Common Agricultural Policy Part 2 - Declining Farm Incomes

The next thing the CAP aims to eradicate is declining farm incomes. These are mainly caused by two things: low income elasticity of demand and/or increases in supply. As usual, we'll display this diagrammatically. Lets suppose we have a fairly inelastic demand curve and at the same time farm efficiency has improved, we can expect the market to now look as follows:

We can see that prices have fallen from P1 to P2 and quantity has risen from Q1 to Q2. However, we can also see that this has caused a fall in income of area a and an additional income of area b for the farmers. Area a is clearly larger than area b, meaning the farmers income as a whole has fallen. The way for farmers to gain is for demand to shift out by a larger amount, as even a small shift in demand would leave farm incomes still falling. 

What the farmers need is a more elastic demand curve for any increases in supply efficiency to actually increase farmers income. However, demand for grown crops is generally more inelastic because it's a necessity and therefore a change in price really doesn't affect demand all that much. This is why the government needs to intervene with the CAP because else there would be no incentive for farmers to make their production mechanisms more efficient as they'd effectively be losing money due to it.

Now we have covered both reasons as to why the CAP is necessary; fluctuating crop prices and declining farm incomes. We will next cover how the EU uses it's policies to correct these issues. Stay tuned!

Sam.

Common Agricultural Policy Part 1 - Price Fluctuations

The Common Agricultural Policy is a massive deal in Europe and the European Union. It's a very expensive policy that started out back in 1962 as a simple price support policy. It has two key objectives: to stabilise prices and to provide income support for social reasons. If you look at the distribution of farms across Europe, it is clear to see why this is needed. The biggest 7% of farmers own roughly half the land, whilst the smallest 50% of farmers own only 7% of land. This is a massive inequality and could lead to monopoly powers, outlandish prices and other such problems if it went unregulated.

We'll first look at a few of the characteristics of the agricultural industry. There are many producers, all are price takes. There are also many consumers, all of which are also price takers. There is generally freedom of entry and exit into the industry. It's about as close to perfect competition as you could get in a realistic scenario. Governments need to intervene for many reasons:

• To reduce price fluctuations.
• Raise farm incomes.
• Protect rural communities.
• To encourage greater self-sufficiency.

Firstly, I'm going to focus on the price fluctuations. In the short term they are caused by instability and the fluctuations in the harvest (good or bad!). Let's assume that the demand for a crop were to rise one year, which would cause a shift to the right of the demand curve. Supply in the short term obviously cannot react to this because supply is fixed each year depending on what is planted. This demand rise will cause a rise from price P1 to P2. This is all shown on the diagram below.

The farmers observe this rise in price and then next year they increase their supply to the market. At P2 the farmers decide that Q2 is the correct quantity to supply to the market. However, at this amount supplied, demand is outstripped and therefore price must fall to P3. The year after, at price P3 a different amount is supplied by the farmers, but at this supply more is demanded and therefore price rises again. This will continue, as shown on the diagram below we can see that the market is slowly spiralling towards a point of equilibrium at which both consumers and producers would be happy. 

We call this concept a stable cobweb. This price fluctuations and changes are supply are making the market more and more stable as over time the fluctuations get smaller until equilibrium is finally met. In this case, the government wouldn't need to intervene in the agricultural industry. However, there is the opposite case. An unstable cobweb could appear. The case of this occurs when the supply of the crop is very elastic. Diagramatically, the supply curve will be much flatter. The same instance as above will occur, demand increases causing a price rise as supply is fixed. In the second term supply is increased due to this new price, but there is oversupply and price has to fall... and so on and so forth. Except, when the supply curve is elastic this doesn't spiral towards equilibrium, it spirals away from it as can be seen in the diagram below.

This shows one of the cases in which the government would need to intervene in the agricultural industry, hence the Common Agricultural Policy. The price fluctuations in this unstable cobweb would keep getting worse and worse if left to market forces. 

