Economy Case

Question 1:

Elasticity of demand is a measure of the responsiveness of quantity demanded to one of the determinants of demand, i.e. price, income and cross factor.

Consumer product in the retail market such as clothing, toys, FMCG, as others may be considered as price elastic: in the normal situation, when retailers reduce the price of the goods, consumers respond by increasing the quantity demanded. This can be further illustrated by the following:

1) In general, we can say these products are nice to have, but not have to have. Therefore, they are more falling into the categories of products that make us a better life, rather than the products we need to survive. On the other hand, they are not luxury products as well, therefore although these products are consider price elastic, the price elasticity will only be a bit larger than 1.

2) Products like clothing, toys are considered as goods with close substitutes. In this sense, they are also price elastic compare to other products.

3) However, when taking income elasticity into account, as these products can be considered as income elastic. Given the bad economy, people get less income; therefore the quantity demanded is decreasing, thus shifting the demand curve. With this situation, consumers react more to price change, meaning the products become more price elastic.

4) Retail business can be consider perfect competition, in this case, the price of certain product is determined by the market and therefore if certain retailer change the price of certain product, the quantity demanded will change as well for this product since consumers will shift the quantity demanded for other product (or the other way around). This demonstrates cross elasticity of such products, which makes them more price elastic as well.

Given the economy situation, people have less income and therefore have less spending power. If retailers remain the price as current level, the quantity demanded will decrease due to a shift of the demand curve. Thus the retailer would like to boost the quantity demanded by cutting the price (move along the demand curve). The motivation behind the price cutting behavior of the retailers is to gain more sales, i.e increase the quantity sold. However, it was not the quantity sold that matters, but the total revenue at such quantity. Given the fact that the products that are sold by the retailers are price elastic, reducing price will lead to increase of total revenue, which is beneficial to the retailers.

Question2:

The retailers are trying their best to avoid the situation where their inventories grow faster than sales. This links to maximizing the profit of the retailers, and it can be demonstrated by the following aspects:

1) Looking at the retailers themselves: if the inventories grow faster than sales, means the quantity sold is less than quantity they supplied (not actual production, but buy them from suppliers etc.). This will lead to less profit. For demonstration purpose, assume for a certain price level P, the quantity sold is Q1, the quantity supplied is Q2 = Q1 + q. The retailers have fix cost FC and variable cost VC to handle one product. Then we have:

a. Profit = Total Revenue (TR) - Total Cost (TC), where TR = P*Q1 and TC = FC+VC*Q2

b. Counting average by dividing Q1: Profit = P - AFC - AVC - VCq/Q1

c. Therefore the additional term VCq/Q1 can be seen as additional fix cost and thus increase the average total cost. Since in competitive markets profit is determined by P-ATC, increase ATC meaning less profit.

2) Looking at the inventories: other than extra costs that lead to the increase of average total cost, the inventory itself will have problems. Depreciation of the product itself over time will lead to a lower value thus lower margin, for example, clothes from last season will be perceived to have a lower value by the consumer. For some products that can only be sold within certain period like meat, milk etc. this depreciation is much more. This will also affects the demand curve by shifting to the left, thus for the same price, the quantity demanded will be less.

3) Therefore, when inventories grow faster than sales, on one hand extra handling cost will incur thus increase total cost, the demand curve will also shift to the left on the other, making the quantity demanded decrease for the same price level. Both effect will do harm to the profit of retailers.

Question3:

The main reason for increased food price is because the new equilibrium price. Given the current situation, there's increase of demand for food, while supply remains the same level or even decreasing. This will lead a shift for demand curve to the right and the supply curve remains the same position or to the left a bit. The shift of the curves will lead to a new and higher equilibrium price. This can be explained in following aspects:

1) Demand: the law of demand indicates that for certain product when other factors remain the same, the quantity demanded is moving at the opposite direction as price change. The factor that influence demand of food can be analyzed with the following aspects:

a. Increase of income (economy): with the development of economy, people have more buying power, and thus have more demand for food. And people will demand more on meat, eggs and milk etc. Since there's increasing demand for meat, egg, milks etc. as output, there will be increasing demand for the input of these outputs, which is also food to some extend (crops, corns, etc.)

b. Increase of population: there are more and more people, thus the intrinsic demand for food will increase.

c. Biofuel: this is very interesting research topic given the high energy cost; however, the side effect for this is also increasing demand for food, since research for biofuel will use a lot of food as input (corn, seed oil etc.)

All these factors indicate that the demand for food is increasing. However, the supply of food is not, which is demonstrated in the point below:

2) Supply: the law of supply indicates that for certain product when other factors remain the same, the quantity supplied is moving the same direction as price change. The factor