CORE PRINCIPLES EXAMINATION: Model Answers and Comments. AEF811 (I) UNIVERSITY OF NEWCASTLE UPON TYNE MSc in INTERNATIONAL AGRICULTURAL MARKETING

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1 AEF811 (I) UNIVERSITY OF NEWCASTLE UPON TYNE MSc in INTERNATIONAL AGRICULTURAL MARKETING International Agricultural & Food Markets Model Answers 1. (a) Distinguish between income elasticity of quantity demanded and income elasticity of expenditure and explain why they may differ significantly for some food products but not for others. Income elasticity of demand ( ) = (% Qd)/(% Y), where Qd is quantity demanded, and Y is income, and signifies change in. The elasticity indicates the proportional change in quantities demanded (purchased) with income changes. So, if income increase by 1%, d shows the % change in quantities purchased. If = 0.5, for instance, then Qd would increase by 0.5% with a 1% increase in income. Income elasticity of expenditure (Ë) shows the proportional increase in spending on a good (Ed) per unit proportional change in income, and is defined as (% Ed)/(% Y). But expenditure Ed is equal to P * Qd, where P is the average price per unit paid for the good. So Ë can be thought of as the sum of and % P/% Y (the elasticity of average price paid per unit with income, which could be denoted Æ). Therefore, = Ë + Æ So, unless Æ for a good is zero, and Ë will be different. Æ indicates the extent to which consumers trade up market as their incomes increase, increasing the average price they pay for a good as they become richer. Thus, for beef, it is likely that consumers will tend to buy more steak and less mince as they become richer, thus increasing the average price they pay per kg. of beef, though their total consumption of beef (kgs.) may not change or even fall. In this case may be zero or even negative, but Ë may be positive, since Æ is positive. The difference for products such as corn flakes or baked beans or frozen chips is likely to be small to nonexistent, since the price-product range for these products tends to be small (little difference between the product alternatives and their prices). It is possible to interpret Æ as an elasticity of quality (where we measure quality only in terms of price per unit) (b) What is the difference between an inferior and a normal good? Give examples of food products which you think may be inferior goods in your own country. A normal good is one for which consumption increases as income increases (for which is positive). An inferior good is one for which consumption decreases as people become richer ( is negative). In the UK, it is likely that white sliced bread and potatoes will show estimates of as negative. In Japan, it is possible that is negative for rice. In other coutries, staple food products might tend to show negative at relatively low income levels. It is also posisble that many goods might become inferior at very high income levels, as people become satiated with more than enough of the goods and services. Prof. David Harvey, AEFM, Oct

2 (c) What is the difference between an income elastic and an income inelastic food product. Would you expect most food products to be income elastic or income inelastic? Income elastic indicates that consumption increases for this product by a greater proportion than income ( > 1). Income inelastic goods have <1, though 0. The implication is that total expenditure on income inelastic goods will not increase as fast as incomes (given Æ = 0, see (a) above). The proportion of total spending in an economy on income inelastic goods will fall as incomes (and spending) increase. Most food products, at least in richer countries, are income inelastic - since the capacity of peoples stomachs is very limited compared with their appetites for other (nonfood) goods and services. As they get richer, they spend proportionately more on other things than on food. However, one might expect some food products to be income elastic ( >1), such as the more exotic products (fresh fruit and vegetables out of season, more expensive cuts of meat. [Note: As a consequence, those who are trying to make a living from selling food will find that they can earn a falling proportion of the total spending in the economy as the economy grows - so, in order to maintain their income levels, either some people must leave the food sector, or they must start to sell other things than just food (such as additional preparation, packaging, cooking etc. - adding value to the food before they sell it to the consumers.] (d) Explain why the proportion of household income spent on food declines as income increases. Essentially the same as above, except that this question refers to spending (Ë) rather than quantity ( ). As household income increases, they spend their additional income on other things than more food, such as consumer durables, holidays, better houses, etc. This relationship is often known as Engle s Law, after Frederich Engle who first formulated the proposition. However, people may spend more income on eating out or buying better prepared or more exotic foods, thus showing Æ > 0, Ë will still tend to be < 1. Comment on answers: In general, this question was done reasonably well. Prof. David Harvey, AEFM, Oct

3 2 In a particular country, the annual consumption of butter is 1,000 tonnes and the price 100 per tonne. There is no international trade in butter. I) Draw a diagram to show the affect on this country s butter market of the introduction of a Government subsidy on butter consumption of 10 per tonne. Notice: a subsidy of 10/tonne in effect means that when consumers spend 100 per tonne, they are in fact buying butter at 110 per tonne, because the government provides an additional 10/t. This could be represented as a 10/t upward shift of the demand curve - to D in the diagram (in spite of good advice only to shift demand or supply curves horizontally, not vertically). However, since the subsidy really doesn t alter the underlying demand conditions at all, some people (DRH included) prefer not to shift either demand or supply curves to represent subsidies or taxes, but simply represent subsidies (or taxes) as wedges between static underlying demand and supply curves, separating the price paid (demand price) from the price received (supply price) by a vertical distance at a common traded quantity. See comments on the exam performance below. II) Explain how the impact of the subsidy on producers and consumers is influenced by whether the demand and supply of butter is price elastic or price inelastic. Twisting the demand curve (for instance) around the current equilibrium point ( 100/t; 1,000 t) is equivalent to changing the elasticity of demand at that point. If the curve is twisted clockwise, making it steeper, demand will be less elastic, more inelastic than before. The effect of this is reduce the quantity increase as a consequence of the subsisdy, and to reduce the price increase effect of the subsidy for suppliers, increasing the price reduction effect for buyers (consumers). Hence, if the intention of the subsidy is to help consumers, it will be more effective in reducing consumer prices the more inelastic is the demand Prof. David Harvey, AEFM, Oct

