Is playing with price actually paying the price?

We have heard of terms such as subsidizing, limiting prices to maximum or minimum, etc. Most of these acts are done by governments in order to prevent certain interests, secure essential needs, prevent inflation, etc.

Let’s analyze some example, and see if economically it makes sense.

We all know that price is determined by market forces, and when demand meets supply, we have a price, demanded quantity and supplied quantity. Anybody who tries to play with price artificially is actually disturbing the equilibrium, and creating artificial demand or supply.

Simple examples below:

Setting Max price: Let’s say, price of bread is Rs 30 per bread as per natural demand-supply relationship. Now govt. thinks that bread is an essential commodity, and Rs 30 is too high, so they set the artificial price at Rs 20. What essentially it will do is increase the demand, and decreases the supply, causing shortage of bread. People will eat more bread, as it’s cheap that the natural price and increase the demand and supplier will try to cut supplies, as at this price, it may not be a decent proposition. Now co-relate this with oil subsidy, which is given to contain inflation.

Setting Min price: Let’s say, price of 1Kg of potatoes is Rs 15 per kg, again as per natural demand supply relationship. Now, govt. comes in to help farmers, saying this price is too less, and should be Rs 20 for farmers to get their due. So, it all starts with good intention, but from economist’s point of view, it means, demand is getting reduced, and supply will get increased. So, there will be surplus in the market. What to do with this surplus? Again govt. comes to help, and start buying to store, or destroy. As you can see, for a short run this is fine, but it’s not a viable model. It’s like funding a startup till it dies its own death.

Well there are many other non-economic reasons for which this a kind of policy exist, but above analysis is purely from economist eyes.

So, from economist’s view point, playing with prices is actually paying the price eventually 🙂

 

 

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Demand Elasticities

It’s a measure of sensitivity of the Quantity demanded vis a vis changes in price. In simple words, does quantity change too much or too little on increase/decrease in price.

Mathematically,

E(d) = (Delta)Q/Q     ÷  (Delta)P/P

So,

E(d) >1 : If percentage change in quantity > percentage change in price, it’s called “Elastic” Demand. For ex, demand of air travel will decrease quite a bit with increase in price, and people may prefer trains or other means of transportation, and vice versa for decrease in price.

E(d) < 1: If percentage change in quantity < percentage change in price, it’s called “Inelastic” Demand. For ex, demand for oil is inelastic, as demand of oil doesn’t vary much with price.  As there are not many substitutes available. Other example is demand for insulin doesn’t change, and remains same, as there’s no other alternative.

E(d) = 0 : This is case of perfect inelastic demand. Quantity doesn’t change at any price.

E(d) = ∞ : This is case of perfect elastic demand. Small variations in price leads to huge changes in the quantity.

Elasticity of a product can be calculated from all the historical data, and is helpful in determining the future prices in case production increases or falls. For example, when oil producing countries go out to decrease the production, what will be its effect on price, etc.

Revenue projections w.r.t Elasticity:

Revenue is Price x Quantity Demanded.

If E(d) >1, then increase in price by x%(say 10%) will decrease in quantity demanded by more than x % (say 20%).

So old revenue = PQ

New revenue = (1.1)P x (0.8)Q = 0.88 PQ , so total effect is that revenue got decreased.

If E(d) <1, then increase in price by x%(say 10%) will decrease in quantity demanded by less than x % (say 5%).

So old revenue = PQ

New revenue = (1.1)P x (0.95)Q = 1.045 PQ , so total effect is that revenue got increased.

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