Tag: demand and supply

When the price is high…

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… we react by trying to curtail demand.

What if, instead, we worked on increasing supply?

Austin Vernon and Eli Dourado ask just such a question in a lovely paper titled “Energy Superabundance: How Cheap, Abundant Energy Will Shape Our Future“

In this policy paper, authors Austin Vernon and Eli Dourado explore what life would be like with endless energy. Coining the term “energy superabundance,” they look at energy policy, not in the usual sense of trying to restrict energy consumption, but as a way to promote energy abundance—a future in which energy is so clean and plentiful, limiting consumption would be entirely unnecessary.

https://www.thecgo.org/research/energy-superabundance/

The paper is lovely for a variety of reasons:

  1. You get to learn a lot about what is going at the cutting edge of a variety of sectors in terms of technological advancements across transportation, agriculture, water usage and material deployment. There are also sections on urbanization, and some speculation about what lies ahead in a concluding section.
  2. It’s sprinkled with interesting factoids which add, at the margin, to your model of the world. Such as Marchetti’s constant, for example, or about start-ups like Nuro, or that 4% of all electricity consumption in Denver goes towards growing cannabis.
  3. The most exciting (tantalizing is a better word, I suppose) prospect is for the deployment of miniaturized nuclear technology. As the paper says, this is still a ways off, but the prospect of accessing electricity without being dependent on a grid is a giddying one.
  4. There’s a bit of econ history as well, such as a brief mention of the Jevons Paradox. ANd speaking of economics, there’s a fascinating paragraph about aircraft economics.

But above all of these, I liked reading the paper for two main reasons. First, this is a paper that is about optimism and technology, and in my opinion, this is a relatively underexplored niche. Underrated for sure, at any rate.

And second, because as a person who loves introducing the principles of economics to people, it’s a great way to help people understand that there’s more than one approach possible when confronted with high prices. Demand curtailment and the drive for efficiency is one – but dramatically increasing supply is another.

And technological optimism is worth a deeper think, no matter where you fall on the spectrum in this regard.

Here is Eli Dourado on Twitter, and here is Austin Vernon.

Daaru in times of the lockdown

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Simran, a student at the Gokhale Institute asks a series of question about the topic du jour:

I had a query in regard to the news that have been doing rounds  – “Why did government order opening of wine shops?”

She asks other, related questions further on in her email, and I’ll get to them, but let’s go with this first.

Now, I am not privy to the decision-making process of either the state or the central governments, but there are two immediate responses that come to mind about the why: one, there is certainly demand for it!

And two, revenues *should* go up with the sale of alcohol. The reason I say should is because there have been arguments made about how the tax that the state government collects is when the distributor sells to the retailer, rather than when the consumer buys from the retailer. I am unable to find a report online of this nature, but I have certainly heard that argument being made. And that as a consequence, opening up liquor shops won’t have that much of an impact on government coffers, because tax has already been collected.

Very briefly, this argument doesn’t hold for at least two reasons. First, because although it is true that part of the tax that is paid is in the nature of an excise duty (that is, taxable when it leaves the manufacturer’s location), there are a whole host of other duties, taxes and cesses that are charged in addition. For instance, did you know that if you raise a glass in Uttar Pradesh, you are doing your bit to take care of abandoned cattle? Other states also impose other taxes – demand, as we are seeing right now, is fairly inelastic, so of course you should expect governments to tax as much as possible.

Second, and to my mind more importantly, never confuse stocks with flows! Forgive the pun, but once alcohol sales start flowing, the chain of taxation will kick into gear at all points. As per this report, all states and union territories put together expected to earn INR 1,75,000 crores (or thereabouts) from the sale of alcohol last year. The flow (and forgive the pun again) is important!

So, simply put, it is about the money.

Simran further goes on to ask:

The Delhi government announced a 70% ‘special coronavirus tax’ on alcohol.

Charging such a huge tax from a daily wage earner does sound cruel. Government claims that the tax will dissuade the poor from drinking but past reports claim that habitual drinker will never quit and this will just shrink the quantity of food he and his family consumes.

I was wanting to delve deeper into this topic –
Alcohol and its effect on poverty or is it
Poverty and its effect on consumption of Alcohol.

