Can good news for the computing industry be bad news for computer chip man- ufacturers? Why do the prices of ski holidays in Europe rise dramatically over public and school holidays? Does drug prohibition increase or decrease drug- related crime? At first, these questions might seem to have little in common. Yet all three questions are about markets and all markets are subject to the forces of supply and demand. Here we apply the versatile tools of supply, demand and elasticity to answer these seemingly complex questions.
Can Good News for the Computer Industry Be Bad News for Chip Makers?
Let’s now return to the question posed at the beginning of this chapter: what happens to chip manufacturers and the market for chips when scientists discover a new material for making chips that is more productive than silicon? Recall from Chapter 4 that we answer such questions in three steps. First, we examine whether the supply or demand curve shifts. Secondly, we consider which direc- tion the curve shifts. Thirdly, we use the supply and demand diagram to see how the market equilibrium changes.
This is a situation that is facing chip manufacturers. Scientists are investigating new materials to make computer chips. Such a material may allow the manufac- turers to be able to work on building processing power at ever smaller concentra- tions and increase computing power considerably. In this case, the discovery of the new material affects the supply curve. Because the material increases the amount of computing power that can be produced on each chip, manufacturers are now willing to supply more chips at any given price. In other words, the sup- ply curve for computing power shifts to the right. The demand curve remains the same because consumers’ desire to buy chips at any given price is not affected by the introduction of the new material. Figure 5.8 shows an example of such a change. When the supply curve shifts from S1to S2, the quantity of chips sold increases from 100 to 110, and the price of chips falls from €10 per gigabyte to
€4 per gigabyte.
But does this discovery make chip manufacturers better off? As a first stab at answering this question, consider what happens to the total revenue received by chip manufacturers; total revenue is P × Q, the price of each chip times the quan- tity sold. The discovery affects manufacturers in two conflicting ways. The new material allows manufacturers to produce more chips with greater computing power (Q rises), but now each chip sells for less (P falls).
Whether total revenue rises or falls depends on the elasticity of demand. We can assume that the demand for chips is inelastic, in producing a computer, chips represent a relatively small proportion of the total cost but they also have few good substitutes. When the demand curve is inelastic, as it is in Figure 5.8, a decrease in price causes total revenue to fall. You can see this in the figure: the price of chips falls substantially, whereas the quantity of chips sold rises only slightly. Total revenue falls from €1 000 to €440. Thus, the discovery of the new material lowers the total revenue that chip manufacturers receive for the sale of their products.
If manufacturers are made worse off by the discovery of this new material, why do they adopt it? The answer to this question goes to the heart of how com- petitive markets work. If each chip manufacturer is a small part of the market for chips, he or she takes the price of chips as given. For any given price of chips, it is better to use the new material in order to produce and sell more chips. Yet when all manufacturers do this, the supply of chips rises, the price falls and man- ufacturers are worse off.
FIGURE 5.8
An Increase in Supply in the Market for Computer Chips
When an advance in chip technology increases the supply of chips fromS1toS2, the price of chips falls. Because the demand for chips is inelastic, the increase in the quantity sold from 100 to 110 is proportionately smaller than the decrease in the price from€10 to€4. As a result, manufacturers’total revenue falls from€1 000 (€10 × 100) to€440 (€4 × 110).
m3
2
Quantity of chips 100
0 Price of chips
3. . . . and a proportionately smaller increase in quantity sold. As a result, revenue falls from m300 to m220.
110
Demand S1
S2 2. . . . leads
to a large fall in price . . .
1. When demand is inelastic, an increase in supply . . .
Although this example is only hypothetical, in fact a new material for making computer chips is being investigated. The material is called hafnium and is used in the nuclear industry. In recent years the manufacture of computer chips has changed dramatically. In the early 1990s, prices per megabyte of DRAM (dynamic random access memory) stood at around $55 but fell to under $1 by the early part of the new century. Manufacturers who were first involved in chip manufacture made high profits but as new firms joined the industry, supply increased and as the technology also spread, supply rose and prices fell. The fall in prices led to a number of firms struggling to stay in business. We assumed above that computer chip manufacturers were price takers but in reality the com- puter chip market is not perfectly competitive. However, the fact that so many smaller manufacturers struggled to survive as chip technology expanded at such a rapid rate from the early 1990s shows that even markets dominated now by a relatively small number of firms exhibit many of the features we have described so far.