4 curve. Similarly with the supply curve, where the more elastic is the supply, the more effective will be a subsidy in reducing consumer prices, while the more inelastic is supply (other things being held constant) the more effective will the consumer subsidy be in raising producer prices. Notice: although governments frequently talk of either consumption or production subsidies, there is no real difference between the two (at this level of analysis). A subsisdy will increase producer or supply price AND reduce demand or buying price, regardless of who is first paid the subsidy. III) Explain what you would expect to happen to Government spending on the butter subsidy if there is a subsequent fall in the price of margarine. A fall in the price of margarine will be expected to shift the demand curve for butter to the left, since margarine is a substitute for butter (reducing the price will encourage consumption of marg. and thus reduce the demand for butter). The effect of this will be to reduce the government spending on the butter subsidy (shown in the above diagram as the shaded area = (Pp - Pc) * Qt). Shifting the demand curve to the left will necessarily make this area ( 000) smaller, since the new equilibrium Qt will be less than before, while the subsidy per tonne is constant at 10/t. Comment on Exam answers: This question was poorly done by nearly all of you. You demonstrate that you have not really understood what these market diagrams tell us and how to use them effectively yet. You will need to get to grips with this logic to make the most of the rest of the course. Many of you tried to shift demand curves or supply curves, without obviously knowing what you were trying to represent, but just remembering that this is how the textbooks illustrate the issue, and consequently getting in a real muddle. The supply curve will have to shift was a frequent remark in the answers - wrong. The supply curve only shifts as and when there is good reason for it to (such as a change in the input costs, or the price of a competing or complementary product on the supply side), not simply to make the analysis work! 3 Return to the original situation in Question 2 (before the introduction of a subsidy), with annual consumption of butter at 1,000 tonnes at a price of 100 per tonne. Suppose this country now becomes open to international trade; suppose, too, that we can represent the rest of the world as a single market in which the current consumption and production of butter is 10,000 tonnes and the price is 40 per tonne. I Explain, with diagrams, what the consequences of this move to free trade would be for both the country and the rest of the world. Traders will seek to buy butter in the rest of the world - for 40/t. and sell it in this country (1) for 100/t, and thus make money. As they do so, however, they will necessarily raise the price in the rest of the world and reduce it in country 1. Thus, as the price is bid up in the rest of the world, so quantity supplied increases and quantity demanded falls, relaeasing a balance for export - the export or excess supply curve. Similarly in Country 1, where the fall in price reduces domestic supplies and increases local demand quantities - expressed as an import or excess demand curve. The equilibrium outcome is determined as below: Prof. David Harvey, AEFM, Oct

5 So, trade improves the position of the rest of the world s producers, who get a higher price and produce more, and this country s (1) consumers, who find their price reduced and consume more. On the other hand, producers in this country (1) and consumers in the rest of the world are worse off with trade than without it. The gainers gain more than the losers lose, though we have not yet covered the full logic of this conclusion. II Comment on whether it would be sensible for a country to introduce a subsidy on domestic consumption in the case of an internationally traded product. What would such a subsidy do? It would reduce the price paid by country 1 consumers, so they would buy more. From whom? Not from local producers, who would not be able to increase their supply, since their price has not changed. So imports would have to increase - but how? Only if the prices paid to the rest of the world increase to encourage supply in the RoW (and discourage demand). In effect, subsidising consumption in country one is equivalent to driving a wedge between the excess demand and the excess supply curves in the trade diagram (middle of the above diagram, pushing the price up in the exporting country (the Rest of the World) and down in the importing country (country 1). So Country 1 would be subsidising producers in the rest of the world, as well as consumers at home, at the expense of domestic producers and foreign consumers. Why does this make sense? I don t think it does. Comments on exam answers: Again, not well done, though some of you managed to get the basics OK. Some provided sensible answers to part 2 which were not quite along the lines suggested above, and were rewarded accordingly. Part 2 of this question was deliberately rather open-ended, allowing more than one answer. This is a common exam (and real life) occurrence, so you should be prepared for it. Prof. David Harvey, AEFM, Oct

6 General Comments on Examination Performance. First - do not be discouraged that your general performance was rather weak in this examination. We are only five weeks into the course, and we would not expect all of you tohave fully mastered these concepts yet. Your exam result should, however, give you a reasonable indication of how much you still need to do. 2nd. A number of you clearly had difficulty in managing the answers in the time allowed. This is a familiar problem and one that you will need to maste quickly - do not spend time presenting information that is not directly relevant to the question, and make sure that you answer the question as succinctly as possible. Allocate your time in the examination proportionately between questions - if each question carries equal marks (as they do unless you are told otherwise), then do not spend all your timeon the first one, and leave yourself no time for the rest. Remember - the first few marks for a question are rleatively easy to collect - you only have to say something sensible. After that, further marks become more and more difficult to collect - however long you spend on the answer, and you run the risk of spoiling a good answer by adding things in which are not clear or ar wrong. 3rd. Your general understanding of the market diagrams (questions 2 and 3) need more work and thought. You should practice using these concepts, as indeed you will be asked to in the rest of the course. Prof. David Harvey, AEFM, Oct