A series of tricky questions indeed! Let’s get to them one by one:

  1. I can think of at least two reasons behind the Delhi government’s decision. First, the high price might deter at least some folks from queuing up, and second, revenues will go up. Unfortunately, these reasons are contradictory! If crowds go down because of the high prices, surely revenue cannot go up at the same time? The answer, as any econ student will tell you, lies in computing the elasticity of demand for alcohol. See this video, for instance, on the topic.
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    Will the habitual drinker quit with such high prices under these circumstances?
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    Honest answer: who knows? You can spend the rest of your lives drawing diagrams and scribbling questions, but at the individual level, we simply don’t know. There are too many variables for us to get a reasonable answer (changes in income, length of the lockdown, the level of desperation for alcohol, the urge to stockpile in face of an uncertain future, for starters). The habitual drinker will certainly think twice, but beyond that nothing useful can, or should, be said. That is my opinion. It is not quite the same topic, but read this article, written by Banerjee and Duflo (and read both of their books!)
  2. I have only glanced through the two links I am sharing here, but hope to read them in more detail later. The first is an exercise in calculating the price elasticity of demand for households in India, and the second is a collation of a lot of studies done on the topic, but it deserves its own separate point…
  3. … not least because writing this blog post helped me learn about the existence of the Institute for Alcohol Studies! (Dear folks at the IAS, let me know if you are in need of test subjects). They have a page on the impact of price on alcohol, and worries about conflict of interest aside, the report that alcohol is relatively price inelastic.
  4. Both studies report much the same thing, although of course a whole host of other factors also come into play (level of education, extent of addiction being just two obvious ones). But long story short, for a one percent increase in price, you should expect demand to go down by less than one percent.
  5. But that still doesn’t answer Simran’s question: does poverty cause one to consume alcohol, or does the consumption of alcohol cause poverty? My honest answer is that we simply can never know for sure, and it is probably both, but hey, nothing should get between a tricky, potentially unanswerable question and econometrics! Knock yourself out!

 

Thank you for the questions, Simran! I enjoyed answering them 🙂

 

Applied Microeconomics

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Every single class that I teach, I end with a little tradition: students must ask me five completely random questions. These questions must necessarily have nothing to do with whatever it is that I taught in that class, but that apart, they can be about absolutely anything under the sun.

There are many, many reasons for this little exercise: a fun way to wrap up class, helps students ask better questions, keeps me on my toes are just three of them. One of the questions that I was asked recently was about the whole Kunal Kamra/Arnab Goswami incident.

Here’s the quick summary of how I answered that question in class: I am not (and this is putting it mildly) a fan of Arnab Goswami, but I wish Kunal Kamra had not done what he did.

In what follows, I try to think like an economist in explaining the latter half of the summary above.

  1. Many more people have a heightened awareness of both Kunal Kamra and Arnab Goswami than before the incident took place, and to the extent that their professions benefit from more publicity, they gain in this one regard. (It is, of course, more complicated and nuanced than that, but this is a blog post.)
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  2. One reason I wish Kunal Kamra hadn’t done what he did is because the ensuing publicity of the video normalizes heckling somebody on a flight/in a public space. Yes, I have seen the video in which Tejaswi Yadav was heckled by the Republic employee, and of course I wish that hadn’t taken place either. My point remains the same in both cases: it has become more acceptable to heckle somebody in a public space, and that isn’t great for civilized discourse.
    In economist-y terms, the price one pays in terms of social disapprobation is lower for everybody. In plain English, it is now ok to do that, is the message that people are left with.
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  3. Both points above taken together imply there is a higher benefit (in terms of attention on social media) to be gained at a lower cost (lower social disapproval), which should lead the economist to predict that we should see more such incidents take place in public. The point remains true no matter who is doing it to whom in terms of the (for lack of a better phrase) ideological divide.
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  4. But then again, the fact that the supply of such incidents will rise effectively means a shifting out of the supply curve (with the quantity of such incidents on the horizontal axis and time spent being informed of these incidents on the vertical one). In English, the more such incidents are reported, the less time we will spend thinking about them.
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  5. That will either disincentivize people from being a part of such incidents, or normalize it entirely to the point of it becoming almost banal. As a cynic, my bet is on the latter.
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  6. Which, by my standards, is society becoming definitively worse off.
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  7. And by that standard, my normative prescription is that one should not engage in heckling somebody in a public space…
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  8. … and, in equilibrium, one should also make this the last article about this topic! This applies as much, of course, to the writer as it does to the reader.

