Archive for the 'Supply/Demand' Category

Oct 24 2010

What does a good IB Economics Commentary look like?

It’s that time of the IB Economics course when I get to start teaching my year one students to write the dreaded Internal Assessment Commentaries. For their first IA, my students are writing a commentary on an article relating to Section 2.1 and 2.2 of the IB course, on supply, demand, market equilibrium and elasticities.

After reading a dozen or so out of my 38 students’ first drafts, I began to realize that what many of them needed was a clearer idea of what a good IB Economics commentary should look like. So I went back through past years’ commentaries and decided in the end just to write a sample commentary myself.

As you know, I do a lot of economics writing, so I thought this would be a breeze; I’d bust out a 700 word commentary modelling to my students what a top IA should look like. Well, I did it, but it proved to be much harder than I thought it would be. Why? Because after my first draft I was at 1100 words! The word limit, as IB students know, is 750, so I proceeded to spend as much time as it took me to write figuring out how to get it down to within the word limit.

Well, I did it. Below is my sample commentary for year one IB students. I do owe some credit to a past student of mine, Maren, whose article I stole and whose own commentary I adapted to write this one.

First, here’s the link to the article:

Where is Switzerland’s Cheapest Place to Live? – SwissInfo

And my commentary:

Introduction of theory:
Demand, supply and elasticity are basic economic concepts that when applied to different markets can help governments and individuals make informed decisions about things as basic as where to live and how to collect taxes.

Connection to article:
Recently, Credit Suisse conducted a survey and determined that Switzerland’s most expensive canton is Geneva, while the cheapest place to live is Appenzell Inner Rhodes, (AIR)

Analysis:
Demand is a curve showing the various amounts of a product consumers want and can purchase at different prices during a specific period of time. Supply is a curve showing the different amounts of a product suppliers are willing to provide at different prices. Equilibrium price and quantity are determined by the intersection of demand and supply. Price elasticity of demand (PED) indicates the responsiveness of consumers to a change in price, and is reflected in the relative slope of demand.

In the graph below, the markets for housing in Geneva and AIR are shown.

Demand for housing in Geneva (Dg), is high because of the many employment opportunities there. In addition, Geneva’s scarce land means supply of housing is low, resulting in a high equilibrium rent (Rg). Demand for housing in Geneva is inelastic, since renters in Geneva are less responsive to changes in rent compared to AIR, perhaps due to the perceived necessity of living close to their work.

Demand for housing in AIR (Da) is low, but supply is high due to the abundance of land. AIR is a rural canton with few jobs, therefore fewer people are willing and able to live there than in Geneva. Since living in the countryside is not a necessity, demand is relatively elastic, or responsive to changes in rent. The lower demand and greater supply make the AIR’s equilibrium rent relatively low.

The effect of a tax on property is a shift of the supply curve to the left and in increase in rents as landowners, forced to pay the canton a share of their rental incomes, raise the rent they charge residents.

In Geneva, property taxes are high, but this has little effect on the quantity demanded.

Geneva’s property tax shifts the supply of housing leftwards, as fewer landlords will be willing and able to supply properties to renters when the canton taxes rental incomes. However, the decrease in quantity demanded is proportionally smaller than the increase in the price caused by the tax, since demand for housing in Geneva is highly inelastic, or unresponsive to the higher price caused by the tax.

Renters in AIR are far more responsive to higher rents caused by property taxes, perhaps because living in AIR is not considered a necessity and there are more substitutes for rural cantons to live in. Renters in Geneva do not have the freedom to live in one of Switzerland’s many rural cantons, and are therefore less responsive to higher rents resulting from cantonal taxes.

Evaluation:
A tax decrease in AIR could lead to a significant increase in the number of people willing to live there, since renters are highly responsive to lower taxes. To some extent, housing in AIR and Geneva are substitutes for one another. Lower taxes in AIR would make living there more attractive, and subsequently the demand for housing in Geneva would fall putting downward pressure on rents there. People would move to AIR, attracted by lower rents, and commute to work in the cities. According to the article, this is already happening:

The disparity in the amount of disposable income… has increased the trend of people moving cantons for financial reasons… Economic necessities had led to an increase… of people moving address and opting to commute into work”.

