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Price Elasticity of Demand

3 Jul

Elasticity of Demand
   Law of demand tells us that if the price of a good declines then the consumer will buy more of this product. However, it doesn’t mention the quantity of good which will be bought.
   The responsiveness (or sensitivity) of demanders to a price change is called product’s price elasticity of demand. For some items it can be very high – for example a new Ferrari, price change of this good can cause very large changes in quantity demanded. Economists say that the demand for these type of products is relative elastic or simply elastic.
   For other items change in price doesn’t affect so much quantity bought (an example can be salt, sugar). The demand for such products is relatively inelastic or simply inelastic.

Price Elasticity Coefficient and Formula 
   In economics price elasticity or inelasticity of demand is denoted by Ed, and it’s calculated by following formula:
Elasticity of Demand
   Also Ed may be calculated by following formula:

Use of Percentage
  Economist use percentage rather that absolute amounts because it’s easier to identify if demand is elastic or not. Also, by using percentage we can correctly compare consumers’ responsiveness to change in price of different items.
Minus Sign
     We know that price and quantity demanded are inverse related. Thus Ed will always be a negative number. As an example, let’s assume that prices decline, so quantity demanded will increase, which means that the numerator in our formula will positive, but the denominator negative, so Ewill be negative. So economists ignore this minus sign and show only absolute value.
Interpretation of Ed

   Elastic Demand
   The Demand is elastic if a specific percentage change in price produces a larger percentage change in quantity demanded. Then Ed>1.

  Inelastic Demand
Demand is called inelastic if a specific percentage change in price produces a smaller percentage change in quantity demanded. In this case Ed<1.  

  Unit Elasticity
   The case that separates Elastic and Inelastic Demand occurs when percentage change in price is the same as percentage change in quantity demanded and this situation is called unit elasticity. In this case Ed=0.

Extreme cases
When it’s said that demand is inelastic it isn’t meant that consumers are completely unresponsive to a price change. In the case that price change results in no percentage change in quantity demanded, economists say that demand is perfectly inelastic. The price elasticity coefficient is zero because there is no response (change in quantity) to a change in price. Examples of items that may produce perfectly inelastic demand are insulin (for diabetics), heroin (for addicts). A line parallel to the vertical axis represents perfectly inelastic demand graphically.
   Conversely, when it’s said that the demand is elastic, it isn’t meant that the demanders are completely responsive for a price change. In this extreme case, when a small reduction in price causes buyers to buy all goods from zero to all that they can obtain, the elasticity coefficient is infinite; economists call this type of demand perfectly elastic. A line parallel to horizontal axis represents perfectly elastic demand.
Perfectly elastic Perfectly inelastic demand
Midpoint Formula
   This formula estimates elasticity at the midpoint of the relevant price range. The midpoint formula for  is stated as follows:

Midpoint Formula

   Take care; use it when you get that the demand for the same numbers is elastic for one direction and inelastic for the opposite one.
A very useful table for elasticity of demand that almost all economists should remember:
Elasticity of Demand Table


Increased Global Competition

3 Jul

Increased Global Competition

Free International trade has brought a harsh competition among producers from different countries. Imports have an important effect on different industries from any country. Also many firms from, let’s say, Japan have become very wealthy and well-known on international market like: Nintendo, Sony, Honda, Panasonic, Mitsubishi. However, there are a lot of firms that can’t compete, because their international competitors make better quality products or price of their goods are relatively lower, or even both these qualities may be present.

So is this competition among firms from the entire planet good or bad? Even if domestic producers may get hurt and a lot of people should find new jobs, foreign competition clearly benefits consumers and society in general. Imports break down monopoly of existing firms, and decrease the price of goods and services. Foreign competition forces domestic producers to improve their production quality and productive efficiency. However many domestic firms may compete successfully in the global market system.

What about Firms which aren’t able to compete? The truth is that they should go out of business. Economic losses mean that the scarce resources aren’t used efficiently. Alternative uses of them may be more profitable and improve the output of the whole country.

Government and Trade

3 Jul

Protective tariffs

People and whole society benefits from specialization and international exchange, but why sometimes governments try to restrict the free flow of imports and encourage exports? What types of world trade barriers exist and why are they applied?

There are four methods by which government can restrict free flow of goods among its country and other nations:

  • Protective tariffs– are some taxes designated to protect domestic producers of goods and services from competition with foreign firms and producers. They cause a rise in the price of imported goods so that buyers will tend to purchase more domestic goods.
  • Import quotas– are limits on the quantities or total value of an item that may be imported in a period of time. If quota if “filled” that good or resource can’t be anymore imported. Import quotas are more effective than tariffs, because with tariffs that items can continue to be imported in large countries, but with quotas all imports are prohibited once quota is filled.
  • Export subsidies-represent government payments to domestic producers of some goods or resources. By offering this money, production costs are reduced, so these firms can lower prices of their products, so that they may sell more goods in world market.
  • Non-tariff barriers (also non-quota barriers)-include burdensome requirements, unreasonable standards related to product’s quality. Some nations require importers of foreign goods to have some type of license and then government restrict number of licenses issued. Some countries may use these inspects to examine if goods aren’t harmful for people’s health, other use them to impede imports.

Why government would impede free trade when it’s beneficial for a nation? Why would it increase quantity and value of exported goods and decrease value and quantity of imported ones?

There is a misunderstanding that greatest benefit from international trade is greater domestic employment in export sector. It’s commonly thought that exports are “good” because they increase employment, but imports are bad because they deprive people from their jobs. Actually the true benefit of free trade is that a nation can get a higher output of goods obtained after international specialization and exchange. A nation can fully employ its labor force and resources with or without international trade. However, international trade enables the society to use its resources in a way that increase the total output and well-being of society.

A nation doesn’t need international trade to operate on PPC. That’s why a non-trading society can have all labor force employed. But, with international trade a nation can reach a point that’s upper than PPC. The gains from trade are “extra-output” –they are production obtained with less cost than if it was produced home.

Political Consideration

While a nation whole gains from trade, it may harm some particular domestic industries or groups of people. These who benefit from import protection are few in number but with enormous authority. The overall costs of quotas and tariffs exceed the benefits. It’s known that if government spends 1 million on protecting an industry, the latter one doesn’t pay back even half of this amount. Since the costs are spread over large number of people the cost related to each demander of that good is quite small. Since public doesn’t know about this stuff it can be won by this political groups by apparent plausibility (“Decrease imports, and so prevent unemployment”) or with some patriotic slogans (“Buy only Australian”).

 Cost for the entire Nation

Tariff and quotas benefit domestic producers but they harm the domestic consumers, who shall pay higher that world prices for that goods and services. They also harm the domestic firms that use protected resources in their production of goods. With less competition from foreign countries, domestic firms may be less efficient at implementing cost-saving methods and improving the method of production.

Protective tariffs

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