 

Addendum: a friend to whom I had sent this post for feedback pointed out that in equilibrium with regard to point 5., people will have to be ever more attention seeking. My friend was horrified by that conclusion, and I agree on both counts.

 

 

 

External Resources about Supply and Demand

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Where should you go online if you want to learn more about supply and demand?

Well, lots of places, really – but here’s a short list of the very best that is out there in making things simple and accessible.

A very good place to start (apart from the very beginning), is with the Principles of Economics section on Marginal Revolution University. Their very first video on the demand and supply section is here, and you can simply click upon the “Next Video” link to go through all of them.

The Wikipedia article is not bad, although a little wordy, in our opinion.

Here’s a simple post by a VC explaining how Uber uses these basic concepts to, well, run a business currently valued at $ 67 billion.

And of course, any and every text on economics will cover the topics we have spoken about here. Most of the links above, and all of the textbooks you might care to look at will be at a more complicated level than in our posts – but that’s the point. After you finish reading these, you should feel equipped to deal with the slightly more difficult ones.

Right, one topic from macroeconomics (the Solow Model) and one from microeconomics (the demand supply framework) down, and lots more to go. To keep things interesting, we’re now going to delve into an exciting area of economic research – behavioral economics. Starting with the next post!

Own Price, Cross Price and Income Elasticity

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We studied elasticity in a previous post:

The percentage change in quantity demanded, given a percentage change in price.

In today’s post, we expand the definition of elasticity a little. That naturally makes it a little complicated, but it also enriches our understanding of it – a good bargain.

What if the price of a substitute changes? What if, that is, the price of Coke changes a little. By what percentage will the quantity demanded of Pepsi change? The measurement of such a thing is called cross price elasticity (substitute).

The percentage change in quantity demanded, given a percentage change in the price of a substitute.

The first definition above is therefore the definition of own price elasticity, while the second one is of cross price elasticity. Cross price elasticity, naturally, will be of twp types – that of complements, and that of substitutes.

There is yet a fourth type of elasticity, called income elasticity of demand. As you might imagine, it is

The percentage change in quantity demanded, given a percentage change in income.

Say your income in a particular month goes down by 10 percent. Is it reasonable to imagine that you will therefore cut back on your consumption of movies in a theatre, or dinners in restaurants? Unless you are a hardcore movie buff, or love eating out a lot, the answer would probably be yes. The income elasticity of demand for these goods is therefore high.

On the other hand, will you cut back your consumption of pills prescribed by your doctor? Almost definitely not, right? The income elasticity of demand for these goods is therefore low.

And that concludes our series on the basics of supply and demand!

Here’s a quick recap:

The demand (and supply) of a good depends upon:

  1.  it’s own price
  2. the price of complements and substitutes
  3. it’s own price elasticity
  4. the cross price elasticities
  5. the income elasticity
  6. changing tastes and preferences
  7. changing incomes

As you can no doubt see, thinking about demand is fairly complex – but it is, nonetheless, rewarding. In the next post, we’ll give you a list of resources for learning more about demand and supply (as we did for the Solow model), and then begin a new topic.

Tastes, Preferences and Income

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Remember CD’s? They used to be the last word in convenient storage, and if you are of a particular age or higher “AVSEQ01.dat” will be a very evocative term indeed.

CD’s these days are available for around 15 rupees each, down from about 50 rupees a while ago, and maybe even higher. The law of demand that we have been learning about all this while suggests that the demand for CD’s should go up, since the price has come down.

Ah, but who uses CD’s these days? All the music you’d ever want to listen to and more is available on multiple streaming services. YouTube ensures that you have more video content to watch than is humanly possible, while services such as Netflix and Amazon Prime have made CD and DVD players ancient relics.

In other words, tastes and preferences of people have changed, and they will not want to buy CD’s, no matter the cost. So it’s not just the price of a good, nor that of complements and substitutes that matters – it also is whether or not you want to buy the good at all or not.

And to complicate matters even further, it’s not just tastes and preferences – it’s also income!

Remember dalda? Every Indian household used to use it in the 1980’s, but families today won’t go within sniffing distance of the stuff. That’s because, generally speaking, incomes have been rising, and households now have the money to make health-conscious choices – which means dalda is out, not matter the price.