Next we'll move on too supply side shocks. This is when supply is affected, either for good or for bad, and therefore the supply of the crop isn't as expected. Once again, diagrams are an easier way of showing this. The first case will be a bad harvest, where supply of the crop is less than what was expected. The diagram below shows this. Supply of the crop has fallen from the expected level of Qe to the actual level of Qa. The area labelled 'b' is income that the farmer has lost, the area labelled 'c' is income gained from this supply side shock. The expected income for the farmer was area 'ab', but the actual income of the farmer is now area 'ac'. If area c is greater than area b then the farmer has gained, otherwise the farmer has lost out due to the bad harvest. Generally, the more inelastic demand is, the greater are 'c' is and therefore the more likely the farmer will benefit. 

I'll quickly go through the other supply side shock as well. As you can guess, this is when there is a better harvest than expected. This causes a shift to the right of actual supply from Qe to Qa. A fall in price is seen from Pe to Pa and once again the farmers income may be affected. Area 'c' is the income gain, area 'b' is the income loss and area 'a' is the income that has stayed constant. If area 'b' is bigger than area 'c' then the farmer has lost out. 

What we have achieved in this blog post is the causes of the fluctuations in prices of harvested goods. This is one of the things the Common Agricultural Policy aims to stop, as stable prices is an aim. In the next post we'll look at what is causing the decline of farmers income and then we'll move on to look at how the government intervenes in this policy to correct these issues.

Stay tuned guys, enjoy!

Sam.

Principles of Economics: Revenue (Microeconomics)

* Sorry about the delay with this post, I've had a busy week and have just got round to writing this up. But I'll have another one up tomorrow as well to make up for it. *

Right, today's post will be relating to revenue and more specifically a firms revenue. We'll start with a few of the basic bits of terminology that I'll be using throughout this post. Firstly, total revenue. This is fairly self-explanatory but I'll give a definition anyway. Total revenue is a firms total earnings in a period of time from the sale of a particular amount of goods, the formula is better known as price x quantity. Average revenue next and this is the amount a firm earns for each unit sold, the formula for this is (total revenue) / (quantity) which you may have noticed just equals price. Marginal revenue is the final term, this refers to the extra revenue gained from selling one more unit of a good. The formula for marginal revenue is (change in total revenue) / (change in quantity).

We'll first look at the revenue curves for a small firm. We'll be assuming this firm is in a perfectly competitive market (Will do a blog post on this later today/tomorrow). Basically, this means that the firms are generally too small to have any effect on the price of the good they are selling. If they raise their price no-one will buy from them, if they lower their price they will find an overwhelming demand and probably be charging less than the cost to produce the good. That being said, the market forces determine the price the firm has to charge.

As you can see here, the demand and supply have met in the market and this has created a price for the good. The firm, shown on the left has a demand curve of this price because consumers will only buy from the firm at this price. No matter the quantity, the price will remain the same. Another note on this, D = AR = MR because the price is constant. The average revenue and marginal revenue will always be the same because we are working with a constant price.  We can model the total revenue of a firm as well. This is simple, first we create a table with the quantity supplied, price and total revenue. We then plot this table. Simple.

Simple as that for a total revenue curve for a small firm. However, when it comes to larger firms and the price of the good does vary with output we are struck with a different scenario. The average revenue curve is still equal to the price and will be the demand curve, but this time it will be downward sloping as with the normal characteristic of demand. The marginal revenue curve will also be downward sloping, but at a faster rate than the average revenue curve and will more than likely reach negative values. This is due to the diminishing marginal rate of production, the marginal revenue falls with each additional good you produce up to a point where producing another good will generate no additional revenue and may even decrease revenue. Before the quantity where marginal revenue equals zero, the average revenue is elastic because an increase in quantity will lead to a rise in revenue. After this point, it's inelastic because a rise in quantity leads to a fall in total revenue. 

And all that's left to add to this is the shape of the total revenue curve when the price varies with output. I should note, this happens in larger firms when they can effect the market price. The total revenue curve would be somewhat hill shaped. It would slope up, reach a peak at some unknown point and then slop down again afterwards. You may be thinking "Ok, great... Why?"! Well, this will come in useful in the next posts when we look at profit maximisation of a firm. 

Thank you for reading again, keep watching for the next few posts which will relate and link to this one. Have a good day!

Sam. 

