The effect of a poor crop, applying demand, supply and elasticity

It will surprise many to learn that the second most expensive spice by weight in the world is Vanilla (Saffron is the most expensive). And there was a poor crop of vanilla last year.

The article linked below shows that in Madagascar the vanilla crop has fallen by up to 700 tonnes from 2000 tonnes a year. Madagascar produces the best vanilla and is favoured by ice cream makers.

The result has been a rise in price from £59 to £144 a tonne and this is being passed on to ice cream makers. While your favorite ice cream flavour might not be vanilla it is the biggest selling ice cream.

The diagram below shows the effect on the vanilla market.

Although the fall in vanilla production is 35% the rise in price is 144%. This gives us a Price Elasticity of Demand (PED) of (-) 0.24. That is very inelastic. Should we be surprised by the result? Well not really, vanilla has few substitutes and those that exist are regarded as being of lower quality. Also vanilla represents a fairly small proportion of household expenditure, despite it's high price per kg. Could we regard it as a necessity? Well for some products yes, although this argument isn't as clear cut. Whatever the PED tells us demand is inelastic!

Notice also that the income of vanilla farmers has shot up, from £118,000 to £187,200. This is what we expect to see in primary product markets and inelastic demand.

What will be the consequence for ice cream prices? Well not as big a price hike as there was for vanilla. The article tells us that 'customers would notice' a rise in vanilla ice cream prices compared to other ice cream. This is suggesting that ice cream flavours are substitutes for each other (they have a high cross-price elasticity of demand, XPED) and there are also alternatives to icecream. So manufacturers are likely to absorb the rise in vanilla price this year and hope for a larger crop in 2016.

The diagram below shows what happens if the ice cream manufacturers passed on the full rise in vanilla prices. Because demand for vanilla ice cream is elastic the price rises from 0P1 to 0P2, but there is a large fall in quantity demanded (Q1 - Q2). So we are likely to see a smaller rise in ice cream price than (P2 - P1) due to competition between ice cream makers and the high XPED between ice cream flavours.

The Guardian article is here

IB students will be able to apply elasticity concepts to this article and use it as an example of primary product markets. It is th stuff good IA's are made of. VCE students will see it as an application of demand and supply analysis and PED. 

The effect of the Brussels bombs

We all know that demand and supply determine prices, but that a change in a condition of demand will alter the market equilibrium. One possible change in the conditions of demand is a random shock, and the Brussels bombing is an unfortunate example.

There have been similar events, such as 9/11 and the Bali bombings, when similar effects were seen and investors have been the first to react by dumping shares in tourism sector firms such as airlines, cruise lines and tour operators.

Following 9/11 the demand for air travel plummeted. People didn't want to risk flying. Not everyone, but quite a few people decided not to take trips. After the Bali bombings many Australians decided that Queensland was a better option.

The effect of this was to shift the demand curve for flights and holidays to the left. The result was a fall in the market price (from 0P1 to 0P2) as firms reacted to a situation of excess supply and fewer flights and holidays taken (Q1 - Q2 fewer).

Following the Brussels bombing shares in many tourist sector companies fell. They anticipated the fall in profits that tourist sector companies were going to earn over the next period and decided the shares were not worth as much as before the bombing. Europe will have some spare hotel rooms and flights will have some spare seats for a while.

The Guardian reports the fall in share prices here

This article is relevant to the application of supply and demand to both VCE and IB students.

Taxing negative externalities - it's a good idea most of the time

Australia has managed to become the subject of much criticism because it insists on dragging its heels on tackling climate change. The rest of the world sees it as an urgent problem that requires concerted action. Australia insists on doing less than everyone else and the world suspects it is because they want to steal a cost advantage!

The British government are now proposing to change their target of an 80% cut in carbon emissions by 2050 to 100%. In other words Britain will not add any carbon to the atmosphere at all due to economic activity. They will do this by taxing carbon emissions and subsidising green energy generation.

There is some doubt about Britain's ability to meet its current target as the BBC article below indicates. However admire the ambition and try not to be too embarrassed by Australia's pathetic effort and climate change deniers.

Dealing with negative externalities with taxes is a well established solution. A.C.Pigou wrote about taxing externalities at the start of last century. Taxes like the Australian carbon tax are known as a Pigouvian tax.

Below re two articles. One on the British governments ambitious target and another on AC Pigou's economics.

The BBC article is here

The Independent talks about Pigou and taxes here

These articles are of great value to VCE Year 12 students and IB students. Knowing how to correct market failure and how taxes work is essential knowledge, as are the pros and cons of using taxes.

The protection of QANTAS raises fares for passengers

Australia likes to protect its jobs, regardless of the harm it does to the bulk of the population. This has been a hard road for politicians to travel but many barriers to competition and trade have been reduced since the Hawke/Keating governments.

But the airline industry remains an area where the government allows significant barriers to entry to remain. There are two specifically:

1. QANTAS must be at least 51% Australian owned
2. International carriers need permission to fly into Australia

The result is that an oligopoly market in air travel with high barriers remains both within Australia and flying internationally. The result is that airfares are higher and service standards lower than would otherwise be the case.

The government are considering relaxing the rule on QANTAS ownership. This would allow a foreign carrier to buy the airline and operate it. They would be less sensitive to Australian jobs, such as servicing the aircraft abroad, but passengers would benefit from lower fares due to reduced costs.

However the best thing the government can do is sign up to the 'Open Skies' policy that operates in most of the developed world. Any airline can fly to and from a country as long as there are take-off and landing slots spare. This intensifies competition and lowers fares. The evidence suggests that international  air fares in Australia are considerably higher than for comparable journeys.

Currently the government will not grant any more flights to foreign airlines, even though they ask on a regular basis.

Imagine if Etihad, Emirates, Thai, Singapore and all the other big carriers could fly into Melbourne six or seven times a day. Plenty of spare capacity and so cheaper seats available. Some jobs would be lost at QANTAS, but more would be created by other airlines and all travellers will benefit.

Competition works and its about time the government let it.

The reaction to the QANTAS proposals is reported here

Wikipedia on Open Skies here