And you could say the same thing for landlines, cassette recorders, cathode ray televisions, desktops, dumbphones – and that’s just from the world of electronics. As societies progress, they experience a rise in incomes and a change in tastes and preferences – and these things impact both the demand and supply of goods.

So, in a nutshell:

The price of a good, its elasticity, the price of its complements and substitutes, changes in incomes, tastes and preferences all impact the demand (and supply) of a particular good.

Next, we’ll take a look at cross price elasticity and income elasticity.

Complements and Substitutes

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Two simple concepts, but really important ones.

When we speak about the demand of, and the supply of any particular thing, it is impacted by a variety of factors. One of these factors is the existence of substitutes and complements.

What are substitutes, and what are complements?

Say you walk into a store at the height of summer, thirsting for a nice, ice-cold cola. If you ask for a can of Coke, and upon being told that Coke isn’t available but Pepsi is, drink that can of Pepsi – well, then, you have “substituted” Pepsi for Coke. Goods that can act as a replacement for each other are substitutes.

These substitutes can be near/far substitutes. If no cola drink is available, and you drink nimbu sharbat instead, that is also a substitute. If you just have a glass of water instead of  a cola, well, that is also a substitute. Pepsi would be a close substitute, while water, arguably would be a not so close substitute.

Complements, on the other hand, are things that go well with, or must be used with, the good in question. Who ever heard of a flat screen TV without a set-top box? Of what use is a plate of pakoras in the monsoons without a hot cup of adrak wali chai? These become complements.

Now the reason these concepts are important is because they help us predict demand better. Say Coke sells its cans for 30 rupees, but Pepsi lowers prices to 20. Will the demand for Coke go up or down? Down, naturally, because a close substitute is available at a lower price.

When the price of a close substitute goes up, the demand for the good in question rises, and vice versa.

Generally speaking the closer the substitute, the more worried you should be about the price. Maruti Suzuki won’t lose sleep over its pricing of the Alto if Rolls Royce ups the prices on its models. Strictly speaking, these are substitutes – but not really. On the other hand, if Hyundai lowers the price on Eon (a very close substitute to the Alto), Maruti Suzuki will pay very, very close attention.

Also, the higher the number of susbtitutes, the lesser your ability to raise prices. Who ever heard of a chaiwalla selling tea at 20? It simply doesn’t make sense, because you can typically walk less than 100 meters to find a another chaiwalla selling an equally good cup of tea for the going rate.

And what about complements? Well, it’s easy to think through this. If the price of set-top boxes rises, the demand for flat-screen TV’s will go down. Think about it – you have to factor in not just the cost of the TV, but also the thing that makes the TV useful in the first place. So as a whole package, if the cost is going to go up, well, demand will go down.

When the price of a complement goes up, the demand for the good in question falls, and vice versa.

Complements and substitutes affect the demand for goods, and are also important concepts in the field of marketing.

Next up, we’ll take a look at changing tastes and preferences.

Examples of elasticity

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Here’s a question for you: when was the last time you passed a petrol pump and saw a discount offer on fuel?

Unless you have a very vivid recollection of your dreams, the answer is always going to be: never.

And why am I able to say that so confidently? Because, in the lingo of the economist, petrol is an inelastic good. That is, as per our last post, the quantity demanded doesn’t decrease all that much, even for very large increases in price.

If society has to be able to move goods and people across long distances, one can’t yet escape the need to refuel vehicles. Mr. Musk is single-handedly trying to change the truth value of that statement, but as things stand, one can’t do without petrol. So even if prices were to be raised, demand wouldn’t change all that much. And which is why it doesn’t make sense to offer discounts on petrol either! Because, if you can sell high quantities without giving discounts – well then, why give discounts in the first place?

This is true for cigarettes too. Not matter what the price, people will buy. And which is why finance ministers in every budget feel very safe in raising the tax on cigarettes – because people will pay.

On the other hand, Myntra sells clothes people don’t especially need, and is one of a thousand sellers (online and offline) in the business of selling a bewildering variety of clothes. If Myntra wants people to buy from them, they’re going to have to offer those clothes at a discount. That’s elastic demand.

And in fact, that last point we made is crucial to understand about elasticity. If there are a number of alternatives available, the elasticity will be high. If there are a low number of alternatives available, the elasticity will be low.