When analysing the effects of technology, it is important to keep in mind that what is bad for manufacturers is not necessarily bad for society as a whole.
Improvement in computing power technology can be bad for manufacturers who find it difficult to survive unless they are very large, but it represents good news for consumers of this computing power (ultimately the users of PCs, lap- tops and so on) who pay less for computing.
Why Do Prices of Ski Holidays Differ so Much at Different Times of the Season?
Ski holidays in Europe are becoming ever more popular. There were an estimated 1.3 million people from the UK taking holidays in European ski resorts in 2010.
For an increasing number of people the pleasure of a holiday on the slopes is a part of the winter but people also face considerable changes in the prices that they have to pay for their holiday. For example, a quick check of a ski company website for the 2010–11 season revealed the prices shown in Table 5.1 for 7-night ski trips, per person to Austria leaving from London.
There is a considerable variation in the prices that holidaymakers have to pay – £710 being the greatest difference. Prices are particularly high leaving on 26 December and 20 February – why? The reason is that at this time of the season the demand for ski holidays increases dramatically because they coincide with annual holiday periods; 26 December is part of the Christmas holidays and when schoolchildren are also on holiday; 20 February is also a major school holi- day for many UK children (although some also have a break which includes or occurs the previous week).
TABLE 5.1
Prices of 7-night Ski holidays in Austria, from London
Departure date Price per person (£)
5 December 2010 470
26 December 2010 1 000
16 January 2011 650
5 February 2011 670
13 February 2011 720
20 February 2011 1 180
27 February 2011 700
WWW.CARTOONSTOCK.COM
The supply of ski holidays does have a limit – there will be a finite number of accommodation places and passes for ski-lifts and so the elasticity of supply is relatively inelastic (see Figure 5.9). It is difficult for tour operators to increase supply of accommodation or ski-passes easily in the short-run in the face of rising demand at these times. The result is that the increase in demand for ski holidays at these peak times results in prices rising significantly to choke off the excess demand. If holidaymakers are able to be flexible about when they take their holidays then they will be able to benefit from lower prices for the same holiday. Away from these peak periods the demand for ski holidays is lower and so tour operators have spare capacity – the supply curve out of peak times is more elastic in the short run. If there was a sudden increase in demand in early December, for example, then tour operators would have the capacity to accommodate that demand so prices would not rise as much as when that capacity is strictly limited.
Cases for which supply is very inelastic in the short run but more elastic in the long run may see different prices exist in the market. Air and rail travel and the use of electricity may all be examples where prices differ markedly at peak times compared with off peak times because of supply constraints and the ability of firms to be able to discriminate between customers at these times.
Does Drug Prohibition Increase or Decrease Drug-related Crime?
A persistent problem facing society is the use of illegal drugs, such as heroin, cocaine, marijuana and ecstasy. Drug use has several adverse effects. One is that
FIGURE 5.9
The Supply of Ski Holidays in Europe
Panel (a) shows the market for ski holidays in off-peak times. The supply curveS1is relatively elastic in the short-run.
An increase in demand fromD1toD2at this time leads to a relatively small increase in price because the increase can be accommodated by releasing some of the spare capacity that tour operators have. Panel (b) shows the market during peak times. The supply of holidays shown by the curveS1is relatively inelastic in the short run. If demand now increases fromD1toD2the result will be a sharp rise in price.
(b) Peak times
750 1100
1350 1300
Quantity of ski holidays bought and sold (000s) S1
D1 D2
Price of ski holidays per person (£) (a) Off peak
450 510
S1
D1 D2
340 250
Quantity of ski holidays bought and sold (000s) Price of ski holidays
per person (£)
drug dependency can ruin the lives of drug users and their families. Another is that drug addicts often turn to robbery and other violent crimes in order to obtain the money needed to support their habit. To discourage the use of illegal drugs, European governments devote billions of euros each year to reduce the flow of drugs into their countries. Let’s use the tools of supply and demand to examine this policy of drug prohibition.
