1. Critically evaluate the following suggestion: “If the price elasticity of demand for food is low, therefore if you own a restaurant, you can charge higher price to increase revenue”.
Consumers’ sensitivity to price is known as the price elasticity of demand. Simply put, it measures the degree of responsiveness of consumers to a given change in price. A good with an elastic demand will have a value greater than 1 and will experience that people are very sensitive to a given change in price. Products with an inelastic demand will find that even if price increases by a small amount, the quantity decrease is less than the increase in revenue (Anderson, et al., 1997).
Goods that are considered as necessities or those that are unique and not easily available tend to have an inelastic demand because people either require them to survive or not many are able to purchase them. Contrastingly, those products that are not essential or for whom many substitutes are available will have an elastic demand because people can easily switch consumption.
Food is a basic necessity that we require in order to survive, which means that it has an inelastic demand. However, restaurants are not the only source of food and it is available elsewhere. Eating at a restaurant can be a luxury for many but given the quality of the ambiance and the food, restaurants do charge a premium for the unique experience. Therefore, unless the taste of the food and the environment of the restaurant are matchless, higher prices might not necessarily increase revenue. This is because people can either cook their own foods and eat or switch to less costly alternatives such as diners. The elasticity concept, if used prudently, can get a lot out of consumers (Rishe, 2013).
2. Describe how a market can be inefficient or inequitable.
Inefficiency in economics is when scare resources are not being put to the best use possible, when resources are either being wasted or unnecessary costs are being incurred. Pareto inefficiency is if all resources are not being used and production is at a lower level than potential, productive inefficiency is when companies are producing at their minimum unit costs and finally allocative inefficiency is when consumers are charged inefficient prices (Ikeda, 2012).
Inefficiency usually creeps in when a market develops one or a few big dominating players. Such companies are either the sole producers of a certain good or have a competitive advantage in comparison to others. This allows these companies to use their power to exploit consumers and increase their revenue.
The above diagram illustrates that monopolies sell at a lower quantity and by restricting supply charge higher prices to maximize revenue. In a competitive market with fierce competition this would not be the case as market forces determine demand and supply. Monopolistic activities ensure higher surplus for producers whereas the consequences are that consumer surplus decreases and society as a whole has to suffer dead weight loss (Beggs).
Oligopolies are another example whereby companies reduce overall surplus by maximizing their revenue. The most pertinent example here would be that of the OPEC. The countries specialize in the production of oil and since it is not freely available they charge higher prices to other countries to increase revenue. Such a situation can also occur if a company faces no competition and hence no incentive to be efficient and operate effectively (Abraham, 2009).
3. Explain why after the end of civil war in Cambodia, it was possible for the country to produce both more consumer goods and more public goods at the same time. Doesn't this violate the economist's notion that there is no such thing as zero opportunity costs? Be sure to use a production possibilities frontier to explain your answer.
A production possibilities frontier illustrates the various combinations of different types of goods that a country can produce given the resource base available to it. All points on the curve represent a trade off as producing more of one type of good would mean giving up some production of the other type. Producing on the curve means that all resources are being utilized and that any point below the curve represents inefficiency as resources are being wasted. All points beyond the curve are unattainable, but through certain events the curve may shift outwards signaling an increase in potential (The Economic Times).
Cambodia suffered a very dark period in the 1970s due the civil war that it endured and that has been a major setback for the country. The strife and turmoil that lasted for 28 years adversely affected the Cambodian economy, depleting it of its human capital as well as physical infrastructure (CIA, 2014). The bombing of the Cambodian countryside and the movement of millions to that area after it were events that took a lot away from the potential of the country. Events such as wars shift the focus of the population from working and producing to safeguarding their lives. With such a situation, the Cambodian economy at the time of the war must have been producing well below potential and inside the curve similar to point C in the diagram below.
After the war, once the situation stabilized a bit and the new government settled in, gradually production increased with new reforms in place and people being able to work again. The government shifted expenditure to areas that needed it and this was reflected in the two most powerful industries of Cambodia, the garment and tourism industry. These changes meant that resources that were idle and not being utilized in production during the war were being put back into efficient use; slowly the economy moved towards growth. On the production possibility frontier this would mean a shift from point C to point A or B in the diagram above. The war brought in such disastrous conditions that production in the country virtually stopped. That’s why after the war, once the people were able to focus on things that were important, all types of goods in the country increased. From such underutilization to economic growth, the economy improved on all fronts.
4. Explain why a high value of a currency might be as much of a problem as a low value?
The exchange rate is the value of the currency of a country with respect to other currencies. In other words, it is also the rate at which one currency can be exchange for another. Exchange rates determine the prices of imports and exports for people of a country and also can be a deciding factor when it comes to balance of payments transactions (Stanlake, 2000).
A high exchange rate of a country would signify that exports would become expensive to foreigners while imports will become cheaper to domestic residents. This may seem beneficial, but over the long run the effect of this higher value would be to divert consumption from within the country to outside of it. As exports become expensive people stop buying from the country, while its own residents buy more from abroad as it is cheaper. This will lead to decreased production within the economy causing unemployment to rise and a possible recession to develop (Mpynihan, Titley, 2012).
Similarly a lower exchange rate value would mean that imports become expensive while exports become affordable. More people would buy from the country and consumption would increase. If this increased demand is not met be excess capacity, the country will experience inflation. Not only this, but a lower exchange rate also means that the government might incur a balance of payments deficit as it has to pay out more (Sloman, Wride, Garratt, 2012).
Anderson, P., McLellan, R., Overton, J., Wolfram, G., 1997. Price elasticity of demand. [online] Mackinac Center. Available at http://www.mackinac.org/1247
Rishe, 2013. Super Bowl XLVIII pricing: a lesson in demand elasticity. [online] Available at: http://www.forbes.com/sites/prishe/2013/09/19/super-bowl-xlviii-pricing-a-lesson-in-demand-elasticity/
Beggs. The economic inefficiency of monopoly. [online] Available at: http://economics.about.com/od/monopoly-category/ss/The-Economic-Inefficiency-Of-Monopoly_6.htm
Ikeda, S., 2012. The virtue of market inefficiency. [online] Available at: http://www.fee.org/the_freeman/detail/the-virtue-of-market-inefficiency
Abraham, N., 2009. First-class inefficiency. [online] Availabke at: http://www.forbes.com/2009/04/16/usps-postal-service-mail-opinions-contributors-monopoly.html
The Economic Times. Definition of Production Possibility Frontier. [online] The Times of India. Available at: http://economictimes.indiatimes.com/definition/production-possibility-frontier
CIA, 2014. Cambodia. [online] CIA World Factbook. Available at: https://www.cia.gov/library/publications/the-world-factbook/geos/cb.html
Stanlake, G.F., 2000. Introductory Economics. Essex: Longman
Mpynihan, D., Titley, B., 2012. Complete Economics for Cambridge IGCSE and O-Level. Oxford University Press
Sloman, J., Wride, A., Garratt, D., 2012. Economics. Financial Times Prentice Hall.