HELP ESSAY QUESTION URGENT (1 Viewer)

anne123123

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Here is a practice economics question that I received from my teacher, wondering if anyone could help me break it down and help me with a few ideas for what to write about it:

With reference to recent events in the Australian economy and the aid of diagrams, explain how equilibrium price and quantity are determined in markets

I have also included the source that I have to mention

much appreciated!!
 

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CM_Tutor

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I would start by defining / describing the concepts of supply and demand and how they determine an equilibrium price in theory. The simplest model would see supply increasing linearly, and demand decreasing linearly, with the price being where they intersect. Factors influencing where these curves lie include cost of production, transportation, value / perceived value in use vs exchange (Smith's diamonds and water paradox), perishability of the item, etc. Classical economic theory would say that an increase in demand produces a new demand curve with an increase equilibrium price, while an increase in supply produces a new curve with a lower price. Low supply coupled with high demand leads to high prices, whether it be the artificially high price of diamonds produced by monopolistic behaviour, or a result of genuine scarcity, like the astonishing record set in 2019 of $343,000 for a standard-size bottle of Japanese whisky (https://www.forbes.com/sites/george...iants-a-rivalry-of-price-quality-and-success/). This is a model, however, and reality may not fit with models, due to factors not included in the model or due to its underlying assumptions. More advanced models take into account the price elasticity of supply and demand. For example, for some essential products demand does not change very much with price. An example would be electricity where prices have increased massively over the last decade but demand has not fallen by nearly as much. If the price of water suddenly doubled overnight, that would not change our need for water and hence demand would not halve. Supply can also have elasticity.

There are plenty of examples that can be drawn from recent Australian / world history, and I would choose ones that illustrate different aspects of the models in operation and ways in which external factors lead them to break down. From the top of my head:
  • Price changes in fruit and vegetables in response to weather events (drought, destruction of crops by plagues of insects - the Irish potato blight of the 1840s being a classic example, both of the operation of the market without restraint / regulation and the long-term response by introducing government regulation). Crops destroyed, supply drops, prices rise, leading to altered consumer behaviour and price drops, etc.
  • Trend in increasing housing prices and how the limited / fixed supply of land / property in the most desirable parts of major cities has led to a boom in house prices, fed in part by government actions. First home owners grant, for example, was meant to increase affordability for new entrants to the market but taxation policy / negative gearing fuels investment by landlords fueling increasing demand.
  • The recent coronavirus pandemic offers several examples:
    • Oil prices have fallen massively due to decreased demand (especially with the airlines not needing much fuel (in relative terms)). The price even went negative briefly as the cost of storage was so high in the face of a glut in supply and reduced demand. OPEC decisions to reduce supply in order to force up the price have a lagging effect as cuts in production can't be done easily and politics between countries and national interest means that the idea of rational actors leading producers to act in their own interests and that supporting the collective interest is flawed.
    • We had a recent massive spike in demand for toilet paper, following on from panic buying. Prices did not spike, however, despite that being the rational response of retailers. Profiteering by raising prices would have done considerable reputational damage, so there was a self-interest motivation to not increase prices. Regulations would also have limited the ability to alter prices. The massive increase in demand led to increased production and thus to an increase in supply, as the model would predict, but this was actually at increased cost for suppliers. Manufacturers increased production by increasing operations to 24/7, which increased their costs as labour is more expensive in overnight shifts. They likely had contractual (if not moral) obligations to implement the increased production, but are limited in their ability to pass the costs on. Demand has now fallen, last week's Woolworths sales of TP actually being below the equivalent week last year for the first time since the panic (the CEO has been sending updates that describe TP demand, so you could plot sales over time to illustrate a demand spike). After so many people have stockpiled, it seems likely that a sustained (but moderate) drop in demand is expected. Theoretically, this should lead to a decrease in prices but I doubt it will happen, just as the prices didn't rise with increased demand. It will harm the manufacturers, though, as it seems unlikely that covid will produce any long-term increase in demand, and so the manufacturers have effectively just brought forward production that would have occurred in the future, but have done so at increased (and likely unrecoverable) cost.
    • There was evidence of profiteering in some cases, and also examples of altruism. For example, I remember seeing a story of a person (in QLD?) who bought TP online and wanted 48 rolls but ended up with 48 boxes, each of 48 rolls. The company recognised it was a mistake and offered to buy back what was not wanted (at the same price), but the consumer kept the excess and sold it to friends / neighbours / people at the local school at the same price. Economic theory would say that this person should have sold them at a profit - there was plenty of demand - out of self-interest, but instead chose to sell at a loss (if the costs of time of arranging the sales, transporting etc are considered) as part of being a good citizen and helping / supporting a community in need.
    • These are two examples of the same flaw in the model - the underlying assumption that people act rationally and in their own economic best interests. The spike in TP demand arose from fear and panic-buying, neither of which was rational. Not raising TP prices by the larger supermarket chains was good for their reputations and is valuable as a tangible example of corporate good citizenship and concern for community welfare, but it meant forgoing additional profits and so was not the rational economic response of letting the market determine the price from the interplay of supply and demand. As for the altruistic Queenslander, s/he illustrates that people act from a variety of motives and in line with their values and beliefs, and not simply from economic self-interest.
    • More generally, the pandemic illustrates how events can lead to a sudden shift in demand. I needed a webcam for online teaching but couldn't find one in a store as demand had skyrocketed... one person at Officeworks told me that they were selling faster than toilet paper!
    • Government action and regulations have played a role in covid, not only altering demand patterns (by restricting travel, for example) but intervening to provide financial support to some businesses. The "free child care" initiative, for example, was meant to provide a financial lifeline to Centre operators whose financial viability was threatened by the drop in demand (as children were kept home). The market response would be that the demand decreases should lead to a drop in prices and ultimately to reduced supply by some operators closing down, etc... but the government sought to prevent this as demand will recover and the industry is vital to keeping parents working and the economy moving. In effect, they fixed a price through the subsidy and by preventing extra fees being charged to maintain viability of services and ensure that the supply remains for when the demand increases (and it is already increasing). They also supported demand by making it "free" for parents, though everyone pays through taxation, and acted in their own self-interest by presenting themselves as helping families in financial need.
    • JobKeeper and JobSeeker programs are not only about keeping people employed and providing financial support, they are about ensuring ongoing economic activity and thus maintaining demand. After all, as in a depression, large drops in demand reduce business profitability, leading to job losses and further reductions in both demand and supply. Uncertain economic conditions coupled with anxiety / fear of the future lead people to alter their behaviour, reducing demand for goods and services deemed less important or even unnecessary. Priorities change to ensure that whatever is deemed most important / valuable is maintained. Crudely, this means the demand for Ferraris will fall more than demand for toilet paper, as one is a luxury and one is a necessity, but it also means changed buying patterns in essentials like food - buying less meat or cheaper cuts, for example, leading to reduced demand, and then falling wholesale prices, then reduced income for farmers, leading them to reduce their own spending, etc.
 