There are many determinants of demand for housing in Switzerland, the primary one being location. High rents in Geneva are explained by the high demand for and the limited supply of housing. On the other hand, residents in AIR enjoy much lower rents, due to the weak demand and abundant land. Cantons should take into consideration the PED for housing when determining their property tax levels. Raising the tax Geneva will have little effect on rentals but could create substantial tax revenue. On the other hand, reducing taxes in AIR may attract many households away from the city to the countryside, drawn by the lower rents and property taxes.

Applying the basic principles of demand, supply and elasticity to Switzerland’s housing market allows households and government alike to make better decisions about where to live and how much to tax citizens.

Note: To see the full commentary including a cover page and highlighted article, click here

46 responses so far

Sep 30 2010

From disequilibrium to equilibrium – how prices allocate resources in a free market

Energy Roundup – WSJ.com : In Today’s Journal: Easing Back on the Gas

Here’s a great example of a market in disequilibrium:

“Amid an abundance of natural-gas supplies and soft prices, gas producers are starting to pull the plug. Chesapeake Energy Corp. said it will cut 6% of its gas production in September in response to low natural-gas prices. The Oklahoma City-based company will also reduce its capital spending by 10% in 2008 and 2009. Other natural-gas producers are cutting back their output as well, analysts said.”

We learn in IB and AP Economics that markets are generally efficient thanks to the signals that prices send from consumers to producers to determine where scarce resources should be allocated. We’ve also learned how supply and demand interact in a market (such as that for natural gas) to determine equilibrium price and quantity. In the above example, there exists a disequilibrium, where either the quantity demanded exceeds the quantity supply (a shortage), or the quantity supplied exceeds the quantity demanded (a surplus).

Based on the excerpt above, discuss the causes and effects of the disequilibrium in the natural gas market. Are resources being under or over-allocated towards gas production right now? What about in a month or two? On a piece of scratch paper, sketch a supply/demand diagram and illustrate the above scenario. Describe the shifts you would draw in such a diagram.

Discussion questions:

  1. What is meant by “soft prices” in the natural gas market? Assuming output by gas producers remained constant, what must have changed to cause the soft prices?
  2. How have firms responded to soft prices? Does the reaction of the gas companies support the law of supply? Explain
  3. In the next month, what will happen to supply of natural gas?
  4. What may happen in the natural gas market  if firms reduce capital spending in the next two years?

Once you’ve read this post, thought about the situation in the gas market, and commented below, read this for a clear, concise explanation of the situation from a college professor, or click here: Environmental Economics: A demand and supply example

10 responses so far

Sep 23 2010

Is bicycle transportation an “inferior good”?

This article was originally published on May 12, 2008. It is being re-published since it relates to our current units in AP and IB Economics.

The Associated Press: Gas prices knock bicycle sales, repairs into higher gear

Greg Mankiw has an ongoing series of posts linking to articles illustrating the impact that rising gas prices have had on demand in markets other than that of the automobile.

One of the determinants of demand for goods and services is the price of related goods and services. As gas prices rise, drivers tend to switch from automobiles to alternative forms of transportation. A few days ago I blogged about the switch from tractors to camels in India, one illustration of the relationship between the price of one good and demand for its substitutes. Mankiw has so far linked to articles about the impact of high gas prices on demand for bicycles, small cars and mass transit.

These three “goods” are all substitutes for the most common form of transport among Americans, the private automobile (often times a gas-guzzler in “the bigger the better” America). When the price of a good like personal vehicular transport increases (in this case due to the price of an input required in private cars, gasoline), the demand for a substitute good will increase.

In the case of bicycles, evidence indicates that just such a change in demand is already underway in America today:

Bicycle shops across the country are reporting strong sales so far this year, and more people are bringing in bikes that have been idled for years, he said.

“People are riding bicycles a lot more often, and it’s due to a mixture of things but escalating gas prices is one of them,” said Bill Nesper, spokesman for the Washington. D.C.-based League of American Bicyclists.

“We’re seeing a spike in the number of calls we’re getting from people wanting tips on bicycle commuting,” he said.

Interestingly, the increase in demand for bicycle travel in response to high gas prices might be even more pronounced due to America’s sluggish growth, 4% inflation and rising unemployment. Real wages have seen little gain in the last couple of years as growth has fallen close to zero while prices have continued to rise. It may be possible that a fall in real incomes in America has spurred new demand for bicycle transportation, which could be considered an inferior good, meaning that as household incomes fall, consumers demand more bicycles for transportation.

