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When consumers buy more then demand rises which in turn leads to price
increase. Heilbroner and Thurow (1998) found that the demand supply
mechanism also works in reverse - if incomes fall then so does demand
and price. Supply can also fall as a result of other micro environment
factors such as a rise in production costs for the producer or even changes
in legal regulations or tax policies.
There are two key areas of theory related to this case. Elasticity and market power.Price elasticity of
demand is the responsiveness of demand to changes in price. We know that demand is negatively
related to price - when price rises demand falls and vice versa. Elasticity gives us some measure about
the strength of the relationship between price and demand. To measure elasticity we use a formula;
1. Ped always has a minus sign in front of it - this is not a minus sign in the mathematical sense
but it is there to remind you that there is a negative relationship between price and demand - as
one goes up the other goes down and vice versa.
2. The nearer the number is to 0 the more inelastic the relationship is. A good with an elasticity of
-0.6 is classed as inelastic but one that has a measure of - 0.8 is more ELASTIC than the other
even though it is still classed as inelastic!
3. If the measure is between 0 and -1 (e.g. -0.35, -0.82 etc) the good is said to be 'inelastic'.
4. If the measure is -1 the percentage change in demand is the same as the percentage change in
price. The good is said to have 'unit elasticity' (unit meaning 1!)
5. If the good has elasticity over 1 (e.g. - 1.36, - 2.87, - 5.1 etc) it is said to be 'elastic'.
Businesses regularly have to think about the price that they charge for a product or service. The decision
they make can have far reaching effects. Let us take a scenario to highlight the issue. A fast food outlet
business charges £2.00 for its burger. Sales are at 5,000 per week. If it wants to increase its profits
what should it do? If it drops its price then it would need to consider how much the price fall should be -
5%, 10%, 20% or more? Or, should it raise the price? Again, if so, how much by? It will know that if it
drops its price demand would be likely to rise, but again how much by? If the price is dropped by 10%
but demand only rises by 4% then it will actually see its revenue fall. But if the fall in price of 10% leads
to a rise in demand of 15% then its revenue would rise. Equally, if it raised the price by 15% but
demand only fell by 11% then its revenue would rise. Prices may need to change because of cost
pressures. Assume that the price of beef rises, should the business pass on the rise in costs to the
consumer as a higher price? If it does what will happen to demand and therefore revenue. It might
actually be more appropriate to leave price as it is and absorb the rise in costs through lower margins. If
the increase in cost is 5% and the business decides to increase prices by 5% but as a result demand
falls by 12% then the strategy will lead to revenues falling. The decisions therefore can be more
informed if the business knows the price elasticity of demand for its product.
• If demand is price inelastic the increasing price will lead to an increase in total revenue because
the fall in demand will be a smaller percentage than the increase in the price.
• Reducing the price when demand is price inelastic would cause total revenue to fall because
demand would rise by a smaller proportion than the reduction in price.
• If demand is price elastic, reducing the price would lead to a rise in total revenue - the rise in
demand would be a greater percentage than the fall in the price.
• If demand is price elastic then increasing the price would lead to a fall in total revenue; the
percentage change in the quantity demanded would be greater than the percentage change in
price.
The Chancellor of the Exchequer and OPEC have a pretty good understanding of price
elasticity. They know that one of the determinants of elasticity is the number and closeness of
substitutes - and that oil and petrol have very few substitutes in the short term. The
Chancellor knows that taxing petrol will yield tax revenues because the price elasticity of
demand for petrol is relatively low. The rise in duty will be passed on to the consumer but the
number of people finding an alternative to petrol is likely to be very low so demand hardly
changes at all. Some people may of course be persuaded to now use public transport (if it is
available) or decide to walk or cycle to their destination but in most cases the number
changing their behaviour in this way is going to be very small.
Goods, which have duty on them such as petrol, tobacco and alcohol, are likely to have an
inelastic demand; it would make little sense for a government to place a tax on a good, which
increases its price and leads to a reduction in tax revenue!
OPEC was set up to represent the interests of countries for whom oil is a key product and the
export of which represents a major proportion of their national income. The eleven countries
are:
• Algeria
• Indonesia
• Iran
• Iraq
• Kuwait
• Libya
• Nigeria
• Qatar
• Saudi Arabia
• Venezuela
Iraq has not taken a full part in the OPEC discussions in recent months for obvious reasons
but is a member. OPEC account for around 40% of total global oil production. What is as
important is that different oil has different qualities and is therefore useful for different
purposes, the oil produced by the OPEC countries are an important part of total world oil
supplies therefore. OPEC acts as a cartel. A cartel is a group of businesses, individuals or
companies who agree to influence the price in a market through controlling supply. OPECs
reasons for acting as a cartel is to protect members interests - they aim to 'stabilise' oil prices
so that both producers and consumers are in a better position to plan ahead and in the case of
producers to know what their revenues are going to be. Each country has a quota, which they
are obliged to adhere to - this highlights the problems that cartels can face - there is always an
incentive for one or more of the group to break the agreement to secure some personal gain.
Despite this, OPEC has been relatively successful in maintaining member relations during its
existence. It was established as a permanent institution in 1960 but there had been discussion
between oil producing states since 1949. OPEC is able to exert influence on the market partly
because it accounts for such a large proportion of oil production but also because it knows
that the price elasticity of demand for oil is low. If it chooses to cut supply therefore, it knows
that the price will be likely to rise but as the price rises, the demand for oil will fall by a very
small amount; this helps to maintain or to boost their revenue. Attempts to maintain price
stability can be difficult because there is no telling what the level of demand is going to be for
oil. This winter, for example, could be a hard one throughout Northern Europe and North
America, if so the demand for oil for heating and so on is likely to be far higher than
expected. See the associated PowerPoint presentation [54K] to see a diagrammatic
explanation of how OPEC might operate to maintain the price of oil at $25 per barrel
following a fall in the demand for oil.
Economies of Scale
Legal Considerations
Sullivan, Arthur; Steven M. Sheffrin (2003). Economics: Principles in action. Upper Saddle River, New Jersey
07458: Pearson Prentice Hall. pp. 104. ISBN 0-13-063085-3
Bized.co.uk, 2010, Mind Your Business , Oil Petrol Taxes and Elasticity,
Available from: http://www.bized.co.uk/current/mind/2003_4/061003.htm
25 December 2010