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.

Australian unemployment falls to 5.8%

Unemployment in Australia, which had seemed to be heading well above the full employment level has shown encouraging signs over the last few months. It has now fallen from a peak of 6.4% last year to 5.8%.

The rise in unemployment was expected due to the ending of the mining investment boom, and the recovery is attributed to the expansionary monetary policy and the depreciation of the dollar.

VCE students need to know how all of the key economic indicators have moved over the previous four years (from 2013 for the current Year 12's). In particular VCE students should know the demand and supply side factors which have influenced each variable and the policy responses (budgetary, monetary and supply-side) these have prompted.

Below is an article from The Guardian which analyses recent trends. It also examines what full employment might mean and whether it is worth pursuing as an economic policy goal.

The Guardian article is here

While this post focuses on Australian Unemployment and the needs of tackling VCE it is also useful for IB students. Consider the impact of different factors of unemployment and how economies are interdependent.

Taxing sugar - should Australia follow the UK?

Yesterday the UK announced a tax on sugary drinks. It might increase some own brand cola products by 80%.

The tax is tackling an negative externality. This time the problem is a  lack of information leads consumers to value sugary drinks too highly. This then causes obesity and imposes higher costs on the public health system. Therefore sugar is a demerit good in this case.

As the last post was on externalities I'll just draw the diagram and link to and ABC article on the subject. Jamie Oliver, a prime mover in the campaign for the 'sugar tax' has urged Australia to follow suit. They should.

The problem with sugary drinks is that consumers don't consider the full costs of them. There is a lack of information about the negative effects of the sugar in the drinks. We could represent this as an additional external cost, but instead here it is shown as consumers overestimating the private benefits of sugary drinks. Therefore Demand (Marginal Private Benefit) is to the right of Marginal Social Benefit.

Placing a tax on the drinks pushes the supply curve to the left. There is a new equilibrium price (0P2) and lower quantity (0Q2). In this case the socially optimal output is achieved, because exactly the right tax has been applied and the deadweight loss of the externality is completely eliminated.

Note that not all of the tax is paid by consumers. Part of the tax comes out of firms profits. How this is divided between consumer and producer is determined by the elasticities of demand and supply.

The ABC article is here

VCE students should note how governments deal with externalities (Unit 3, outcome 1). IB students will need to understand the way markets fail in the technical way the diagram shows it and is an excellent example of tackling demerit goods.

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.

Trade figures may not be that relaible!

A Peking University professor has claimed that China is running a trade deficit. The Chinese government claims it is still running a huge trade surplus.

The Current Account surplus which people have generally believed China has been running is shown below from 1995.

The Current Account is made up of trade in goods and services, income and transfers. China has been thought to have a large surplus in goods and a smaller deficit in services.

A Current Account surplus implies an equivalent Financial and Capital Account deficit. However China does not allow the free transfer of capital. Therefore there can be a problem moving capital in or out of the country. The motive for controlling capital flows for China has a great deal to do with maintaining the exchange rate at the level they desire (a managed exchange rate).

Professor Balding is claiming there has been false accounting. Exporters overstating invoices to allow an inflow of capital into China in earlier years and now importers working to help capital flow out of China.

There are numerous issues here. Based on the fact the Balance of Payments must always balance (i.e. sum to zero) Professor Balding has found that China's trade performance has been overstated and the Chinese economy might not be doing as well as we thought. He has also given us an excellent example of how capital controls are only ever partially effective, someone always finds a way around them.

Forbes reports Professor Balding's findings here

IB students will find this article a good application of  the theory of the Balance of Payments and can use it to link to the performance of the real economy to the Current Account. VCE students will see how the Current and Financial accounts are linked.

Penalty rates. A story to watch.

The Productivity Commission in Australia are looking at a variety of work practise's and this includes whether penalty rates are set appropriately.

Penalty rates are generally called 'overtime rates' in the rest of the English speaking world. It refers to the 'bonus' paid to workers who work extra hours over their usual working week or work at anti-social times, such as weekends. In Australia these rates continue to be set on a national level and for particular industry's.

Some argue that the rates set are too high. In some industry's the rates can be 200% of normal wages. The graph below shows the rates for the hospitality industry.

The traditional argument on penalty rates is that they lead to lower employment. The higher the wage rate then the lower the demand for labour. The same argument can be applied to the minimum wage. The graph below shows the effect of a penalty rate, PR, set above the market wage rate W. The effect is to lower employment by N - Nd hours when penalty rates apply. Notice that Ns - Nd hours of work are offered by workers, but are not taken up (involuntary unemployment).

Another way of looking at this is that penalty rates will cause firms costs to be higher. This leads to market prices being pushed up and so output, and so employment, in an affected industry is lower. The diagram below shows this with the industry or firm supply curve SPR reflecting the higher costs of penalty rates compared to no penalty rates, SNR.

There is some doubt about this analysis. When firms have a great deal of power relative to their employees, as they do in retail and hospitality, they might be able to force wage rates below market rates (W). This means that penalty rates protect workers from profit maximising employers. 

There is also not much evidence to suggest firms close down, or don't operate, when penalty rates apply. 

Below are some articles that look at this issue. The Productivity Commission will give its final report around July, it is worth being ready for it.

The ABC looks at Commission proposals here

Q&A fact check claims on penalty rates here

This is good analytical practice for IB and VCE economists. It might be a fruitful area for IA's or EE's for IB students.