Since bicycles represent such a drastically cheaper method of transportation, high gas and food prices, a weak dollar, and falling real wages accompanying the economic slowdown have had a negative income effect on American consumers, leading to increases in demand for inferior goods such as bicycle transportation

That said, having worked in a bike shop myself for two years in college, I can say that most consumers looking at new bicycles are not doing so because of falling incomes. Quite the opposite, in fact, indicating that new bicycles are normal goods (those for which as income rises, demand rises). However, the article states that in addition to increases in new sales, “more people are bringing in bikes that have been idled for years”.

It may be that while new bicycles themselves are normal goods, bicycle transportation as a whole is an inferior good. The increase in demand for new bicycles could be explained by the substitution effect (as the price of motor vehicle transportation rises, its substitute, bicycle transport, becomes more attractive to consumers) and at the same time explained by the income effect too (as real incomes have fallen, demand for the bicycle transport has risen).

This phenomenon is an excellent illustration of how the income and substitution effects work in conjunction to explain the inverse relationship between price and quantity demanded for automobiles (the law of demand), as well as the concept of cross-price elasticity of demand between two substitute goods.

Discussion Questions:

  1. Both the price of substitute goods and income affect demand for a particular product. How have both the prices of substitutes for bikes and the income of bike consumers influenced the demand for bicycles in different ways?
  2. What is the definition of an “inferior good” in economics?Do you believe bicycle transportation is an “inferior good”?
  3. Are all bikes the same? Do you think demand for some bicycles responds differently to changes in income than demand for other bicycles?

97 responses so far

Sep 23 2010

The magical recession proof bunny

Chocolate Sales: A Sweet Spot in the Recession – TIME

Living in Switzerland, I find an article featuring a local business from the town my school is in irresistible, particularly when it appear in TIME magazine. Lindt chocolate, the company featured in this article, manufactures its delicate treats right down the hill from the ZIS campus, which means that when the wind is just right, you can just catch the scent of fresh, creamy chocolate wafting up the hillside while walking to campus.

Lindt, as well as its global competitors in the chocolate business, is enjoying surge in demand even while countless other industries are forced to cut back production, lay off workers, and close their factory doors. From TIME:

While the credit crisis has slowed down sales of everything from cars to organic groceries, people seem happy to keep shelling out for chocolate. Last year, as the global recession was gaining ground, Swiss chocolate makers bucked the trend with record sales — nearly 185,000 tons, an increase of 2% over 2007, sold domestically and in 140 export markets…

“Switzerland’s image sells well abroad, and nothing says ‘Switzerland’ more than chocolate,” says Stephane Garelli, director of the World Competitiveness Center at the Institute of Management Development (IMD) in Lausanne, predicting that this comfort food will continue to sweeten the sour economy for months to come…

“Now that people don’t have a new television or a new car,” he noted, “they eat a bit more chocolate.”

“Chocolate is one of the more recession-resilient food sectors,” says Dean Best, executive director of Just-Food, a U.K.-based news and information website for the global food industry. “With consumers eating out less and eating at home more, there is evidence that they are still allowing themselves the occasional indulgence — and chocolate is a relatively inexpensive indulgence.”

But the question of why there is no meltdown in the chocolate business may be more a matter of psychology than economics. “There is well-documented evidence going back to Freud, showing that in times of anxiety and uncertainty, when people need a boost, they turn to chocolate,” says Garelli of the IMD. “That’s why when the economy is bad, chocolate is still selling well.”

Which goes to show that chocolate is more than a candy treat — it’s real food for the soul.

So does this mean chocolate is an inferior good, or one for which demand increases as incomes fall? I doubt many Swiss chocolate producers would consider their product inferior, but perhaps it does fit the definition.

On the other hand, perhaps the reason demand for chocolate increases during a recession has more to do with the substitution effect than the income effect. As people eat out less, they consume fewer expensive deserts at restaurants and instead fill their shopping baskets with more affordable dessert options for the home. I can say from experience that this is the case for myself.

Living in Switzerland, I find myself rarely going out to eat at restaurants, an activity reserved for special occasions in this country where a steak can set you back 75 dollars. Instead, I eat at home almost every night, and nothing is more appealing to me, especially during hard economic times, than a bar of delicious chocolate after a home cooked meal. Demand for chocolate may rise during recessions simply because the demand for one of its substitutes (restaurant desserts) falls.