Suppose the government increases the number of undercover police devoted to the war on drugs. What happens in the market for illegal drugs? As is usual, we answer this question in three steps. First, we consider whether the supply or demand curve shifts. Secondly, we consider the direction of the shift. Thirdly, we see how the shift affects the equilibrium price and quantity.
Although the purpose of drug prohibition is to reduce drug use, its direct impact is on the sellers of drugs rather than the buyers. When the government stops some drugs from entering the country and arrests more smugglers, it raises the cost of selling drugs and, therefore, reduces the quantity of drugs supplied at any given price. The demand for drugs – the amount buyers want at any given price – is not changed. As panel (a) of Figure 5.10 shows, prohibition shifts the supply curve to the left from S1 to S2 and leaves the demand curve the same.
The equilibrium price of drugs rises from P1to P2, and the equilibrium quantity falls from Q1to Q2. The fall in the equilibrium quantity shows that drug prohibi- tion does reduce drug use.
FIGURE 5.10
Policies to Reduce the Use of Illegal Drugs
Drug prohibition reduces the supply of drugs fromS1toS2, as in panel (a). If the demand for drugs is inelastic, then the total amount paid by drug users rises, even as the amount of drug use falls. By contrast, drug education reduces the demand for drugs fromD1toD2, as in panel (b). Because both price and quantity fall, the amount paid by drug users falls.
P2
P1
Quantity of drugs
0 Q2 Q1
Price of drugs
Demand S2
S1
Q2 Q1
(a) Drug prohibition
Quantity of drugs 0
Price of drugs
Supply
D2
D1
(b) Drug education
3. . . . and reduces the quantity sold.
2. . . . which raises the price . . .
2. . . . which reduces the price . . .
P1
P2
1. Drug prohibition reduces the supply of drugs . . .
1. Drug education reduces the demand for drugs . . .
3. . . . and reduces the quantity sold.
But what about the amount of drug-related crime? To answer this question, consider the total amount that drug users pay for the drugs they buy. Because few drug addicts are likely to break their self-destructive habits in response to a higher price, it is likely that the demand for drugs is inelastic, as it is drawn in the figure. If demand is inelastic, then an increase in price raises total revenue in the drug market. That is, because drug prohibition raises the price of drugs proportionately more than it reduces drug use, it raises the total amount of money that drug users pay for drugs. Addicts who already had to steal to sup- port their habits would have an even greater need for quick cash. Thus, drug prohibition could increase drug-related crime.
Because of this adverse effect of drug prohibition, some analysts argue for alternative approaches to the drug problem. Rather than trying to reduce the supply of drugs, policy makers might try to reduce the demand by pursuing a policy of drug education. Successful drug education has the effects shown in panel (b) of Figure 5.10. The demand curve shifts to the left from D1to D2. As a result, the equilibrium quantity falls from Q1 to Q2, and the equilibrium price falls from P1to P2. Total revenue, which is price times quantity, also falls. Thus, in contrast to drug prohibition, drug education can reduce both drug use and drug-related crime.
Advocates of drug prohibition might argue that the effects of this policy are different in the long run from what they are in the short run, because the elastic- ity of demand may depend on the time horizon. The demand for drugs is proba- bly inelastic over short periods of time because higher prices do not substantially affect drug use by established addicts. But demand may be more elastic over lon- ger periods of time because higher prices would discourage experimentation with drugs among the young and, over time, lead to fewer drug addicts. In this case, drug prohibition would increase drug-related crime in the short run while decreasing it in the long run.
Quick Quiz How might a drought that destroys half of all farm crops be good for farmers? If such a drought is good for farmers, why don’t farmers destroy their own crops in the absence of a drought?
I N T H E N E W S
Cutting Price in the Console Wars
When firms make pricing decisions, they will have to consider both the short-run and long-run effects, and price elasticity will almost certainly play some part in decision-making. This article looks at pricing of games consoles.