Principles of Economics: Supply (Microeconomics)

*Disclaimer: I'm fully aware of the fact that I've already written a post on supply. However, I've decided to cover it again now I know more on the subject and can give a better coverage.* 

Okay, I'll dive straight into this one with the main principle of supply: 'When the price of a good rises, the quantity supplied will also rise'. Now, it's all well and good just stating that, however we need to know the reasons why this happens. Let's look at three of them:

• Beyond a certain level of production for the producer costs are likely to rise at a quicker rate than previously. This could be due to having to pay overtime to staff members or increased maintenance costs for machinery. Either way, the quantity supplied by producers will only rise if the price rises so that it becomes efficient for them to raise their costs.
• A more basic reason now: The higher the price of the good, the more profitable it is for the firm. In general terms this theory holds true. Most firms have an aim of profit maximisation, so therefore they'll increase supply when the price rises to maximise profits.  Both of these two points are short term reasons as to why supply rises when price increases.
• A long term reason is because when price rises in an industry new firms are encouraged to join the market with the hope of profit. This increase in firms will increase the supply to the market. 

Here we have a very basic graphical presentation of the supply curve. A supply curve shows us the supply schedule. Supply schedule refers to the amount producers are able to and willing to produce at different prices at a set point in time, it is normally shown in a table and can then be presented in a graph like the one above. The supply curve will generally slope upwards from left to right, to show that the higher the price the higher the supply will be. Obviously, price elasticity of supply plays a part in the steepness of the slope but I'll get on to that point in a few blog post times, I'm keeping it very basic here. 

As with demand, there are many factors apart from just price that affect the supply of a good to the market. These are the main ones:

• Production cost - Higher costs mean less profits means less supply and vice versa. This can be because of a change in the input prices (wages, raw materials), government policy (subsidies, taxation), organisation changes or technology changes.
• Nature - This can include the weather, disease, natural disaster. Basically things that are out of human control.
• Aims of the producer - The supply of a firm aiming to maximise profit will be different to a firm aiming for sales maximisation. Therefore different producer aims will cause varying levels of supply. 
• Expectations - If prices are expected to rise, producers will hold onto stock in anticipation of this rise meaning supply will fall. This works the opposite way for if prices are expected to fall.
• Number of suppliers - Simply put, more producers means more supply, less producers means less supply. 
• Profitability of alternatives - If a substitute in supply is more profitable, supply for the good in question may fall. Alternatively, if a substitute in supply is less profitable, the good in questions supply may rise as the producer re-diverts resources. 
• Profitability of goods in joint supply - Goods that are produced together mean if the profitability of the joint good rises then the supply of the good in question may also rise. Works the opposite way too.

As with demand, there can either be a movement along the supply curve or a shift in the supply curve. 

A change in price will mean a movement along the supply curve. So, the supply curve will stay at the initial place of 'Supply 1' on the diagram and the point supplied will just move up or down that curve. If any of the other determinants of supply stated above change then we can expect a shift in supply. A shift to the right, 'Supply 1' to 'Supply 2' on the diagram, shows an increase in supply. A shift to the left, 'Supply 1' to 'Supply 3' on the diagram, shows a decrease in supply. A movement along the curve is known as a change in the quantity supplied whereas a shift in the supply curve is known as a change in supply.

There we have it, a recap on the basics of supply. Next to come in terms of principles of economics will be marginal utility theory, so stay tuned for that! Thanks for reading and have a good day.

Sam. 

Government Intervention - Taxation (Microeconomics)

Another way the government can intervene to correct market failure is through taxation. Basically, the government will try to tax goods with lots of negative externalities to attempt to discourage consumers from buying them, thus lowering consumption and somewhat correcting the market failure.

The government has two forms of taxation at its disposal, these being direct and indirect.

1. Direct Taxes - These are taxes off the incomes of individuals and firms. So examples of these would be income tax and corporation tax. Direct taxes cannot be avoided.
2. Indirect Taxes - These are taxes charged locally on goods and services. Examples would be VAT (Value added tax) and council tax (Tax on your house).

The aim of the tax is to try to reduce the consumption of the good by raising the price. So, the tax shifts the supply curve leftwards, moving the equilibrium point to a higher price and lower quantity. The tax that is imposed should equal the value of the negative externality. The price rises and the price then takes into account the full cost of the negative externality, this is known as the polluter pays principle. Basically, the polluter is now paying for all the pollution caused. 