So the trick, as an entrepreneur, is to build a product that people absolutely want to  -need to! – buy, but also build a product that has no real alternative. You may absolutely want a cup of chai in the evening, but there will be a dozen chaiwallahs in your neighbourhood. On the other hand, you may be the only seller selling neon pink umbrellas with prickly handles – there’s no real alternative to your product, sure – but people don’t seem to want to buy it.

Inelastic products hit that sweet spot that combine both of these features, and that allows the company responsible for that product to reap the profits. Apple is the easiest example around, but there are so many more examples around us. Perhaps the best way of understanding elasticity is to try and come up with some examples from the world around you. Give it a shot!

In the next post, we’ll take a look at two related concepts: complements, and substitutes.

Explaining Elasticity

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Open any micro textbook, and this is the definition of elasticity of demand that you will find (more or less):

“The percentage change in quantity demanded, given a percentage change in price”

Here is what it means, in practice. Say you’re a shopkeeper selling plain black umbrellas. Let’s say you sell them for a hundred rupees each. At this price, every month, you are able to sell 100 of them.

One especially sleepy Tuesday afternoon, you think to yourself that it’s been a while since I hiked the price at which I sell these umbrellas, so let’s start selling ’em at 110 rupees tomorrow.

All right, so do you still expect to sell 100 umbrellas this month, now that the price is 110 instead of 100? Do you expect to sell more than 100, less than 100? The answer to this question is the elasticity of demand for plain black umbrellas in your shop. One would think it’s fair to assume that the demand will go down with an increase in price. By how much, though?

There’s been a 10 percent increase in price. Will there be a 10 percent decrease in demand? If so, then the elasticity of demand for black umbrellas is -1. Economists usually leave out the “minus” since that’s more or less a given. If the percentage change in quantity demanded is the same as the percentage change in price, we say that the good in question has unitary elasticity.

What if there is a higher than 10 percent change in quantity demanded given a percentage change in price? What if, say, the percentage change in quantity demanded is 20 percent – what if you now sell only 80 umbrellas? In that case 20/10=2 – the elasticity will be 2.

Here’s the math: 20 percent because (80-100)/100=-20 percent, and 10 percent because (110-100)/100=10 percent.

We call the demand for such goods elastic. That is, a slight change in price leads to large changes in demand.

Similarly, if there is a small fall in demand – say, you sell 99 umbrellas instead of 100, elasticity in that case would be 0.1 (try and work out the math yourself). And we would then call the demand for this good inelastic. That is, changes in price have little to no impact upon quantity demanded.

If you’re learning about elasticity for the first time, though, it might be best to not get caught up in the math right away, and think through the intuition:

If I increase the price of a good a little bit, will the change in quantity demanded be as much as the change in price, or less, or more?

The quantifiable response to that question is the measurement of elasticity. It’s what allows Apple to never give a discount on their latest iPhones, and it’s what keeps goods on Myntra on near permanent sales.

And we’ll be taking a look at some real life examples in the next blog post!

 

3 factors that impact demand and supply

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The Gurugram story that we learnt about in the previous post was a fairly simple one. We spoke about how people on both sides of the divide (demand and supply) think about prices and therefore their decisions about how much to supply and how much to demand. Alas, if it were only that simple.

As it turns out, there are many, many other factors at play when it comes to thinking about demand and supply. In this post, we are going to list out these factors, and in the posts to follow, we’re going to speak about each one of them in turn.

First, the existence of things that may be substitutes, and things that may be complements to the thing being analyzed. For example, flats/apartments may be one thing, but what about bungalows? A bungalow is a substitute for an apartment. Will a change in the price of bungalows affect the demand for apartments? If so, how? Buying an apartment also means, presumably, hiring an interior decorator.  Will the rates being charged by an interior decorator impact the decision to buy a flat? This is the analysis of complementary goods and substitute goods – one part of the puzzle.

Second, a change in taste and preferences. For example, with a rise in incomes, people may not want to stay in apartments, but in bungalows. Conversely, if there is a fall in income, people may not want to stay in apartments, but in slums. These things also impact our analysis.

Third, how sensitive is demand to a change in price. Very large changes in prices may not impact the demand for cigarettes all that much (and any finance minister worth his salt will tell you this), while very small changes in price will change the demand for jewellery significantly.

Each of these are factors that impact significantly both the demand and supply of a good, as as we mentioned, in the three posts that follow, we will take a look at each one of them, beginning with the third factor listed above: elasticity.