CM_Tutor

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  • Some prices are regulated and determined without regard to changes in supply and demand - look at public transport fares, for example, where overcrowded trains may lead some people to drive instead (lowering demand for tickets, and producing a more comfortable commute for others, which should make it more 'valuable' in some sense, yet prices don't change).
  • Private Health Insurance offers another example of pricing - with new procedures and medications driving up costs, demand is decreasing. The viability of their business model relies on government support and intervention (the health insurance rebate, for example), which reduces costs to the purchaser and thus supports demand. The rationale is that it reduces pressure on the public health system (which is expensive and paid for in large part by the government and thus through taxes instead of directly by patients).
  • Things that are "free" are often seen as of low or lower value and thus wasted. The Pharmaceutical Benefits Scheme in Australia has a co-payment for medications largely as a signal that the medications are of value and should not be wasted. Patients will only fill a prescription that they have to pay (at least something) for if they intend to use it. Before the co-payment was introduced, there was greater demand as the price was seen as $0. Demand for pharmaceuticals is an interesting case, too: it is predictable for medications taken regularly (a daily dose of XYZ), it is predictable for treating specific conditions (though not on an individual level), and it is subject to spikes - Seasonal demand for cold and flu medications, for example, or the stockpiling of panadol / paracetamol that happened early in covid. On the specific conditions, the demand at an individual level is often inelastic. At this moment, my demand for cisplatin, a drug that treats certain types of cancer, is nil as I don't have cancer. If I was diagnosed with such a cancer tomorrow, my demand would become high, and likely it would be relatively uninfluenced by price. If it was going to cost me $1,000 a month, I'd find a way to pay it.
  • As the costs of production fall, the supply at a particular price will rise (due to increased profitability), leading to the option of discounting while maintaining margins and decreased prices, leading to an increase in demand. Over the longer term, this can be seen in the pricing trends in areas like electronics / computing. A computer made now is much more powerful than was one made ten years ago, and yet it likely sells at a lower price. New models of phones make the perceived value of older phones much less, despite similar basic capabilities, reducing prices to sell off surplus supply in the face of reduced demand. More generally, discounting is a standard practice that illustrates the lowering of a price to stimulate demand and thereby clear older / unwanted stock. Supermarkets do this all the time, reducing the price of items that are close to their use by date to make some money from them because once the date has passed, they cannot be sold and so the value drops to zero. In fact, unsold outdated stock becomes a cost because it needs to be disposed of and it takes up space. An asset - a bottle of milk that will expire tomorrow that I can try to sell for $2, or offer for quick sale at $1 - becomes a liability two days later, as I can't sell it, I have no reason to keep it, and disposing of it will incur at the least labour costs. As the retailer, I am better off stimulating demand by offering it for $1, even if it cost me $1.50, because that has already been spent and the question is not "will I buy this bottle for $1.50 to sell it for $1 and lose 50c?" (to which the answer is obviously "no"), but "having already spent $1.50, do I try to recover $1 to sell it fast, or keep it at $2 and hope to profit, at the risk of getting $0 and incurring costs in disposal?" If I think I can sell it at $2, great... but if the demand for short-dated milk is such that I have far more supply, I am better off stimulating demand with a discount.
  • Breaking monopolistic power also reduces prices by opening up additional supply (De Beers regulated supply of diamonds to keep prices high for a long time) or adding competition (bring new telecommunications companies into the Australian market to compete with Telecom (as it then was) had huge effects on reducing pricing which had for years been inconsistent with the actual cost of supplying the service).
Ok, that's a lot more than I was planning to say! There are plenty of other examples that you could highlight. My advice is to decide what you want to say, write an outline (dot points) of the structure, then decide what illustrations are suitable. Wikipedia has some good material on these topics, including factors that influence elasticity of both supply and demand. Of course, Wikipedia is not a reliable source nor a suitable reference, but the references that it uses are typically good and can help.

Good luck!
 

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