There are problems with taxation however. Firstly, the amount to tax is difficult to workout. As it is hard to estimate the exact cost of a negative externality it means it is difficult to tax the absolute correct amount, most of the time its either too much or too little. Price elasticity of demand comes into play too. A rise in price caused by the taxation may not cause a big enough fall in demand because the goods PED may be inelastic. This is another problem. 

That's all for this topic, next is 'Government Intervention - Subsidies'. Stay tuned. :-)

Price Elasticity of Supply (Microeconomics)

This will be the last elasticity post for a while, i promise...

Right, so price elasticity of supply is sometimes referred to as PES. It measures the responsiveness of supply to a change in price. Basically, it indicates the amount a supplier is willing to to provide to a market after a change in price. The aim of a supplier is to maximise profits, so therefore the price elasticity of a supply should always be positive (If the price of a good increase so should supply, and vice versa.)

The formula for PES goes like this:

PES = % Change in quantity supplied ÷ % Change in price

As stated previously, the result will almost always be positive as it's highly unlikely that if price falls then suppliers will supply more of a good to the market. The figures gained from the formula are once again important:

• Greater than 1. If the result is over 1 then it tells us that the goods price elasticity of supply is elastic. So a price rise will lead to a more than responsive rise in supply.
• Between 0 and 1. If the result is between 0 and 1 then the goods price elasticity of supply is inelastic. This means a price rise will lead to a less than responsive rise in supply.
• Exactly 1. If the result is 1 then the goods price elasticity of supply is unitary. A change in price leads to an exactly proportional change in supply.

There are three main determinants of the price elasticity of supply of a good. The first is time period. If it takes a lot of time to adjust the supply of a good then it's likely the goods PES will be inelastic. An example of this would be Christmas trees with the long growing period. The next determinant is availability of factors of production. If there is no spare resources or labour to increase production then the PES is likely to be inelastic, and vice versa. Finally, availability of stocks of a product. If a supplier has plenty of goods stored away that can be added to the market should price change then the PES will likely be elastic. If there is no way of storing, or isnt any stored, PES will likely be inelastic. 

An example as usual. The price of shampoo increases by 22% over a period of time, over the same period suppliers supply 15% more shampoo to the market.

PES = 15% ÷ 22% = 0.68

This tells us that the PES of the shampoo is inelastic, suggesting that maybe it takes a long time to produce, there was no extra stored away or there is no spare factors of production. 

That's all for price elasticity of supply. 

Cross Elasticity of Demand (Microeconomics)

Cross elasticity of demand, sometimes referred to as XED, measures the responsiveness of demand for one good after a change in price of another good. The theory assumes that all other factors stay the same and that only the price of one good is what's affecting the demand for another good.

As with the previous elasticity theories, there is a formula involved here too, that being:

XED = % Change in quantity demanded of product A ÷ % Change in price of product B.

The sign and size of the result given after the formula is vital:

• A positive result means that the two goods are substitute goods, so the price of one good rises then the demand of the other good also rises and vice versa. These goods tend to be bought instead of each other.
• A negative result means that the two goods are complimentary goods. Meaning if the price of one good rises then demand for the other will fall and vice versa. The two goods are normally bought together.
• If the result is 0 it means there is no relationship between the two goods.

The size of the result indicates how strong the relationship between the two goods is. If the figure is a high one (or very low if the result is negative) it shows to us that the two goods are close substitutes or have a high degree of complementarity. 

An example is in need i think. So, say the price of Audi cars increased by 10%, which caused a demand increase for BMW cars of 15%. Lets work this out...

XED = 15% ÷ 10% = 1.5

Thus, with this answer we can see that these two goods are substitute goods (positive value), and quite close substitutes at that because the figure is fairly high.

Short but sweet, that's the basics. Thanks!

Income Elasticity of Demand (Microeconomics)

The theory of income elasticity of demand measures the responsiveness of demand to a change in income levels. It is assumed that all other factors affecting demand are unchanged, the only thing that may change it is income.

The formula for income elasticity of demand (YED) is:

YED = % Change in quantity demanded ÷ % Change in income.