Discussion questions:

  1. Do you think chocolate is an inferior good or a normal good? What’s the difference? What types of goods do YOU consome more of when you find yourself faced with a tighter budget?
  2. Does economics have a good explanation for the above situation? The article mentions Freud, a pioneer in  the field of psychology; do humans’ economic behavior always appear rational?
  3. If chocolate were an inferior good, what would happen to chocolate sales when the global economy finally turns around and incomes start increasing? What do you think will happen to chocolate sales when the economy starts imrpoving? Explain.

31 responses so far

Sep 22 2010

Luxury goods: the biggest rip off in the world or the “must have items” for any self-respecting European?

TDeluxe: How Luxury Lost Its Luster – Dana Thomas – Books – Review – New York Times

Unit 2 in IB and AP Economics begins by examining the interaction of supply and demand in product markets, and the importance of these factors in determining the equilibrium price in any particular product market.

In the above article from the NY times, the author reviews a book that exposes the diminished quality and attention to detail among manufacturers of luxury goods (think Prada, Gucci, etc…) The era of globalization and off-shoring of manufacturing has aided luxury firms in their quest for profits, as they’ve been able to significantly cut costs while maintaining exorbitant prices for their product.

The author takes issue with the alleged demise in the luxury market of attention to detail and craftsmanship, as competition and profit seeking behavior have led to an industry where the back alley workshops of Milan and Paris have been replaced by the factory floors of China and Vietnam. Free trade has allowed European luxury brands to produce more of their products at lower costs, which leads the author to her current question: “Why is this stuff still so expensive even as the cost of producing it goes down?”

Despite her accusations of poor quality and greedy, profit seeking managers in the luxury goods industry, the author seem unable to resist the luxury goods she claims to despise:

When, I asked myself, did it become commonplace to charge several thousand dollars for a mass-produced handbag? How could the flimsy designer sundress I bought on sale (a “steal”, the saleswoman assured me) still wind up costing a whole month’s salary? Why is my favorite brand of lipstick more expensive than a nice bottle of Italian wine? When did these products’ values grow so distorted, and what is the would-be customer to make of it all?

The author continues…

the luxury industry is a sham because its offerings in no way merit the high price tags they command. Yet once upon a time, they most certainly did. In the 19th and early 20th centuries, when many of luxury’s founding fathers first set up shop, paying more money meant getting something truly exceptional. Dresses from Christian Dior, luggage from Louis Vuitton, jewelry from Cartier: in the golden period of luxury, these items carried prestige because of their superior craftsmanship and design. True, only the very privileged could afford them, but it was this exclusivity that gave them their cachet. Although they may have “cared about making a profit” the merchants who served this pampered class aimed chiefly to produce the finest products possible.

It appears that the author never took an introductory economics course. If she had, she would clearly understand that price is not determined by the level of craftsmanship, the attention to detail, nor the level of exclusivity represented by a particular purse, shoe or dress. Rather, price is determined by the interaction of Demand AND Supply in the market for all goods, EVEN luxury goods!

When she claims that “the merchents who served this pampered class aimed chiefly ‘to produce the finest products possible'”, the reviewer is forgetting some of the basic teachings of capitalism’s founding father. Adam Smith himself could have corrected the NYT reviewer when he said,

Whoever offers to another a bargain of any kind, proposes to do this. Give me that which I want, and you shall have this which you want, is the meaning of every such offer…

Smith knew as any economics student should know that exchanges in any market happen not because of a mutual appreciation for craftsmanship or artistry, rather because a producer (firm) wants to make a profit by charging as high a price possible to a consumer (household). In the case of luxury goods, Gucci and Prada never made high quality goods because they loved making high quality goods, rather they made them cause consumers demanded them and were willing to pay top dollar for them.

What the author is missing is a basic understanding of the determinants of Demand. The price a good commands in the market has little to do with how much it cost to produce or where it was produced, and everything to do with the level of demand relative to the level of supply.

Discussion questions:

  1. Why do Prada, Gucci, Cartier and other luxury brands command such high prices relative to cheaper substitutes widely available to consumers?
  2. As nothing else changes and the price of luxury goods goes up, how is demand affected? Explain.
  3. What are some of the determinants of demand that have kept the price of luxury brand goods high even as the costs of production have been reduced due to cheap overseas manufacturing?

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38 responses so far

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