or delays. Apart from reducing the costs of operation, improved infrastructure acts as an incentive to the investors to establish more investments such as rental property (Blanchard & Johnson 2013, p. 40). As a result, the aggregate supply in the economy will increase, leading to lower prices.

On the graph five below, improvement in education and training, as well as infrastructure, will make the aggregate supply curve to shift rightward from SRAS1 to SRAS2. The change in the aggregate supply results in a decrease in the price levels, that is, from P2 to P1. Similarly, the total quantity of products provided in the economy will increase, that is, movement from Q1 to Q2.

Price Controls

Graph 5: Increase in the Aggregate Supply

Reduction in the Interest Rates

The interest rates are in a position to stimulate both consumption and investments in an economy. The decrease in the interest rates indicates that the cost of borrowing money in the economy is relatively low. Therefore, individuals will increase their borrowing a situation that will result in higher levels of consumption in the economy (Boyes & Melvin 2012, p. 64). Furthermore, reduced cost of borrowing motivates the investors to borrow money and establish business ventures and hence increases in the aggregate demand.

Reduction in Taxes

The government can also fuel the economy by reducing the amount of taxes imposed on individuals. Reduced taxes represent an increase in the real income of employees (Sikdar 2011, p. 46). With more cash in hand, the consumers are likely to increase their purchases thus leading to an increase in the aggregate demand.

Graph 6: Increase in the aggregate demand

Reduction in the interest rates and taxes will result in an increase in consumption and investment levels causing a shift in the aggregate demand. On the graph six above, this situation is shown by the shift of aggregate demand curve from AD to AD1. As the AD curve shifts, the output changes from Y1 to Y2. One shortcoming of demand-side policies is that they result in demand-pull inflation. On the graph above, the prices increase to P2 from P1.

Cost-push inflation takes place when there is an increase in the cost of factors used in production such as raw material and labor (Nils Gottfries; Palgrave Macmillan. 2013, p. 57). An increase in the cost of inputs diminishes the goods supplied in the economy. One of the common causes of cost-push inflation is the hike in the price of oil in the international market. Moreover, unexpected shutdown or damage to the production facility, increase in minimum wages as well as mandatory pay increment results in the cost-push inflation. For this type of inflation to occur, the demand for the commodity affected must remain constant (Frank & Bernanke 2011, p. 68). Since the producers are profit motivated, they pass the extra costs of production to the consumers through higher prices.

Graph 7: cost-push inflation

An increase in the factors of production causes the aggregate supply curve to shift leftward from SRAS1 to SRAS2. The change in the total supply results in an increase in the prices of goods from P1 to P2. Likewise, the real GDP declines, that is, a change from Y2 to Y1. During cost push inflation the level of employment will drop significantly as the firm freezes the hiring of new employees while other business lay off the workers. Therefore, there will be an increase in the unemployment levels.

Demand-Pull Inflation

Demand-pull inflation is caused by expansionary monetary and fiscal policies of the government (Carlin & Soskice 2014, p. 39). The conventional expansionary monetary instruments include a reduction in the interest rates and buying of government bonds. On the other hand, the expansionary fiscal policies entail a decrease in the taxes and increase in public expenditure such as transfer payments. These instruments increase the amount of money in the economy. The individuals, therefore, tend to buy more goods. With an increase in demand, while the supply remains constant, demand-pull inflation occurs.

Graph 8: demand-pull inflation

Expansionary policies make the aggregate demand curve to change from AD to AD1. This change leads to an increase in the prices, from P1 to P2. Likewise, the real GDP increases, from Y1 to Y2. Moreover, the employment levels in the economy will rise as investors will have easy access to money to initiate investments thus create job opportunities (Hubbard & O'Brien 2013, p. 52).

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