The result of the formula will tell us one key thing, and the positive or negative sign is vital as it tells us whether the change in income has caused an increase or a decrease in demand levels. Goods with a positive income elasticity of demand are known as normal goods. Meaning a rise in comes causes demand for these goods to rise as well. Examples of these normal goods are holidays, eating at restaurants, flat-screen TVs and home improvements. As with PED, if the figure given by the formula is between 0 and 1 then the good is seen as income inelastic, if the result is greater than 1 then the good is seen as income elastic.

Goods that have a relatively large income elasticity of demand are sometimes referred to as 'superior goods'. These are normal goods in theory, but as demand for them rises considerably after an income rise then they are seen as more superior. It's difficult to offer examples as what may be a normal good for a well off family may be a seen as a superior good by a poorer family.

However, if the result of the figures entered into the formula is negative then the good in question is known as an inferior good. This means that a rise in income levels will cause a fall in demand for these goods, and vice versa. Examples of these inferior goods would be supermarket own brand food and second-hand items.

Lets try an example. Say incomes rose by 5%, creating a rise in demand of 10% for Ford cars. (These figures are made up)

YED = 10% ÷ 5% = 2. So therefore these Ford cars are a normal good which are income elastic, meaning a rise in incomes has a more than proportionate rise on demand.

Just remember when using the formula that if demand or incomes fall then a minus sign needs to go before the percentage. That's all for income elasticity of demand, cheers.

Price Elasticity of Demand (Microeconomics)

Price elasticity of demand can be a difficult to concept to get to grips with, so i'll attempt to keep this simple and easy to understand.

Firstly, what do we mean by elasticity? Well, the elasticity is the extent to which demand responds to a change in market conditions... in this case the market conditions are price. So, price elasticity of demand measures the responsiveness of demand to a change in price.

There is a special formula for calculating the price elasticity of demand (PED) of a good...

PED = % Change in demand ÷ % Change in price.

The result of this formula will always be a negative value. Now, this figure will tell us how elastic the good is.

• When PED = -1 .... Demand has unitary elasticity. Meaning that a rise in price will cause a fall in demand of equal amount. And vice versa if price falls.
• When PED = 0 .... Demand is perfectly inelastic. Meaning that any change in price will have no effect on demand what-so-ever.
• When PED is between -1 and -Infinity .... Demand is elastic. Meaning a change in price will have a more than proportionate effect on demand.
• When PED is between -1 and 0 .... Demand in inelastic. Meaning a change in price will have a less than proportionate effect on demand.

The price elasticity of demand of a good dictates how steep the demand curve will be on a supply and demand diagram for that particular good. If a good is perfectly inelastic the demand curve will be vertical, because demand is the same at any given price. If a good is very elastic then the demand curve will be virtually horizontal because a small change in price will have a large effect on the demand for the good. 

Generally, if a good is considered a necessity... such as petrol, cigarettes or insulin then its PED will always be very inelastic because people need these items, no matter the price they have to buy them. On the flip side, if a good is considered a luxury good... such as holidays abroad, new cars and CDs then its PED will be very elastic because they aren't needed and people can stop buying them even if the price rises a little.

There are three main determinants of price elasticity of demand:

1. Availability of substitute goods. If there are plenty of substitute goods available then it is highly likely that the PED of this product will be elastic because there are plenty of alternatives for consumers if prices rose. Also if there are no substitute goods, then the chances are the product will be inelastic.
2. The price of the product compared to peoples income. If the good takes up a very small amount of peoples income then price is likely to be inelastic as people don't worry about price rises as they will only be tiny. However, if the good is a large percentage of peoples income then price is likely to be elastic because a price rise will have a large effect and stop people purchasing.
3. Time. If people find it difficult to change spending habits on goods then those goods will be inelastic as people cannot change what they buy quickly, even if prices rise. However, if people can change there spending habits for goods quickly then those goods will be elastic.

Lets do a little example of working out the price elasticity of demand. Remember these figures are made up! Say the cost of a book rises from £10 to £12, causing a fall in demand from 5000 to 4500.

The % change in demand would be -10% (-500÷5000 x 100)

The % change in price would be 20% (2÷10 x 100) 

So, we have -10% ÷ 20% = -0.5. This result tells us that this books price elasticity of demand is inelastic, a 20% rise in price only caused a 10% fall in demand. Must be one good book!

Thanks for reading!