During the summer of 2009 rumours had been circulating suggesting that Sony was planning to cut the price of its PlayStation 3 (PS3) in the face of com- petition from other games consoles.
The market was in a position where there were no plans by any of the main players in the market to release new consoles. As a result, price was being seen as a way in which games
console manufacturers might be able to compete for sales. Sony’s PS3 has not taken off in the same way as the launch of its previous versions and part of the reason has been the existence of
CONCLUSION
According to an old quip, even a parrot can become an economist simply by learning to say ‘supply and demand’. These last two chapters should have con- vinced you that there is much truth in this statement. The tools of supply and demand allow you to analyse many of the most important events and policies that shape the economy. You are now well on your way to becoming an econo- mist (or, at least, a well educated parrot).
cheaper consoles such as Microsoft’s Xbox 360, which retailed upwards of
£129 (€150) and Nintendo’s Wii, which sold at around £169 (€196). The PS3 was retailing at around the £300 (€350) mark but at a press conference ahead of the Game.Com show in Cologne in August, Sony officials announced that the price would be cut. In Europe the PS3 would sell for€299, £249.99 in the UK and $299 in the US.
A new slimmer version of the PS3, which uses 34 per cent less power and is over a third lighter and around a third smaller was to be released in Septem- ber. Production of existing PS3 con- soles would cease and the price
reductions would take place immedi- ately. Part of the reason for the price cut is that figures show it is very effec- tive in generating sales. Sony was hop- ing that the price elasticity of demand in the short run for the PS3 would be sufficiently elastic to generate increased sales and more than cover the lost revenue resulting from the lower price. In considering the price reduction Sony would have had to con- sider the reaction of its rivals, Nintendo, manufacturer of the Wii, and Microsoft who make the Xbox 360. In addition, it would be looking at the extent to which these rival products were substitutes to a PS3 in consumers’minds and the role
of complements – the various games which users can buy for the console.
Analysts suggested that any price cut by Sony would be met with similar tac- tics from Microsoft and Nintendo. The size of those cuts and whether they will indeed follow suit and when, will influ- ence the size of the effect on sales and thus total revenue for Sony.
Reports in early 2010 suggest that the price cut may have had some effect. In the final five weeks of 2009, Sony announced that it had sold 3.8 million consoles worldwide. This represented an increase of 76 per cent on the equivalent period in 2008.
S U M M A R Y
• The price elasticity of demand measures how much the quantity demanded responds to changes in the price.
Demand tends to be more elastic if close substitutes are available, if the good is a luxury rather than a necessity, if the market is narrowly defined or if buyers have
substantial time to react to a price change.
• The price elasticity of demand is calculated as the per- centage change in quantity demanded divided by the per- centage change in price. If the elasticity is less than 1, so that quantity demanded moves proportionately less than the price, demand is said to be inelastic. If the elasticity is greater than 1, so that quantity demanded moves propor- tionately more than the price, demand is said to be elastic.
• Total revenue, the total amount paid for a good, equals the price of the good times the quantity sold. For inelastic demand curves, total revenue rises as price rises. For elastic demand curves, total revenue falls as price rises.
• The income elasticity of demand measures how much the quantity demanded responds to changes in consumers’
income. The cross-price elasticity of demand measures how much the quantity demanded of one good responds to changes in the price of another good.
• The price elasticity of supply measures how much the quantity supplied responds to changes in the price. This elasticity often depends on the time horizon under consideration. In most markets, supply is more elastic in the long run than in the short run.
• The price elasticity of supply is calculated as the per- centage change in quantity supplied divided by the per- centage change in price. If the elasticity is less than 1, so that quantity supplied moves proportionately less than the price, supply is said to be inelastic. If the elasticity is greater than 1, so that quantity supplied moves propor- tionately more than the price, supply is said to be elastic.
• The tools of supply and demand can be applied in many different kinds of markets. This chapter uses them to analyse the market for computer chips, the market for ski holidays and the market for illegal drugs.